Hedging Company Stock with Total Return Swaps
On recent earnings calls, numerous Fortune 1000 CFOs have had to highlight significant P&L volatility caused by the Company Stock portions of their nonqualified deferred compensation plans. This is because as with other notional investments within these plans, when the Company Stock rises or falls, Compensation Expense is directly impacted (assuming the Company Stock is settled in cash – which we will address later).
The following table illustrates the material earnings volatility due to a $10 million plan liability allocated to one Fortune 1000 company’s own stock. As an example, in Q1 2020 earnings were positively impacted by $3.6 million while the following quarter (Q2 2020) earnings were negatively impacted by $3.5 million.
One popular option to eliminate this volatility is the use of a Total Return Swap (TRS). The TRS is a relatively straightforward transaction where a company pays a bank 1-month LIBOR plus a spread, and receives the returns of its deferred compensation plan. The transaction is typically settled in cash on a monthly basis to limit credit exposure and reweighted monthly so plan liabilities and the TRS are continuously correlated.
The accounting treatment for the TRS is particularly beneficial as gains and losses are recorded in Compensation Expense directly offsetting plan liabilities. The favorable economic impact is also material as the company would pay LIBOR + spread (currently less than 1%) and receive the returns of its stock (which is generally believed to be materially in excess of 1%). In addition, a TRS on Company Stock is tax-free.
As illustrated by the table above, with the addition of the TRS, the maximum quarterly impact to earnings is reduced from $3.6 million to $76k, with a total P&L benefit over the 4.75 years of $5.7 million. Thus, the TRS mitigates P&L volatility and eliminates the need for the CFO to highlight this issue on earnings calls while also generating substantial economic value.
If the Company Stock is settled in stock rather than cash, there typically is no P&L volatility – the stock would flow through Equity. These companies can still realize the significant economic benefit of utilizing a TRS to hedge their Company Stock. Additionally, hedging with a TRS can allow these companies to settle the Company Stock in cash without creating P&L volatility. Settling in cash is likely preferable to the company, as it would not need to issue/buyback stock, and to participants, as they would receive cash to pay taxes associated with plan distributions.
Some plan sponsors have become concerned about over-concentration in company stock for plan participants – especially as they near retirement. By using the TRS, a plan sponsor may also be able to allow plan participants to diversify their plan investments into a broader investment menu. This could be done at any time – based on a timeline that fits a plan sponsor’s broader compensation objectives.
Hedging Company Stock with a TRS can provide a variety of benefits, from mitigating earnings volatility, to generating substantial economic value, to allowing a company to settle this portion of their plan in cash.