Futures or Swaps – Which is Optimal for Hedging Deferred Compensation Plans?
In recent years, many companies have shifted from hedging Nonqualified Deferred Compensation Plan liabilities with on-balance-sheet strategies (such as mutual funds or Corporate-Owned Life Insurance) to off-balance-sheet hedges. This has resulted in significant cost savings and reduced P&L volatility.
This analysis compares two of the most popular off-balance-sheet strategies for hedging these plan liabilities: Total Return Swaps (TRS) and Futures.
The cost of a TRS is measured by LIBOR (soon-to-be SOFR) plus a spread, while the cost of Futures is measured by the implied cost of rolling the contracts (which can be volatile), commissions, and the cost of posting margin.
While the cost structures differ for these two distinct approaches, the all-in cost should be essentially equivalent over time. This is because if there were an arbitrage opportunity, it would be easy for banks to swing from one execution method to the other to minimize cost. This simply doesn’t happen.
From time to time, banks have stated, Swaps may be less expensive than Futures because a bank’s positioning or inventory needs could drive a better level for the Swap.
Importantly, the cost of Futures has been consistently more volatile than the cost of Swaps.
Due to the limited investment options for Futures and the volatility in the implied cost of rolling the contracts, hedging with Futures can result in tracking error that would not be applicable to a TRS.
Hedging with a TRS typically results in minimal tracking error, as the TRS can be linked to a wide array of indices, ETFs, and mutual funds, and there is minimal volatility in the cost of the TRS.
Futures require the company to post margin.
Under a TRS, margin is negotiable and, in our experience, typically not required.
The TRS allows for a tax hedge election to defer the TRS gains, losses, and expenses until benefit payments are made to participants and an offsetting deduction is received.
When this is done appropriately (i.e. with very specialized tax recordkeeping that tracks the TRS relative to each specific deferral), it is supported by a Will-Level Tax Opinion, Private Letter Ruling, and it has passed audit with the IRS.
The taxation of Futures typically occurs upon expiration of the contract.
The accounting treatment for a TRS is favorable, as gains/losses may be booked in Compensation Expense, directly offsetting the plan liability. Atlas clients have had no issues with their auditors and obtaining this accounting treatment.
The accounting treatment for Futures may be the same as that of a TRS, but companies should consult with their auditors.
Futures are more operationally burdensome than a TRS, with internal resources consumed to administer the hedge.
All administrative aspects of the TRS may be cost-effectively outsourced to Atlas.
In recent years, numerous Fortune 1000 companies have shifted to off-balance-sheet strategies for hedging their Nonqualified Deferred Compensation Plan liabilities. Two of the most popular approaches are using Total Return Swaps and Futures. The TRS typically results in lower tracking error, tax benefits, no margin requirements, less volatile costs, and a lower operational burden compared to Futures.