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Nonqualified Successes

A boom in ''top hat'' deferred compensation programs spurs companies to compare funding methods.
Jinny St. Goar, CFO Magazine
October 1, 1999

Like most companies, Boston Edison Co. likes to avoid unpleasant surprises. So last year, the utility chose to fund its nonqualifed deferred compensation plan with investments that mimic the securities in its established tax-sheltered 401(k) plan. The nonqualifed plan, a "top hat" designed to provide retirement benefits for senior managers, already had been fully funded for several years -- using corporate-owned life insurance, or COLI. But by setting up a new approach that tracks the 401(k)'s performance, "we now have the best program imaginable," declares Donald Anastasia, Boston Edison's assistant treasurer.

The Massachusetts utility is in good company. At hundreds of corporations around the United States, finance executives are reviewing their funding choices for those deferred compensation plans that don't meet Internal Revenue Service tax-exemption standards-- hoping to get balance-sheet protection for the programs that serve the retirement needs of employees paid more than the maximum salary the IRS allows. Between 65 and 70 percent of concerns with more than 5,000 employees have top hats, according to New York­based Buck Consultants, specialists in deferred benefits planning. That's up from 55 to 60 percent five years ago.

For the most part, the pursuit of funding for such liabilities is a recent development. Until 1992, few companies bothered to arrange funding for their top hats at all. Instead, they managed retirement benefits for the upper ranks of management--which were generally paid out in a lump sum at the point of retirement-- on a pay-as-you-go basis. "As long as these liabilities were not so large as to be unmanageable, and the company was earning a more-than-average return on capital, then it made sense to finance the lump sums out of profits," says Gordon Gould, chief actuary at Towers Perrin, an HR management consulting firm. (About half the companies with nonqualified plans still forgo formal funding for them.)

As 1993 approached, however, pressure on big companies to arrange funding increased sharply. That year, Congress declared that employees earning more than $150,000 couldn't qualify for tax-sheltered 401(k) contributions. (The ceiling, which previously had been $235,840, has since been allowed to creep up to $160,000. Another boost in the ceiling, to $200,000, is now being considered.) With the ceiling set to be lowered, companies rushed to create or extend nonqualified plans--of either the defined- benefit or the defined-contribution variety -- and the number of participants in such plans grew exponentially. In 1992, new nonqualified- plan filings with the Labor Department surged from 1,842 to 6,619, and filings have topped 4,500 each year since.

While reliable statistics on top hats are rare -- the government doesn't compile such data--Buck Consultants estimates that about $3 billion is likely deferred each year, based on reasonable assumptions about how many employees companies make eligible. And with plans in place, companies have expanded them by including lower-paid executives as well. Indeed, in 1998, the Los Angeles­based compensation and benefits strategy firm Compensation Resource Group found that 53 percent of Fortune 1,000 companies offered nonqualified benefits to employees earning less than $100,000 a year.

As nonqualified-plan participants have increased, so also has the importance of the plans as a source of retirement income. "As much as 90 percent of a CEO's retirement income can come from a nonqualified plan," says Chris Rich, president of Lyons Compensation & Benefits LLC, a Waltham, Massachusetts-based benefits consulting group.

But it is the funding of the plans that has become a priority for finance departments of late. And there, CFOs have two major choices: setting up a trust containing a portfolio of investments, or tying benefits to COLI outside of any trust arrangement.

Blessings from a Rabbi Trust
Hewlett-Packard Co. has put a lot of work into its top-hat funding arrangements. For years, the huge Palo Alto, California-based computer maker chose the pay-as-you-go approach, and the liability associated with the plan was credited only at a rate of return linked to a fixed-income instrument. "But for the security of the benefits -- basically for the peace of mind of the executives whose assets are held in trust--we decided to purchase real assets in 1996," says Jean-Claude Gauthier, global benefits financing manager, who oversees the financing of HP's benefits programs around the world.

Gauthier, like the finance executives at many companies, chose something called a rabbi trust to help fund his company's top hat. Under a rabbi trust (so named because the first one was created by a rabbi who wanted to assure that his pension would be portable if he switched synagogues), the employer gets to set aside funds in an irrevocable grantor trust. The trusts are the most common funding structures for nonqualified plans, although trust assets cannot be insulated from general creditors in bankruptcy filings--the trade-off that makes the set-aside for executives acceptable to the government.

HP finances its rabbi-trust assets with an institutional index fund linked to the Standard & Poor's 500. The fund, purchased from The Vanguard Group, was chosen specifically because of its tax implications. With the fund's low turnover in assets, taxable capital gains are kept to a minimum. That's important, because tax issues plague nonqualified plans, even if they use rabbi trusts.


One problem, of course, is that in any compensation deferral, the company loses its deduction for that portion of the executive's income. Another problem is that the income to the fund is taxable. "Based on several assumptions, we have figured the cost of that tax drag at about 20 percent of the expected return on the S&P 500," explains Gauthier. HP splits the 20 percent down the middle with the executives whose compensation is being deferred. The company has the advantage of being able to take the 70 percent deduction for dividends received, which is unavailable to executives.

But dividing the 20 percent impact between the company and the executives can go either way, notes Gauthier. So, if the S&P 500 index declines in a year, the executive and the company share the tax loss, instead of paying taxes.

Insurance for Retirement Pay
Other companies have preferred to fund their top hats without a rabbi trust, setting up corporate-owned insurance as its main funding vehicle.

COLI plans were popularized by the insurance brokers that stepped in to fill the needs of senior management as their rights to tax- exempt pension benefits deteriorated. More than half the top hats offered by companies involve corporate-owned insurance in some way. And, as of last year, according to a William M. Mercer Inc. survey, 11 percent of companies with nonqualified plans funded them using COLI, without benefit of a rabbi trust. COLI policies cover the lives of the top-hat participants. The premiums are not terribly costly, because these instruments act like all life insurance policies, with their cash value accumulating annually on a tax-free basis.

But COLI has presented an array of problems. Some companies see "structural" conflicts. Life insurance is generally held until death, and paying an annuity or a lump sum before death is "a fundamental mismatch," according to Towers Perrin's Gould. The contradiction was one reason Boston Edison chose to abandon COLI, says assistant treasurer Anastasia.

Even if a company isn't worried about the mismatch, returns are often modest, and fees and costs associated with COLI plans are considerable. State and federal premium taxes can be as high as 2.5 percent--levied annually. And one-time fees include deferred acquisition charges, underwriting charges, and financial reporting charges, for a total of 1 to 5 percent of the initial premium. Finally, to cover the insurer's profits, risk charges are levied out of assets at between 25 and 50 basis points (0.25 percent to 0.5 percent). On top of all these nicks, funds invested in equities incur the standard brokerage fees for trading, along with asset-based annual investment management fees.

COLI Considerations
Corporate-owned life insurance also developed a bit of a bad name with some finance executives in the 1980s, in part because of the aggressive sales techniques developed by companies that sold the plans. Sales personnel for a time were drawn by high commissions of up to 30 percent -- they are now far lower -- and the product they delivered often didn't live up to the buyers' expectations. Further, in 1986, Congress removed some of COLI's allure by severely limiting the ability of companies to borrow money against the cash value of their policies. Companies had often used the borrowed money to pay subsequent COLI premiums, and took deductions on the interest on their loans.

The problems involving COLI sales largely have been remedied, though. And insurance-backed deferred compensation makes particular sense in certain specific circumstances. Because banks have to hold capital in reserve to meet the Bank of International Settlements's capital standards, for example, such regulated financial institutions can tuck Treasurys into a COLI wrapper, with those government securities counting toward the bank's required reserves, notes Gordon Gould.

Generally, though, the most efficient use of capital is the critical consideration in selecting between COLI funding and market funding for deferred compensation plans. Gould notes that if a company is borrowing funds to back the insurance, its return on invested capital must exceed the rate of return generated by whatever investment vehicle the COLI package uses. Otherwise, the COLI product does not make sense.

Corporate finance officials considering a COLI approach should also be selective about what cost comparisons are used. Lyons's Rich raises the case of a company with a 12-to-15 percent weighted average cost of capital, but with an equity cost of about 15 percent, and an aftertax cost of debt that is only 5 percent or below. "You could look at just the cost of debt here, to compare with your COLI returns of 7 percent," Rich points out. That might give a company a faulty indicator, given the higher returns on cost of capital and equity. "the issue is not black and white."

The use of COLI for top-hat funding has apparently been shrinking. "Initially, there was enormous confusion as to why to fund, and then about the funding vehicles themselves," says Lyons's Chris Rich. "The funding decisions were being driven by the [COLI] product salespeople," who often were drawn by the large commissions.

The question of the appropriateness of insurance backing was yet another spur for Boston Edison to review its original COLI- funded top hat, and and to start funding with "mirror 401(k)" investments, through a rabbi trust. The tax liabilities on the investment plan for the nonqualified program are entirely shouldered by the company, and "we consider these taxes to be a normal cost of doing business," says Anastasia.


Still, the insurance vehicle is always an option, even among finance executives who have rejected using COLI for now. "I get many people making sales calls to promote the use of COLI, and have taken serious looks at the products," reports Hewlett-Packard's Gauthier. "I would not preclude [my company from] using COLI," he adds.

When to Stay Put
Companies that can't make use of a rabbi trust for some reason often have little choice but to stick with the pay-as-you-go approach. At Champion International Corp., a Stamford, Connecticut-based forest-products producer, for example, vice president of finance and treasurer Thomas L. Hart is keeping his company's nonqualified deferred compensation plan unfunded. "The company's history of profitability in the highly cyclical pulp-and- paper industry is erratic," he says, so it lacks the regular stream of earnings necessary to fund a rabbi trust year to year.

Steven Price, a consultant with The Todd Organization Inc., a Greensboro, North Carolina, executive benefits firm whose consultants design, fund, and implement benefit packages, including COLI policies, points out that cash-flow problems are among the biggest negative side effects associated with top hats. He offers the hypothetical case of a company deferring $1 million as part of a nonqualified plan. Because the company can't take a deduction on this share of the executive's pay, it must come up with an additional $400,000 to make that $1 million whole after taxes. Further, assume that the $1 million had a 10 percent return, half of which was capital gain. While the capital-gains portion wouldn't be taxed until it was realized, taxes on the other half--about $50,000 in interest--would be about $20,000, assuming a 38 percent corporate tax rate. Thus, according to Price's numbers, the company would have to put out $420,000 for the liability.

Champion International, with its volatile profitability record nullifying any thoughts of a rabbi trust, has a threshold return on invested capital of 11 percent, tough to beat with a COLI product, given all the fees. Similarly high targets exist elsewhere, even in the regulated world of electric utilities. At Boston Edison, for example, where all top- hat assets come from executives who are in regulated portions of its businesses, the return on capital is capped at 11 to 12 percent.

Happiness at the Water Cooler
Hewlett-Packard and other companies that have chosen to fund their rabbi trusts with mirror 401(k)s may be reacting at least in part to water-cooler conversations praising the spectacular performance of many qualified plans in the hot mutual-fund market of recent years. At Constellation Energy Group Inc., senior executives choose how much they want to defer into their nonqualified accounts, and then allocate those investment dollars to the same mutual funds that are available through the qualified 401(k) plan. At this holding company, which was created this past May by Baltimore Gas and Electric Co., 50 of the 63 eligible Baltimore G&E senior executives decided to take part in the nonqualified plan. Before the "mirror" top hat was established in 1996, just 25 chose participation.

When Boston Edison selected its mirror 401(k) plan, it also decided to provide a directed brokerage option giving employees more control over their top-hat investment accounts. This has raised questions about how much insulation the rabbi-trust arrangement actually provides for participants. "We solved this with language about their directing their investments at the sufferance and agreement of the company," explains Anastasia. "We offer [senior executives] the opportunity--with approval, which may not be granted--to direct the investment for their own benefit. And they suffer the gain or the loss."

Experts say the sophistication level of top- hat funding options will keep building as companies move to reduce the vulnerability of the money being squirreled away for their senior executives. "I don't think there's any question," says Hal Wallach, a principal at Buck Consultants, "that senior financial officers are keenly aware of the growing amount of as-yet-unfunded deferred compensation."

----------------------------------------------- --------------------------------- A Top-Hat Glossary
Nonqualified Plans (Top Hats)
Provide deferred compensation benefits that would be due to executives and other key employees in the absence of Internal Revenue Code qualified-plan limits. Qualified plans cannot discriminate in favor of highly paid employees, must be funded, and must have vesting provisions. But corporations design specialized nonqualified plans more freely absent the tax advantages.

Contribution Limits
The maximum annual compensation for receiving qualified benefits is $160,000, so employees earning more are candidates for nonqualified plans. While there is no statutory limit on the amount of the pay that can be deferred under non-tax-advantaged plans, the average deferral is 20 percent of compensation.

Rabbi Trust
A grantor trust in which assets remain the general assets of the employer and are available to creditors in a bankruptcy. Still, the trusts help protect participants from a change in control, or an employer's change of heart. There is no current taxation to the participant, and the employer's tax deduction is postponed until the benefits are paid.


COLI
Corporate-owned life insurance, with the company as owner and beneficiary of the policy. COLI policies grow tax-deferred, and eventually convert to a tax-free return through death proceeds. But premiums are not tax-deductible to the company, and the company must be ready to pay benefits from current cash in the interval between retirement and death.

Mirror 401(k)s
A plan design that gives participants exactly what they would have received under a qualified 401(k). The choices for financing, as for qualified plans, include mutual funds, company stock, or any other investment assets. Employers lose the use of those earmarked monies, and do not get the tax advantages of COLI. And the company is still liable for taxes on the earnings of the funds. But investment returns provide an exact match of assets and liabilities, and ease employee tensions over the return differential compared with qualified plans.




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