Retirement Plans

Beyond Reach?

Companies are struggling to secure mounting retirement benefits for senior executives. And Uncle Sam is very interested.
Gordon WilliamsJune 1, 1998

Senior executives at Lear Corp. are worried– not about their company’s business, but about their retirement benefits.

As a result of internal growth and acquisitions, Lear, a $7 billion (in revenues) maker of automobile interiors, in Southfield, Michigan, has four nonqualified retirement plans–deferred compensation arrangements that don’t enjoy the tax benefits of 401(k) plans and other “qualified” retirement plans. Because nonqualified benefits that are out of reach of creditors become taxable when funded, Lears’s plans are unfunded, so liabilities in those plans are piling up, and the beneficiaries — senior management–are increasingly concerned.

“The underlying liabilities are starting to escalate, and the executives are starting to get a little nervous that we have no protection,” says Lear vice president for global compensation and benefits Michael Miller. “The executives are asking, ‘What if something happens? Do we have any protection?’” Miller doesn’t have a definitive answer for that yet, though he is exploring various possibilities, including so-called rabbi trusts, which protect benefits from a change in management but not from the claims of creditors. “We are looking at alternatives for how to protect this money,” he says.

To be sure, a significant number of companies are purchasing life insurance in hopes of securing those benefits. But the coverage has drawbacks (see “COLI Isn’t Holy,” below).

Annuities are also sometimes used to secure nonqualified plan benefits. According to Peter Biggins, a principal at benefits consultancy Hewitt Associates LLC, in Lincolnshire, Illinois, an annuity represents a means “to shift the obligation to someone else.” That becomes increasingly important, he says, as benefits increase. Companies have to ask themselves, “At what point does the growth of unfunded liabilities become a concern?” Of course, beneficiaries then have to worry about the financial condition of the insurer, although they can limit the risk by sticking to annuities underwritten by the strongest carriers.

Lear isn’t the only company worried about retaining key people and therefore casting about for ways to make their nonqualified promises more secure. Essentially, nonqualified plans are IOUs–a corporation’s promise today to pay John Q. Executive a pension in x years. But while backing every tax-qualified retirement plan is an irrevocable funded trust, the typical nonqualified plan is nothing more than the unsecured promise of the employer to pay the benefit when the plan participant retires.

That wasn’t much of a concern a few years ago, when the typical nonqualified plan had just a handful of participants and plan liabilities were relatively modest. But times have changed. According to a recent survey of companies with nonqualified plans conducted by Hewitt Associates, nearly two out of five companies have established rabbi trusts to secure benefits against the threat of a takeover. Less than 5 percent fund so-called secular trusts to secure the benefits against creditors as well.

What’s more, companies are still trying to cope with a 1992 tax-law change that slashed the maximum amount of annual income that can be used to calculate qualified pension benefits from $235,840 to $150,000. Two years later, Congress added insult to injury–at least to the highly paid–by imposing a new sort of cap on annual contributions. Instead of annual inflation-adjustment increases in the allowable maximum contribution, such increases were allowed only when inflation dictated that the cap go up by a multiple of $10,000. That wasn’t a big change. But it did make retirement plans that much more vulnerable to future inflation.

Indexation has raised the income limit from $150,000 to $160,000. That’s still a far cry from the $235,800 limit, when the “needs” of only a few executives fell outside the qualified retirement plan–and thus warranted something special. That was typically arranged through supplemental executive retirement plans and “top-hat” plans. With such a small, select population, companies could custom design nonqualified plans to meet the needs of those few individuals. Details of the plans were not highly visible, and if five people were involved, each probably had a different plan.

“Maybe a handful of people in the typical company earned more than that, and you took care of them,” recalls Curt Morgan, a principal with The Kwasha Lipton Group, the human resources advisory section of Coopers & Lybrand. Today, with the income cap down, compensation up, and the white-collar job market increasingly tight, the typical company is offering dozens, even hundreds, of people nonqualified pension treatment.

“With the government systematically nibbling at the salary cap, it’s not uncommon in a large company to find 300 to 400 people being offered some variety of nonqualified benefit,” says Howard Edelstein, a Cleveland-based principal with The Todd Organization, a benefits consulting firm.

But special arrangements are obviously impractical for a large number of employees. So now companies are trying to offer participants in nonqualified plans the same range of investment options they get in qualified plans, which have been adding more to meet the demands of middle managers, as well as rank-and-file workers. In fact, most companies are making their nonqualified plans look as much like their qualified plans as possible.

“Most companies are moving away from any kind of top-hat plan that has some special formula for highly paid individuals,” says Kwasha Lipton consultant Carl Weinberg.

Certainly, a company could just tell its higher-bracket people to make their own retirement arrangements. But that would leave the executives subject to recruitment by competitors that do offer nonqualified pension benefits. Miller says Lear has used sweetened pension deals as one device to lure senior executives from other companies.

In the absence of a cost-effective, tax-free magic bullet for completely securing nonqualified benefits, most companies are trying to enhance the types of benefits they offer. What most seem to have settled on is a greater range of investment options, especially those that promise higher returns. Consider Sears Roebuck & Co., the $41 billion (in sales) retailing giant. No longer is the return on Sears’s deferred compensation limited to the rate on commercial paper, as it was until 1993. Today, explains Stanley Wright, president of Sears Investment Management Co., Sears executives can choose to have the money invested in commercial paper, the Lehman Intermediate Bond Index, Sears stock, or the Standard & Poor’s 500.

With higher returns, of course, come even greater liabilities when executives claim their money, unless those benefits have been funded. Since Sears’s benefits are not, Wright recently began hedging those liabilities by buying futures contracts on the S&P 500. If stock market appreciation lifts Sears’s deferred compensation liabilities by, say, $2 million, the S&P 500 contracts would similarly appreciate. “Management knows it won’t have a negative surprise because all of a sudden the liabilities in the deferred comp account increased by $2 million,” he says.

But offering a greater range of investment options for nonqualified benefits isn’t simple. Consider the hoops Harris Corp., a $4 billion (in revenues) manufacturer of electronics equipment in Melbourne, Florida, jumps through to make its nonqualified plan mirror its qualified plan. The goal is “to make the difference between the qualified and the nonqualified plan almost invisible to the employee,” says David Wasserman, Harris’s vice president and treasurer.

But that isn’t easy. Whatever income fits within the strictures of the qualified retirement plan can be invested in any or all of eight investment funds. Whatever income goes beyond the cap and is nonqualified can be invested in the same funds on a “phantom” basis. There’s no actual purchase of fund shares in the nonqualified plan. What the executive gets is Harris’s promise to pay a retirement benefit based on what his or her investment choices would have earned had the money been invested for real.

Confused? Say, for example, that inside the 401 (k) plan an employee’s shares of the investment funds increased by an average of 15 percent a year. Outside the plan, the phantom stake should then also increase by 15 percent annually.

“We promise our executives that whatever return they would have made if they had been able to put all their money into these 401(k) choices is the return they will get out,” says Wasserman.

To be sure, real money is going into the excess portion of the plan. That money is backed by a rabbi trust, providing some assurance to the participant that the money will be available at retirement. However, the participant doesn’t derive immediate benefit from the investments, because he or she has only a “phantom” interest in the investment proceeds.

Yet the funds in the nonqualified plan aren’t actually invested in those eight vehicles. Instead, Harris invests the money in an S&P 500 index fund created for the company by an investment manager. The index fund essentially matches the market–and so matches the return “earned” by the phantom investments. In fact, it actually exceeds the typical phantom return.

Why are the returns phantom and the investments made in an index fund instead of the 401(k) vehicles? Phantom investments keep the earnings free of tax for the employee. And because index funds are extremely tax efficient, Harris’s own tax liability is more modest than it would be if the money were actually invested in the 401(k) funds. (Their tax inefficiency doesn’t matter in the 401[k] plan; there’s no tax liability for anyone to worry about there.)

How can the index fund return more than the average return on the phantom investments in the nonqualified plan? Because in making their own choices, some executives will tilt toward money funds and other conservative investments. As long as the overall return of the excess account falls below the return flowing to Harris from the index fund, Harris can pay whatever tax bill it runs up, and still cover the return of those phantom accounts. Says Wasserman: “We want to get the highest return in the most efficient way we can.”

Harris could run the nonqualified portion of the 401(k) on an unfunded basis–merely crediting each participant with that year’s return and funding the benefit only when it is finally paid out. After all, there’s no tax deduction on contributions to the nonqualified plan until the benefit is actually paid. So why has Harris chosen to fund the nonqualified plan? “We have gone down the road of giving our executives more of a comfort level,” says Wasserman.

Other approaches designed to secure employee loyalty are cropping up. Besides offering more investment options, Sears is also considering using nonqualified plans in conjunction with stock options, which enable executives to defer tax on their gains. That’s especially important for executives, Sears’s Wright said at a recent conference of the Financial Executives Institute, in New York, because stock options are a so-called preference item for the alternative minimum tax, which means the gains are difficult to otherwise shelter from tax.

As long as Congress keeps a lid on qualified plan benefits, there’s likely to be no end to the variations on the nonqualified benefits highly paid employees are offered. But that won’t make the promises any more real.

Gordon Williams is a freelance writer based in New York.

———————————————– ——————————— Promises, Promises
Unlike traditional retirement plans, a nonqualified plan is only a promise. You can’t blame executives in such plans for wanting that promise to be backed by something solid. After all, the 1990s beganwith a wave of corporate failures and is ending with record mergers and takeovers. Who can say whether a company can make good on today’s unfunded pension promises 20 years from now?

So pressure keeps growing to back those nonqualified liabilities with cold, hard cash. Nor is there much new under the sun when it comes to how to provide that backing. Michael Miller, vice president for global compensation and benefits at Lear Corp., an automobile- interiors manufacturer in Southfield, Michigan, is listening to recommendations on how to fund nonqualified pension liabilities.

Corporate-owned life insurance, assuming it isn’t knocked out of the box by Congress, is an efficient way of financing plan liabilities, but to provide more assurance to your executives, you must choose from among the following:

Rabbi trust. The idea was dreamed up about 20 years ago by a rabbi who wanted to be sure he would get his promised pension even if he jumped to another congregation. The typical rabbi trust is an irrevocable grantor trust, established by the employer. The trust agreement guarantees that the company will pay off as promised–if it can. Unfortunately, to keep the money in the trust safe from taxes, it must be available to general creditors of the company in case of bankruptcy. So the assurance for executives isn’t total. But the rabbi trust is still the most widely used vehicle for companies that want to fund their nonqualified plans.

Secular trust. This time, the executive pays taxes on money put into the trust. That eliminates the risk of losing the pension to corporate creditors, but at an obvious immediate cost. Secular trusts aren’t very popular.

Rabbicular trust. This concept was invented three years ago by St. Louis attorney Michael Goldstein. It begins with a rabbi trust, but one with triggers linked to a company’s financial ratios. If the company begins to skid, the trigger is pulled and the rabbi trust converts into a secular trust.

The rabbicular trust sounds good, but although the trust is being widely adopted, the Internal Revenue Service hasn’t yet given a private letter ruling on the matter, says Howard Edelstein, Cleveland-based principal with The Todd Organization, a benefits consulting firm.

In 1992, the IRS issued Revenue Procedure 92- 64, which features a model rabbi trust. Follow the model and your rabbi trust is preapproved by the IRS. “If you depart from that model, you have no assurance that your plan will work,” says Edelstein.

In other words, the IRS might look favorably on the conversion of a rabbi trust into a secular trust–but then again, maybe it won’t.- -G.W.

———————————————– ——————————— COLI Isn’t Holy
In a recent Hewitt Associates LLC survey of companies with nonqualified plans in place, approximately one out of five said they use life insurance to fund benefits, according to the Lincolnshire, Illinois, benefits consultancy. Is company-owned life insurance (COLI) worth buying for that purpose?

Maybe, maybe not. Here’s how COLI works. A company buys a life insurance policy to cover the lives of some or all of the employees in its nonqualified plan. The premiums could be relatively small, because, as with all life insurance, the cash value of the policy would keep building up, year after year, free from all taxes. When an employee retires, the cash value would be tapped to pay his or her pension. But the policy belongs to the company. So when the employee dies, the company captures the death benefit–which, because of the attributes of life insurance, is tax free.

The tax-advantaged nature of life insurance makes COLI especially effective in a nonqualified plan, because there is no immediate tax break for assets put into such a plan.

The trouble is, COLI labors under threat from the nation’s capital, where the insurance arrangement has been under fire for more than a decade. Until now, however, the fire was directed mostly against companies that tried to wring one additional tax benefit from life insurance–the ability to borrow against the cash value. A company would buy the policy and pay the premiums until some cash value built up. Then it would borrow against the cash, use the borrowed money to pay subsequent premiums, and take a deduction on the interest on the policy loans.

Starting in 1986, Congress decided that companies would no longer leverage COLI in this fashion. Now, however, the Clinton Administration’s proposed 1999 budget threatens companies that use COLI with the loss of a portion of their deductions for interest on corporate debt. If a company’s COLI policies equal 5 percent of total corporate assets, it would not be able to deduct 5 percent of its interest on outstanding debt.

Most consultants predict the proposed COLI provision either won’t become law or will be modified substantially before passage. Even if the provision is enacted, Congress is unlikely to apply it to policies already in place at the time. Still, any corporation that uses COLI has to wonder what comes next.

In any case, more than a few companies have found another reason to avoid COLI: They simply find it too costly. For example, Harris Corp., a $4 billion (in revenues) maker of electronics equipment, in Melbourne, Florida, recently compared two different policies with an S&P index fund that the company currently uses to fund a rabbi trust. According to David Wasserman, vice president and treasurer of Harris, the investment fees for the most attractive of the two policies started at 85 basis points, compared with as little as 4 basis points for the index fund.

Wasserman does see advantages apart from the tax benefits. For one thing, Wasserman told treasurers at a recent meeting of the Financial Executives Institute, in New York, COLI provides immediate funding, perhaps overfunding, when one takes into account the death benefit.

“One basic question,” Wasserman continued, “is: Can tax deferral outearn the cost?” To address that issue, he suggested that finance executives might well find it possible to negotiate lower sales commissions from insurers.

Because of COLI’s potentially high costs, in fact, Peter Biggins, a Hewitt principal, suggests that it may be cheaper in some cases for companies to buy variable annuities, thereby securing the benefits from creditors, and “gross up” employees for the resulting tax liability.

Still, the insurance is owned by the company, not the employee. So COLI in itself does nothing to provide the employee with assurance that he or she will someday receive the benefits.–G.W.