Insights

Deferred Compensation Plan Hedging Options: A Primer

The following summary is a sample of the evaluations Atlas has developed for clients to provide an objective qualitative and quantitative assessment of strategies to effectively hedge the material 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 popular and commonly used tool to hedge the volatility of a DCP for numerous companies.


A TRS is a relatively straightforward 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.

  • The accounting “geography” is particularly favorable as TRS gains and losses flow through Compensation Expense/Operating Earnings directly offsetting the P&L impact of plan liabilities.

  • Financial reporting is straightforward and typically recorded as “Derivatives not Designated as Hedging Instruments.

  • 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 that the favorable economic impact is material 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 have been constructed to evaluate 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 Support Services


Atlas provides comprehensive support for the evaluation, implementation, and management of a TRS strategy. Our services have been designed to optimize the TRS and prevent issues that can arise (i.e. significant tracking error, jeopardizing the tax treatment, ineffective accounting treatment, errors in settlement calculations, etc.).


Due Diligence

  • Due diligence of TRS vs. funded strategies – financial impact, financial reporting, etc.

  • Construct a detailed “cost/benefit” analysis of a TRS vs. funded strategies – cash flow and P&L/earnings analysis specific to the company’s fact pattern

Implementation

  • Assist in the evaluation of appropriate accounting and tax treatment with company’s internal staff and external auditors

Management

  • 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

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