Weighing the Options for Funding Nonqualified Benefits
Over the past several years, there have been laws enacted to address perceived abuses in the area of executive compensation. In addition, rating agencies are beginning to cast a negative eye on corporate balance sheets with unfunded benefit liabilities. In light of these regulations, this article focuses on the ânew realityâ of funding nonqualified plans.
The basics havenât changed. From the corporate perspective, nonqualified plans are not required to be funded. In fact, formal funding of a nonqualified benefit plan (e.g., SERPs, deferred compensation plans, 401(k) excess arrangements, etc.) creates immediate taxation for the executive, even though actual benefits may not be immediately received. From a participantâs perspective, a lack of funding creates a risky proposition. A companyâs promise to pay benefits, without funding to back it up, isnât very valuable to a participant after a change of con- trol, a management change of heart, corporate bankruptcy or simply when sizable benefits become due and cash flow is tight.
For most companies, financial issues play an important role in the decision to fund nonqualified benefit liabilities. Unfunded plans can cause volatility to the income statement, as well as a negative drag on earnings. Further, many companies find it prudent to decide to fund when cash is more readily available, because it assures the availability of cash to pay future benefits. Finally, boards are beginning to focus on the idea that current management should be responsible for funding their own benefit costs, rather than deferring those costs to future generations.
Another objective of what is often referred to as âinformally fundingâ executive benefits is to provide participants with a level of security comparable to that of qualified plan benefits. While itâs not possible to provide precisely the same level of security without adverse tax consequences, a funded, irrevocable rabbi trust (i.e., a rabbi trust holding assets to secure nonqualified benefit payments owed to participants) can protect participantsâ balances, except in the case of bankruptcy or insolvency, where bankruptcy courts may (but are not required to) honor the benefit obligation to the participants.
Which asset is best held by the rabbi trust is a separate decision from establishing the trust itself. Corporations must also weigh factors such as after-tax return, earnings impact, cash flow, asset/liability tracking and flexibility (see Figure 1). No single funding vehicle/asset fits best in all situations. The choice of what asset(s) a company should use to informally fund its nonqualified benefits is unique to its specific financial situation. The attributes of various asset alternatives may be weighted more heavily than others in assessing their appropriateness.
Corporate annuities, company stock, managed portfolios/mutual funds and corporate-owned life insurance (COLI) have all received favorable IRS rulings for placement in a rabbi trust. An examination of the attributes of these potential informal funding assets and an analysis of the degree to which each investment addresses assessment criteria (see Figure 2) can help identify which best meet the companyâs overall objectives.
Cash Flow â Will the asset require excessive cash flow, either during contributions or to assist with benefit payments? The ability of the asset strategy to meet changing cash-flow needs, either during the funding phase or as distributions come due, should be considered.
Assessment: All of the investments would be viewed favorably with regard to cash flow requirements when both short- and long-term considerations are weighed. Company stock is likely to require the least up-front cash.
Earnings Impact â Will the asset generate an earnings gain that will offset the nonqualified plan earnings expense? Different asset types are treated differently in terms of how gains and losses flow through to the companyâs earnings statement. The resulting impact on corporate earnings also links to the companyâs equity value. The impact on earnings can be driven not only by what type of assets are being held to fund the benefit obligations, but also how those assets are being used (i.e., based on actual facts and circumstances). For example, realized gains on mutual funds may or may not flow through to the income statement. Post-Sarbanes-Oxley, auditors are more likely to classify mutual funds held in a rabbi trust as âavailable for sale.â With that classification, realized gains flow through to the income statement and unrealized gains bypass the income statement and go to shareholder equity. This creates minimal P&L offset to annual benefit costs.
Assessment: Corporate annuities and COLI earn the highest marks for earnings impact, with gains and losses flowing through to the income statement, creating an offset for the benefit expense.
Asset/Liability Tracking â Will increases or decreases in the performance of the liability be hedged by the performance of the asset? Equity-type investment strategies are typically preferable for tracking equity-allocated benefit liabilities, while debt or âabsolute returnâ strategies may be preferable for less volatile liabilities such as fixed (debt/interest) allocations or defined-benefit arrangements.
Assessment: Using an asset that will respond to changes in market conditions and economic cycles in the same manner as the benefit liabilities being funded will enable the company to better hedge against volatility in benefit-related expenses and help ensure sufficient assets are available to pay benefits as they come due. Each of the four assets would typically move in a fashion comparable to similar benefit liabilities.
Flexibility â Can the asset be used in multiple circumstances? Will it provide liquidity to meet various plan needs? There are many different features to consider with regard to a vehicleâs ability to alter asset allocation in response to changing participant nonqualified deferred compensation notional account allocations, changing levels of benefits in other plan types (e.g., as new participants are added to the plan or when compensation and the resulting benefit levels materially differ from forecast) and changing âcash-outâ needs (e.g., as participants terminate, retire or die).
Assessment: ACCESS TO VALUES â In terms of investments that can readily be converted to cash, all are fairly liquid.
FLEXIBLE DEPOSIT OPTIONS â All have some degree of flexibility for increasing investment size or deposits over time, as benefit costs do not always grow in a predictable fashion (new participants are added, salaries increase, etc.).
ABILITY TO CHANGE ASSET MIX WITHOUT ADVERSE TAX CONSEQUENCES â To effectively track benefit liabilities, the company may want to periodically move (or âreallocateâ) assets. Purchasers of variable COLI can initially select and periodically reallocate from a broad range of asset classes, including common stock, fixed income, real estate, etc., without incurring taxation on gains. This occurs because of the tax-favored treatment of the buildup of cash value inside the COLI product. Additionally, COLI and annuities can be exchanged without triggering a tax consequence (through 1035 exchanges). Transferring either of the other investment alternatives will, in most circumstances, create a taxable event.
ABILITY TO DISTRIBUTE CASH WHEN BENEFITS ARE DUE â Both corporate annuities and COLI can be structured to match benefit payments as they come due. A managed portfolio, by definition, could be structured to match benefit payments as well. However, managing for both tax efficiency and cash flow could pose a problem. Company stock does not offer this timing advantage due to market-related considerations.
EASE OF DISTRIBUTION â Again, since the timing and size of benefit payments are not always predictable, the ability to easily distribute discrete âpiecesâ of the investment is important when funding benefits. Large corporate annuities fail this test because of their significant lot size.
After-tax Return â Will the assetâs after-tax growth keep pace with the tax-deferred benefit liability growth? Asset types vary in their ability to manage tax impact, which can optimize the net return on the underlying investment strategy and minimize the capital required to fund the benefit obligations.
Assessment: Of the four vehicles, all but the annuities are capable of offering minimal tax impact. Except for within a COLI product, the ability to offer a tax advantage might be inversely related to the ability to offer an income statement offset or a significant base rate of return. A careful analysis of total return, incorporating tax effectiveness, income statement effectiveness and timing of cash flows is required once the field of alternatives has been narrowed based on security and flexibility issues.
- Security â How does the asset perform from a security perspective? Will it work well within the rabbi trust or with other security devices? Security is impacted by the degree of risk associated with any particular investment.
Conclusion
The choice of a funding vehicle should hinge on an assessment of each investmentâs risk-adjusted return. For exam- ple, while corporate-owned annuities appear to possess attributes similar to company stock in the basic ranking process, increases in their account value are taxable to the corporation on an annual basis.
Further, with the 2006 passage of the Pension Protection Act â and the language therein defining âCOLI Best Practicesâ â the government has codified the viability and appropriateness of COLI as an asset for informally funding nonqualified SERPs, deferred compensation plans, 401(k) excess arrangements and other corporate liabilities.
Other vehicles that have been approved for use in a rabbi trust, such as zero coupon bonds, tax exempts and real estate, were not included in this analysis due to their generally poor overall ranking. However, if a company has specific objectives that make these vehicles attractive, the same evaluation method could be used. Whichever investment is ultimately chosen, using this process will provide companies with the confidence of knowing that the significant financial issues surrounding informally funding nonqualified executive benefits have been considered.
Variable life insurance and annuities require a long-term commitment and may not be suitable for all clients. Ownership of any security, including variable annuities, life insurance and mutual funds involves risks. The value of the investment options will fluctuate and, when redeemed, may be worth more or less than the original cost. Early withdrawals may trigger tax penalties. Withdrawals will reduce the value of the death benefit and any optional benefits.
