Human Capital & Careers

Cashless Severance

Here's a relatively new way to pay off departing employees.
Lisa YoonJuly 30, 2001

American Express Co. is laying off another 4,000 to 5,000 people. JDS Uniphase is laying off another 7,000 people. Hewlett-Packard is canning 6,000. Lucent is cutting another 20,000 or so.

The steady drumbeat of layoffs continues week after week, with few signs of a letup.

And wherever layoffs take place, severance is sure to follow. And, as most senior financial executives know, severance could be a big cash drain for companies at precisely the time they are trying to conserve cash.

Don’t despair. A new method allows companies to save cash by restructuring the laid-off employee’s pension benefit, says Tom Murphy of Unifi Network, PricewaterhouseCoopers LLP’s human resources and benefits consulting subsidiary.

Through a qualified severance arrangement, a few companies have increased pensions by the amount of the calculated severance package. Companies then save cash while still delivering the value of the severance benefit to the departing employee.

How? By somewhat raiding their overfunded pension plans.

“Many companies are restructuring now, and at the same time, many of them find they have a run-up in plan assets, despite the stock market’s recent collapse,” says Murphy, who declines to name his Fortune-500 clients using the method, explaining it’s too early in the implementation. He adds despite the market’s “less-than-wonderful” recent performance, pension portfolios that are diverse enough should have taken a relatively soft hit.

So, under these qualified severance arrangements, companies are allocating some of the overfunded assets to the accrued benefits of pension plan participants.

Murphy notes that this does not mean “dipping into” a pension surplus to fund a cash severance. According to Internal Revenue Service code, pension trust funds can only be used to finance pension-related activities.

While these qualified severance agreements let companies save cash, they also (obviously) reduce the surplus position of the pension fund. “It’s a tradeoff,” says Murphy. “It’s just another way to do it [fund severance packages].”

Before deciding to implement this strategy, however, here’s what you need to consider:

  • First, be clear about the reason for using the method. “You don’t put it in [the employment contract at the time of hire] as a general provision,” says Murphy. “You should only use it to address a particular event, like a plant closing or layoffs.”

This is because qualified pension plans are required to provide “definitely determinable benefits” (i.e. determined by a formula) to plan participants. As part of this requirement, the plan must explicitly identify the group eligible for any severance benefits offered under the plan.

  • Be aware that in some cases, benefits may have to be paid out of company cash. The IRS sets a ceiling–currently $170,000–on the salary to which a pension formula is applicable. (This figure changes from time to time to account for inflation.) To illustrate, if an employee earns $200,000 and his company’s pension formula allows for 40 percent of salary, the company can only pay 40 percent of $170,000; the remaining $30,000 is subject to the company’s severance formula, to be paid in cash.
  • A qualified severance arrangement can be paid either as a lump sum or paid as an annuity. However, if the participant decides on the lump sum, he or she must first show spousal consent as required by qualified plan distribution rules.

In addition, certain pre-retirement distributions (generally those paid before age 59 1/2 which are not rolled over into a tax deferred investment vehicle) are subject to a 10 percent excise tax payable by the employee. The program can be designed for distributions to “gross up,” or increase by the amount of the excise tax, to account for this tax.

  • Make sure the plan meets non-discrimination requirements. According to IRS rules, the plan must be able to demonstrate that the level of benefits being provided under the plan does not disproportionately favor highly compensated employees. The most common way to meet this requirement is to calculate the rate of benefit accrual of each person in the plan. Low-paid employees must accrue benefits for at least 70 percent of the rate at which highly compensated employees accrue benefits. The current cut-off between high and low compensation is $85,000 per year.

In the end, the “tradeoff” aspect of the program is in the accounting. When a company pays a cash severance, the expense is taken off the balance sheet as a payroll expense. But when increasing a pension benefit, amortization and interest on the amount by which the pension was augmented are expensed. For example, if an employee’s $100,000 pension benefit was increased by another $100,000 in lieu of severance, the additional $100,000 is amortized, usually through flat-line amortization over 15 years.

“Make sure you analyze the cost of the plan,” says Murphy. “Weigh the increase in expense as compared to the expense of the existing severance program, including an analysis of the current cost of capital (or internal rate of return) to find out if this program would work for your company.”

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