Jason Stephens of CAPTRUST’s Nonqualified Executive Benefits team examines the three elements he considers essential to creating an effective nonqualified deferred compensation plan financing strategy: a plan’s financing method, earnings hedge strategy, and target funding level. He makes the case that these elements can and should be tailored—based upon each plan sponsor’s specific economic needs—to provide a cost-efficient long-term financing solution. This article references a CAPTRUST position paper titled A Three-Step Approach to Nonqualified Plan Financing that was published in April 2013.
Employers that sponsor nonqualified deferred compensation plans understand that these plans can be a powerful tool to attract and retain valuable employees and independent contractors. At the same time, nonqualified plan adoption also introduces financial risk to the employer, as amounts deferred generate an unfunded corporate liability that can potentially grow at unpredictable rates. Therefore, it is important for nonqualified plan sponsors to consider how to effectively manage their plan’s eventual liquidity needs while also recognizing the potential for financial statement volatility due to the growth of participant account balances. Fortunately, nonqualified plan sponsors have a number of tools at their disposal to help manage those issues mentioned above that essentially boil down to one thing: the plan’s financing strategy. A well-thought-out financing strategy, involving a combination of an appropriate financing method, hedging strategy, and funding level, while taking several company-specific variables into account, can better manage plan financing volatility and liquidity and help plan sponsors feel more confident about the optimization of their plan’s financing. In our experience, plan sponsors generally select among four primary financing method options.
The most common methods today include:
• unfinanced, where the plan sponsor leaves the benefit liability unfunded,
• financing with mutual funds or other taxable securities,
• financing with life insurance, or
• use of a total return swap.
The unfinanced approach, which suggests that no assets are set aside to informally fund the nonqualified liability, may make sense if a company has a high return on capital indicating a better alternative for available funds, while the use of taxable securities like mutual funds is a common approach favored for simplicity and flexibility despite potential negative tax and cash flow consequences. Financing with life insurance offers tax advantages, yet can be relatively complex to understand and manage. Finally, a relatively new concept, the total return swap, involves transferring liability hedging risk to a third party for a fee. Each of these methods offers certain advantages and disadvantages depending upon numerous plan sponsor specific goals and economic variables.
A nonqualified plan’s hedging strategy is also an important element that contributes to the plan’s overall economic success. A close correlation between the movement of assets and plan liabilities generates a smaller possibility of difference developing between assets and liabilities, which helps minimize financial statement impact. Sponsors that elect to finance their plan’s benefit liability must additionally decide among three hedging strategies.
The three approaches to hedging include:
• a mirror strategy where assets and liability investment options are identical,
• a mapping strategy where liability investment options are mapped to different asset investment options, and
• a discretion strategy where the plan sponsor invests the assets independent of the plan liability or uses a total return swap.
Utilizing a mirror strategy is the most common approach. A mapping strategy is generally selected when it is impractical or impossible to mirror participant liability choices due to investment or administrative constraints. As an alternative, the plan sponsor selects similar — but not identical — investments. The disadvantage with both of these strategies is that corporate assets are directed by plan participants — who often have neither the time, knowledge, nor desire to effectively manage their nonqualified plan account. With a discretion strategy, plan assets are managed to maximize their return, independent of how plan liabilities are directed. Sponsors that finance their plans via total return swap have a contractual hedge against liability earnings growth that is offered by the swap provider. Each of these hedging strategy options offers advantages and disadvantages that depend on a plan’s financing method and the plan sponsor’s level of risk tolerance.
A third element controlled by the plan sponsor is the plan’s funding level, the degree to which nonqualified plan liabilities are offset by a corresponding asset portfolio.
Traditional options for funding include:
• a pre-tax benefi t funding level,
• an after-tax funding level, and
• a death benefit cost recovery level.
Targeting a pre-tax funding level, the plan sponsor manages an asset portfolio that is equivalent to 100% of the liability portfolio. An after-tax funding level takes into account the future tax deduction benefit associated with the eventual payment of plan liabilities, and the plan sponsor manages an asset portfolio equivalent to its after-tax benefit liability. Death benefit cost recovery is an available option for plans financed with life insurance — where plan sponsors intend for the present value of the expected future death benefits to equal the plan liability value.
In a soon-to-be-published white paper titled A Three-Step Approach to Nonqualified Plan Financing, CAPTRUST more closely examines the three elements we consider central to creating an effective nonqualified plan financing strategy. Our paper makes the case that these elements can and should be tailored — based upon each plan sponsor’s specific economic needs — to provide a cost-efficient long-term financing solution. In addition, we also examine several key economic variables that influence this analysis, including the plan sponsor’s marginal income tax rate, the selected discount rate, return on capital, nonqualified plan earnings assumptions, and liquidity needs.