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Scrambled Nest Eggs

Deferred-compensation legislation and likely rule changes in stock option accounting could shake up executive retirement plans.
Craig Schneider, CFO.com | US
October 8, 2002

In response to recent cases of senior executives "cooking the books," federal legislators and finance regulators want to do some cooking of their own. What they're looking at are ways to scramble the nest eggs of certain high earners.

Reports of executives also getting paid huge sums in the wake of alleged fraudulent schemes have irked investors and sparked legislative action. Mark Swartz, the former Tyco International CFO, recently looked to push his luck. Lawyers for the finance executive, who has been charged with pirating more than $600 million from the company, reportedly proposed using $5 million that he received from his deferred compensation plan to secure his $50 million bail bond. In the end, his family posted bail to keep Swartz out of jail while he awaits trial, but it's the thought that counts.

Indeed, intiatives to curb excessive pay and make deferred compensation less attractive may have some unintended consequences that reach far beyond the Swartz's of the world: Ideas kicking around Congress and the Financial Accounting Standards Board (FASB) could leave many law-abiding senior executives with less than they planned to have at retirement.

Hope's not all lost, however. Certain strategies, some involving maneuvering within curbs on the sale of company stock, can help executives avert severe depletion of retirement funds with some added tax savings.

Consider a provision of H.R. 5095, a bill introduced last July, that could wreak havoc on existing non-qualified deferred compensation plans. Currently in widespread use by large corporations, such plans enable highly paid executives to pile tax savings on to the skimpy amount they can save under a 401(k). In a 401(k), after all, an employee can sock away only as much as $11,000 this year. In contrast, deferred compensation plans have no legislated contribution limit. The dollars are taxed when the employee has the right to get the benefits, which is typically at retirement.

The framers of the H.R. 5095 provision, however, want to change the taxation of non-qualified deferred compensation plans. The bill would make the plans taxable when employees contribute to the fund, rather than when they have the right to receive benefits. The proposal puzzles Bob Leeper, a managing director of Charon/ECA, a Newark, New Jersey-based consultancy for the design and implementation of benefit strategies.

Because it would make taxation immediate, the bill would unravel the plans' essential purpose. "By definition there would be no deferral," Leeper says of the bill's potential ill effect. "The net result is that you wouldn't see as much retirement savings."

Although the bill hasn't gotten very far in this session of Congress, the idea could crop up later if legislators are on the hunt for tax revenues. Such an initiative couldn't come at a worse time for CFOs, many of whom are baby-boomers planning for retirement. Close to one-third (32 percent) of CFOs hope their next move will be retirement, according to a survey by RHI Management Resources. Released in July, the survey was based on responses from 1,400 CFOs of U.S. companies with more than 20 employees.

Other high-profile finance chiefs are just months short of riding off into the sunset. Verizon Communications' Frederic Salerno and Intuit's Greg Santora plan to retire at the end of this year, while Cisco Systems' Larry Carter is looking to step down next May, on his 60th birthday.

Stock Naked
Other CFOs might not want to wait much longer than that. Why? FASB is in the throes of deciding whether stock options should be expensed. But if companies are forced to expense them, executive retirement portfolios could dwindle, some critics fear. That's because many employers would substitute cash for options, thus diminishing the growth potential of the portfolios.

To mitigate the potential effect that expensing options might have on their equity compensation programs, one-third of 200 big U.S. employers responding to a recent Mercer Human Resource Consulting survey said they would cut the number of options granted to workers. If senior executives are included in that group and paid in cash instead of options, they might have to rethink their strategies for financing retirement.

Taking options out of the retirement portfolio will hurt many executives' future savings, asserts Barbara Raasch, the partner in charge of wealth management solutions at Ernst & Young. "At the end of the day," she says, "the executive will make less money, and the company will pay more money because they have to pay more cash [rather than less costly stock]."

Sunset Strategies
Regardless of what regulators or members of Congress do, senior executives typically face a perpetual retirement planning burden in deciding how to deal with their huge holdings of company stock. Often, there's little chance of diversification until after retirement because of company restrictions on exercising options and selling stock. What's more, those curbs might change after retirement. For instance, an executive might have to exercise options or sell stock within three years rather than within a 10-year span.


Still, there are some tax strategies that executives with large numbers of company shares in their 401(k) plans can use to assure the poshness of their golden years, experts say.

Marvin Rotenberg, national director of retirement services at Fleet Private Clients Group, suggests removing company stock that has a very low cost basis from a 401(k) and donating the shares to a charitable trust as a way of slashing tax bills. He cites the example of an executive in the 38.6 percent tax bracket who takes $100,000 worth of shares, at an average cost basis of $30,000, out of a 401(k), when taking a lump sum distribution. The executive would pay income tax of $11,580 on the cost basis of $30,000.

If the executive needs more cash and sells the $100,000 worth of shares, he would also have to pay only a 20 percent capital gains tax, or $14,000, on the $70,000 gain. The total tax: $25,580. If the funds were extracted from an IRA, the tax rate would increase to 38.6 percent.

But the executive has a more efficient choice in terms of taxes. Upon retiring, the executive could take the $100,000 of stock out of the 401(k) and place it in a charitable remainder unit trust (CRUT). The CRUT could be set up to pay the executive, starting at retirement, a fixed rate of 6 percent a year, or $6,000, for instance. As the account balance grows, the amount will increase. Whatever is left over after the executive dies goes to his or her favorite charity.

A chief lure of the CRUT is that, at least in Rotenberg's example, the contributors would be entitled to a current tax deduction of 29 percent. The deduction assumes a 6 percent fixed rate paid to a husband and wife of 65 years of age and a $100,000 contribution. That would amount to $29,000, and at the 38.6 percent tax rate, the deduction would be worth $11,194. Hence the amount virtually cancels out the $11,580 tax paid on the $30,000 average stock cost, leaving the individual with a total tax bill of $386 on $100,000 worth of stock.

The risk in using a CRUT is that the principle isn't guaranteed, since the return is based on the price of the company stock. Indeed, for purposes of diversification, anyone who owns a lot of company stock may want to evaluate how much they still want to hold after retirement.

An alternative, Rotenberg says, would be to take the stock from the 401(k) and transfer it upon retirement to a rollover IRA, where the investment can be diversified without tax consequences.

From the changes proposed on Capitol Hill to the upcoming decisions out of FASB, every bit of tax savings may help at the time of retirement. Says Raasch: "People are expected to live longer. So you need to have that much more in insurance for your family, for disability, for yourself, and building a retirement nest egg to get you there."




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