Contemporary Best Practices: Hedging Deferred Compensation Plans with Total Return Swaps
By Benjamin R. Eisler, Managing Director, Atlas Financial Partners
A Total Return Swap (TRS) is a popular tool used by numerous companies to mitigate earnings volatility caused by their Deferred Compensation Plans. Due to Atlas’s dominant position in the TRS marketplace, we have great visibility into “Best Practices” for this strategy. This report describes an optimized TRS structure that avoids issues which can otherwise arise (i.e. tracking error, a weak tax position, errors in settlement calculations, etc.).
Ensuring Protection of Tax Position Upon Potential IRS Audit
Atlas’s clients utilize a tax hedging election under IRC section 1221(b) to defer the tax recognition of TRS gains, losses, and expenses until benefit payments are actually made to participants (generally in 10-15+ years). However, to ensure protection of a company’s tax position upon potential IRS audit, we recommend the company conduct comprehensive tax recordkeeping to specifically track the TRS gains, losses, and expenses in a manner that is consistent with tax policy and representations made to the IRS in obtaining the Private Letter Ruling and Will-Level Tax Opinion.
The tracking is done assuming “mini-swaps” that are attributable to each specific participant. Consequently, when a benefit payment is made to a participant, the company will have a reasonable and consistent method to determine how much of the aggregate deferred TRS gains, losses, and expenses relate to that specific benefit payment – and the specific amount of income recognition for tax purposes.
These tax reporting and processes have been audited at the client level by the IRS with no deficiencies—and should have material value to companies in protecting their deferred TRS gains.
Minimizing Tracking Error
Our clients typically rebalance their TRS hedge monthly and monitor their DCP liabilities on a daily basis. Consequently, if there are significant fluctuations within the plan liability (investment reallocations, large distributions, etc.) – the TRS is then rebalanced intra-month accordingly.
The daily monitoring of the liability effectively provides an “early warning” system that detects and prevents material tracking error before it occurs.
This approach, taken by almost all of our clients, of: (i) monthly re-weighting of the TRS to keep it closely correlated with the DCP liabilities, and (ii) daily monitoring of the liability balances—typically results in correlations of 99%+!
Credit Risk Mitigation and Cash Generation
Our clients typically settle the TRS monthly to mitigate counterparty exposure and obtain the most favorable pricing from bank counterparties.
Generating cash for reinvestment within the company is an added benefit of monthly settlements—particularly as these cash settlements can be generated without tax (see above).
Importantly, plan menus can be constructed such that they satisfy the interests of both plan participants and the plan sponsor, by providing participants with tools to make sensible allocation decisions while avoiding exposures that cannot be hedged.
Our clients have found that they can offer a broad menu of active and passive investment options similar to their 401(k) plan and hedge it effectively with the TRS.
Fully Outsourced Administration
Each of the above goals can be accomplished cost effectively while also minimizing the burden on the company’s treasury team of managing the TRS. Atlas has developed specialized systems and processes specifically to manage TRS hedges of DCP liabilities.
Our responsibilities include but are not limited to:
Comprehensive management/execution of monthly TRS rebalances and settlements, including independent verification of swap settlement calculations to avoid errors – which can often be costly and material
Daily monitoring of plan liabilities and execution of intra-month TRS rebalances as necessary
Tax recordkeeping and reporting consistent with the PLR and tax opinion to ensure the above tax benefit and protection upon potential IRS audit
Comprehensive monthly financial reporting of TRS results
When implementing a TRS hedge of deferred compensation plan liabilities, it is critical that companies structure the strategy to avoid pitfalls. This can be successfully accomplished cost effectively through outsourcing the administration. Atlas would be happy to answer any additional questions.