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Spiked Interest Warrants Nonqualified Plan Financing Policy Statement Discussion
Michael G. Curran, CFP®, CLU®, ChFC® Senior Vice President | CAPTRUST Nonqualified Executive Benefits
In recent years, we have heard from nonqualified plan recordkeepers that the financial crisis — and subsequent environment of economic uncertainty — dampened enthusiasm for nonqualified deferred compensation plans. Contributions dropped precipitously in 2008 and remained stagnant until 2011. Nevertheless, it appears that plan sponsor interest in nonqualified plans is on the rise—along with contribution levels into these flexible retirement plans.
What’s driving this resurgence of interest? It stands to reason that the recovering economy; 401(k) retirement plan contribution limits; and demand from executives who are still trying to recover from stock option, retirement plan, and personal investment losses incurred during the financial crisis are contributors. Coming out of election season and the fiscal cliff debate, it is not hard to imagine that rising federal and state income tax rates and the new 3.8% Medicare tax on net investment income are also helping to drive renewed interest.
Given the present potential for dramatic growth of nonqualified plan balances — due to increased demand for tax-deferred retirement savings and improved capital markets — retirement committees are taking an increasingly active role in managing their companies’ nonqualified plans. They are seeking to ensure plans are optimized to attract and retain top executives while being operated as effectively as possible. One of the most important aspects of managing a plan is its informal funding — or financing.
While the vast majority of plan sponsors do, in fact, set aside assets to finance nonqualified plan liabilities, how they do it tends to be very circumstantial. One plan sponsor may finance its plan with mutual funds because its nonqualified plan is administered by a mutual fund company. Another may use life insurance because a life insurance agent initially “sold” the concept of a nonqualified plan. These choices are not necessarily problematic. However, they may not be intentional decisions and may not provide the best long-term benefit to the plan sponsor. Put more positively, the best approach to addressing nonqualified plan financing options involves establishing a sound and intentional financing strategy.
As part of this process, all of the key decisions related to plan financing should be documented in a formal “financing policy statement.” Similar to an investment policy statement, the idea behind creating a financing policy statement is quite simple and beneficial.
Among the decisions to be documented in a financing policy statement are the plan sponsor’s selections of:
Financing method—Are assets being set aside to finance future benefit payments? Are those assets invested in mutual funds, life insurance, or some other vehicle — like a total return swap?
Target funding level—How much of the future benefit liability is financed? Are 100% of future benefit payments financed, or some lower level?
Earnings hedge strategy—How are the assets set aside invested? Do they mirror the participant benefit elections, or are they invested some other way?
Use of a Rabbi Trust—Does the sponsor own the assets outright, or are they held in a Rabbi Trust as a way to address potential participant risk concerns?
Benefit distribution strategy—What is the sponsor’s cheapest source of cash at the time of a benefit payment? What is the priority of liquidity sources for benefit payments?
A well-considered financing strategy will help the plan sponsor better manage plan costs, reduce balance sheet volatility, and secure participant benefits. A well-documented financing policy statement that memorializes key decisions related to the strategy will facilitate day-to-day operations and provide continuity as key management and retirement committee members turn over. It will also provide guidance to your plan advisors and facilitate ongoing oversight of the plan to help make sure it remains optimized for the benefit of participants and the company.
If you would like to learn more about how to create a financing policy statement for your company’s nonqualified plan, please contact your CAPTRUST financial advisor.
This document is intended to be informational only. CAPTRUST does not render legal, accounting, or tax advice. Please consult the appropriate legal, accounting, or tax advisor if you require such advice. The opinions expressed in this report are subject to change without notice. This material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. The information and statistics in this report are from sources believed to be reliable but are not warranted by CAPTRUST Financial Advisors to be accurate or complete. All publication rights reserved. None of the material in this publication may be reproduced in any form without the express written permission of CAPTRUST: 919.870.6822.
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