Deferred Compensation Plan Hedging Options: A Primer
The following summary is a sample of the reviews Atlas has developed for clients of strategies to effectively hedge the fluctuations of Deferred Compensation Plan (DCP) liabilities which adversely impact corporate earnings.
There are several issues caused by DCP liabilities:
Mark-to-market fluctuations of these plan liabilities create material earnings volatility
Executives select from a menu of investment options and fluctuations of these investments flow through Operating Income/Compensation Expense
Hedging this exposure with physical assets (i.e. mutual funds/COLI) has significant limitations
Would require company to tie up corporate capital at a substantial cost
Mutual funds would be taxed currently
Would not eliminate volatility in Operating Earnings/Compensation Expense, as earnings of the assets would flow through Other Income – resulting in a material mismatch for financial reporting
TRS – Overview
A Total Return Swap (TRS) is a commonly used tool to hedge the volatility of a DCP for numerous companies.
A TRS is a transaction where a bank agrees to exchange (or “swap”) the total return (capital appreciation/depreciation) of an asset or basket of assets for a fee.
Typical pricing is 1 month LIBOR plus a “spread,” with a 1-year price/“spread” commitment and a monthly reset of TRS “weightings” so plan liabilities and TRS are continuously correlated.
No upfront cash payment is required.
TRS gains and losses flow through Compensation Expense/Operating Earnings directly offsetting the P&L impact of plan liabilities.
Taxes on TRS gains can be deferred until benefit payments are made to participants (Treasury Reg. 1.1221-2(b)(2) and section 1221(b)(2) of the IRC).
Note the economic impact as deferrals would not need to be used to purchase mutual funds– but could instead be utilized for corporate purposes.
Financial Modeling
The following models quantify the impact to cash flow and corporate earnings (P&L) of different hedging options for the DCP.
Assumptions:
Plan Liability – $300 million
Corporate Tax Rate – 24.75%
Cost of Capital – 6%
Investment Return – 5.2% - based on the expected return of the liabilities to be hedged
TRS Expense – 1% - based on 1-month LIBOR + spread
The following table summarizes the results for the “current state” (not hedging), TRS, and mutual funds, showing an incremental NPV benefit to the company of more than $96 million from hedging with the TRS.
Summary of TRS Administrative Services
Atlas provides comprehensive support for the review, implementation, and administration of a TRS strategy. Our services have been designed to prevent issues that can arise (i.e. significant tracking error, jeopardizing the tax treatment, ineffective accounting treatment, errors in settlement calculations, etc.).
Review
Review of TRS vs. funded strategies – cash flow and P&L/earnings impact, tax and accounting, etc.
Implementation
Assist in the evaluation of appropriate accounting and tax treatment with company’s internal staff and external auditors
Develop implementation plan
Administration
Monitor swap notional positions daily relative to plan balances to avoid significant tracking error
Monitor intra-period movements in the plan and initiate off-cycle TRS reweight if necessary to avoid tracking error
Ensure recordkeeper promptly communicates significant plan events to avoid tracking error
Detailed tax recordkeeping at the participant level (250k records maintained on average per client) to allow for deferral of TRS gains, losses, and expenses, and assistance with IRS audits
Provide robust report set detailing all components of swap (Financing Leg, Equity Leg, Accounting Entries, P&L, Tracking Error, and Balance Sheet reports, with custom reports available upon request) to avoid consumption of internal resources
Independently calculate swap settlement each period and compare with bank prior to settlement notice, to ensure accuracy (many settlements may otherwise have errors