Jason Stephens, CFS, ARPS
Director | CAPTRUST Nonqualified Practice Leader
In our most recent position paper, A Three-Step Approach to Nonqualified Plan Financing: Now is the Time to Revisit Your Strategy, we introduce a conceptual framework for nonqualified deferred compensation plan sponsors to help them make intentional decisions about how to finance their plans’ benefit liabilities. The paper emphasizes the importance of selecting an appropriate combination of financing method, earnings hedge strategy, and target funding level as key factors for plan optimization. Although understated, a number of behavioral factors are influential to this decision-making process. Plan sponsors should be mindful of these influences because they can lead to unintended consequences that are not in the companies’ long-term best interest.
Unlike qualified plans where liabilities are funded by assets set aside for the exclusive benefit of participants and beneficiaries, in nonqualified plans, participant deferrals plus any sponsor contributions remain under the company’s control and are subject to general creditors. This circumstance creates a separation between the assets and liabilities of a nonqualified deferred compensation plan and provides the means by which participants avoid constructive receipt of compensation and, in turn, current income taxation. Although there is no requirement to informally fund or finance nonqualified plan liabilities, many sponsors choose to do so. According to a recent study conducted by Plan Sponsor Council of America and the Boston Research Group, more than 60% of plan sponsors manage these obligations by informally setting assets aside.1
Financing plan liabilities means removing assets from daily operations, which may not always make economic sense. From a capital budgeting standpoint, setting these funds aside suggests that investing in the capital markets is more attractive than investing in company operations. Although this comment oversimplifies the analysis, it illustrates the point that plan sponsors may not always make decisions to finance nonqualified benefit liabilities based purely on economics.
This urge to set aside assets against nonqualified plan liabilities demonstrates the impact of mental accounting. Mental accounting is a concept from behavioral economics that describes how people tend to compartmentalize or categorize their current and future obligations into separate, nontransferable “buckets” or accounts — sometimes seemingly contrary to rational thought. Beyond the economics, there are several other good reasons to finance nonqualified benefit liabilities. These reasons include demonstrating the commitment of corporate management to support the plan and reinforcing the perception that the assets are only on loan from the employees (and should be treated accordingly).
For plan sponsors choosing to finance — because it makes economic sense, is behaviorally helpful, or serves as a goodwill gesture to participants — one common solution is to invest these assets in a manner similar to plan liabilities. This earnings hedge strategy, known as mirroring or mapping, keeps financial statement volatility to a minimum since plan liabilities and assets set aside will tend to move in tandem. While volatility is muted using this approach, the insinuation is that plan participants are better stewards of assets than the corporation. As referenced in an earlier article, recent data refutes this point. This suggests another impact of mental accounting, whereby many companies appear willing to accept suboptimal performance of corporate assets in order to neutralize the growth of a specific liability.
One solution available to plan sponsors who wish to informally fund benefit liabilities, while still maximizing the use of corporate funds in light of behavioral tendencies, is to apply discretion over nonqualified assets. With this approach, the plan sponsor maintains control of plan assets and invests them according to a long-term, well-diversified investment strategy. Using discretion allows the company to better optimize the performance of the asset, while still earmarking the funds in support of the nonqualified plan. If performance of the investment strategy exceeds liability growth, earnings can be used to offset plan costs and potentially increase corporate profits. The opposite outcome is also possible since short-term volatility (both positive and negative) increases whenever assets and liabilities are decoupled.
Utilizing a discretionary approach to manage nonqualified plan assets is an interesting concept that should be explored by plan sponsors looking to optimize nonqualified plan performance, while addressing behavioral shortcomings. Understanding and addressing these influences is critical in helping plan sponsors make intentional decisions regarding the management and long-term success of their plans.
1 Boston Research/PSCA, “A Study of Non-Qualified Plan Sponsor Attitudes and Behavior,” Final Report. p.6, June 2011