Financing the Pain New Ideas on Funding Nonqualified Benefit Liabilities May 6, 2011
Plan Funding – A Case Study Overview and Background • Sample Company maintains several nonqualified benefit plans for certain select officers and executives. These plans include nonqualified defined benefit plans (typically called Supplemental Executive Retirement Plans or “SERPs”, nonqualified defined contribution plans (Deferred Compensation Plans or “DCPs”) as well as post retirement benefit plans.
Sample Company’s Previous Funding Strategy – Partially Funded with Taxable Securities and Partially Unfunded • The obligations of Sample Company’s plans were partially informally financed with taxable securities within a rabbi trust (e.g., mutual funds). For tax purposes, the assets in Sample Company’s rabbi trust were treated as corporate assets, so earnings on the trust assets generated a tax liability to Sample Company. A portion of the plan liabilities were not funded.
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Funding Nonqualified Benefit Plans The Funding Question? • Nonqualified plans cannot be formally funded like qualified plans. Instead, nonqualified plans may only be “informally” funded or “financed”.
To “informally” fund or “finance” a plan, companies set aside assets equal to liabilities while remaining exempt from ERISA’s rules on vesting, benefit accruals and payments. The purpose of informal funding is to: Hedge the P&L exposure associated with the plan’s variable liabilities (i.e., participants’ DCP accounts),
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Offset the P&L expense associated with the accrual of defined benefit plans under ASC 715-30 (formerly FAS 158) or other postretirement benefits under ASC 715-10 (formerly FAS 106) Provide benefit security (i.e., back-up the Company’s “promise to pay”), and Potentially provide liquidity to pay future plan benefits.
Funding Nonqualified Benefit Plans The Funding Question? • The asset pool set aside by the Company must remain on the Company’s books, and must be subject to the claims of general creditors in the event of corporate bankruptcy. • Informal funding of DCP’s is now the norm according to one survey.
From Clark Consulting’s 2009 Survey of Executive Benefits.
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Funding Nonqualified Benefit Plans Why Do Companies Informally Fund Benefit Plans? • This is Partially Employee Money A portion of the cash used to fund DCP obligations is equal to executives’ deferrals. Compensation left “in-trust” with the Company should be afforded the security of earmarked assets.
• Correlated Asset-Liability Matching to Minimize P&L Impact of DCPs The advent of investment-oriented DCPs has induced companies to set aside assets that are similarly-invested to hedge the obligations of the DCP. This strategy creates a highly-correlated asset-liability match to minimize the P&L impact of the DCP.
• Pension Fund or Alternative Allocation to Minimize P&L Impact of SERPs The appropriate use of a pension fund allocation or alternative allocation can tax efficiently offset the expense accrual associated with nonqualified defined benefit plans or other postretirement plans. • Financial Statement Impact Resolves the hot topic of unfunded benefit obligations, particularly post-retirement obligations by setting aside assets for current and future liabilities.
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Funding Nonqualified Benefit Plans Why Do Companies Informally Fund Nonqualified Benefit Plans? • Avoids the “Social Security Syndrome” A current allocation of dollars to fund a growing liability removes the financial burden from successor management and shareholders. • Benefit Security
There is a positive correlation between the extent to which assets are set aside to meet benefit obligations and the perceived value of those benefit plans to participants. Putting assets in a trust will interpose an independent third party to protect participants’ balances, and ensure they are paid. Funding provides security for plan participants against events that might reduce or eliminate the Company’s ability or willingness to pay (e.g., change of control). • Tax-Advantaged Funding Available The funding of a DCP can be designed to allow for a non-taxable accumulation of assets.
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Benefit Security
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Because nonqualified plans reflect an unsecured “promise to pay,” most corporations that have implemented such plans seek to protect benefits from certain events. In evaluating benefit security, it is important to identify which of the following events are of concern to participants.
Change Change in in Control Control
Will Will an an unfriendly unfriendly acquirer acquirer take take away away past past or or future future benefits accruals or terminate the plan entirely? benefits accruals or terminate the plan entirely?
Change Change in in Financial Financial Condition Condition
Will Will the the employer employer be be in in aa financial financial position position to to pay pay the the benefits, benefits, and/or and/or will will cash cash be be available available to to pay pay benefits? benefits?
Change Change of of Heart Heart
Will Will current current or or future future management management change change its its mind mind and discontinue benefits for whatever reason? and discontinue benefits for whatever reason?
Bankruptcy Bankruptcy
Will Will the the changing changing economic economic environment environment control control the the financial financial success success or or failure failure of of the the company company resulting resulting in in bankruptcy bankruptcy or or insolvency? insolvency?
Benefit Security
Funded Rabbi Trust Characteristics •
The most prevalent security device being used by companies today.
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Assets are irrevocably set aside in the trust for the benefit of the plan participant.
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Protection is afforded in the event of:
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Change of Control
Change of Heart
Change in financial condition, short of bankruptcy
Well established tax and legal support:
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Benefit payments can be made from the trust (or from corporate cash).
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Assets are accessible to corporate creditors in the event of bankruptcy.
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Trust assets are company assets.
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Trust is administered on an aggregate basis.
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Trust income is taxed at company tax rate:
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IRS Rev. Procedure 92-64 provides “model” Rabbi Trust
Unless invested in tax-advantaged vehicles (TOLI)
Benefit Security
Funded Rabbi Trust Characteristics (continued) •
Protects against all preretirement and post-retirement events except corporate bankruptcy.
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Bankruptcy:
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Set-up costs of trust are minimal, but an independent trustee is required:
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Trustee fees are typically $5,000 - $15,000 per year based on the size of the trust assets VerityPoint does not act as a trustee, but we can recommend one if desired
A Rabbi Trust does not provide for the following:
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Trust provides no protection against creditors Plan participants remain general unsecured creditors
Protection in the event of an employer’s bankruptcy or insolvency Protection against an interpleader action filed in court by the Trustee if the Trustee is unsure whether a benefit payment should be made Protection against legal fees associated with protecting or pursuing benefits
Benefit Security
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Prevalence – Data on Fortune 1000 companies and their use of security devices.
Analyzing the Funding Decision
Companies should consider several criteria when evaluating different funding instruments:
Identify Investment Alte rnatives
Security Asset/Liability Matching Flexibility After-Tax Return Up-Front Cash Required
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Identify Investment with Highest Rank
What are the Alternatives?
“Pay- (The Unfunded Benefit Obligation) As-You-Go” •
An unfunded plan will result in the:
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The advantage of an unfunded “Pay-As-You-Go” plan is cash flow:
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Greatest charge to earnings and the greatest potential liability to the company. 100% of the payout must come from future cash flow since the future liability is unfunded. There is no out-of-pocket cost for the company in the early years. This advantage disappears quickly as executives retire, since the company will be obligated to make the cash benefit payments.
What are the Alternatives?
Municipal Bonds • Bonds tend to be familiar asset choice among Treasury professionals in corporate America and many of them are comfortable with this asset class as long as the particular bond meets investment policy criteria. • Advantages
Exempt from federal and state income tax Stable return Stable Issuer (usually a government entity)
• Disadvantages
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Returns can look stagnant in an up market Some municipalities have flirted with insolvency Tax consequences on liquidation
What are the Alternatives?
Taxable Investments •
A Company applying this funding strategy will typically purchase and hold mutual funds in a trust account to fund the accruing Plan liability. This funding method offers flexible investment options.
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Flexibility
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Tax Consequences
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Very liquid; but administratively and operationally cumbersome. Burdens the trustee to track the cost basis for transfers among funds and the taxation resulting from the fund itself. Realized gains from trading within a fund (i.e., rebalancing the funds pursuant to the company’s allocation selections) generate recognizable income that is currently taxable, but not currently deductible. Increasing percentage of bonds in the portfolio (as participants age) will generate currently taxable income. Unrealized gains, in a mutual fund held by a trust to fund nonqualified benefit plans, may not be currently recognized as an offset to current P&L charges associated with such gains. The cash required to fund the increasing income tax liability will either increase the Company’s cost of the plan or, if the cash required to pay the income tax is netted against the plan assets, a funding shortfall will result.
What are the Alternatives?
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Trust Owned Life Insurance • Congressional Approval: Life insurance is one of the few tax-advantaged investment options. If a life insurance policy is held until death, its death benefits are paid tax-free to the beneficiary. Codified in 2006 in Internal Revenue Code Dection 101(j). For corporations in high tax brackets, TOLI can be especially beneficial as a DCP funding device. • Favorable Tax Consequences: No realized gains from trading within a fund. No taxable event when moving between subaccount funds (i.e., daily participant rebalancing). Tax deferral of investment growth. Tax-free death proceeds. • Favorable Relative Returns: Due to tax deferral of earnings, the present value cost of TOLI is typically less than a similarly-invested taxable managed fund. Management fees are similar to taxable managed funds, but even after deducting additional insurance charges (e.g., premium tax, policy fees, mortality and expense charges, etc.) TOLI policies compare favorably to taxable managed funds over the life of the investment, especially given the competiveness and transparency of modern products.
What are the Alternatives?
Total Return Hedge
• • •
Allows companies to maintain current plan funding strategy while freeing up capital for other needs Market risk and volatility is transferred to a third party Unlike a taxable portfolio, tax cost is recognized at the same time as the tax deduction*
*U.S. Patent # 6,766,303
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Total Return Hedge (TRH) Mutual Fund
Mutual Fund
Mutual Fund
TRH
Plan Liability Assets
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Mutual Fund
Hedging Program Mechanics* Swap Provider Pays Sample Company: return on underlying investments in nonqualified benefit plan
Sample Company Pays Swap Provider: LIBOR–based rate Hedge Administrator: performs critical recordkeeping functions Pays LIBOR-based rate
Sample Company
Swap Provider Pays return on benchmark investments
Administrator
• • •
Tracks deferral information Re-weights swap on a dynamic basis utilizing record keeper data Manages implementation & ongoing swap-related reporting
*The methods and products disclosed in this presentation are covered by one or more of the following: U.S. Patent No. 6,766,303 and/or pending U.S. patent applications
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TRH Addresses Hedging Challenges Capital Efficiency
Tax Treatment
Accounting Match
Economic Match
Flexibility
Swap provider executes the hedge, committing its own capital to do so. Gains, losses and hedge expenses are tax-deferred until a plan participant takes distribution from the plan (1221(b)(2) tax treatment)*. Total Return Hedge is marked-to-market and thus, directly offsets changes in the benefit liability on the income statement.
Total Return Hedge is designed to help protect Sample Company from economic exposure emanating from nonqualified benefit plans. Total Return Hedge can be modified or terminated at reset dates – typically every 1 to 3 months – to match the nonqualified benefit plan exposure.
*IRS 2003 Private Letter Ruling
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Funding Alternatives The Two Most Prevalent Funding Vehicles Are: • Taxable Securities (e.g., Mutual Funds) • Corporate or Trust Owned Life Insurance (COLI/TOLI) Many tax-paying companies that offer nonqualified benefit plans take advantage of the tax-advantaged funding available.
From Clark Consulting’s 2009 Survey of Executive Benefits.
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Summary of Funding Alternatives Unfunded
Taxable Portfolio
COLI/TOLI
Total Return Hedge
Negative
Neutral
Positive
Neutral
Positive
Negative
Negative S/T Positive L/T
Positive
No
Yes
Yes
Yes
N/A
Negative
Positive
Neutral
N/A
Liquid
Accessible Via Loans or Withdrawals
N/A
P&L Impact Cash Flow Impact Asset Liability Match Tax Impact Liquidity
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Questions?
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VerityPoint - Overview
VerityPoint specializes in the creative design, funding and security of nonqualified executive benefit plans. VerityPoint provides tailored, customized executive benefits consulting and liability financing strategies for our clients, which consist of mid-sized and large corporations and banks. VerityPoint is an independent entity and its principals have, in the aggregate, over 100 years of experience in the nonqualified plan business along with earlier professional backgrounds in finance, tax, law, public accounting, benefits, insurance, and strategic consulting. Headquartered in Los Angeles with a nationwide clientele of over $2 billion in plan account balances.