How Companies Can Fund Deferred Compensation Plans—at a Much Lower Cost
David J. Marshall
Over the years, many Fortune 1000 companies have made the decision to informally “fund” their Nonqualified Deferred Compensation (NQDC) plans. Typically, assets such as mutual funds or Corporate-Owned Life Insurance (COLI) are set aside in a grantor trust (a so-called “Rabbi Trust”) to fund benefits. There are multiple challenges with this approach.
High Cost: The cost of funding in this manner is extremely high as returns for these assets are typically far below the returns a company could generate by investing the assets in their operating businesses. For example, if a company were to have a cost of capital of 8% and the trust assets earn 5% after-tax, the annual cost to the company of funding the plan is 3%. In addition, while the cost is high, the value of the funding is limited as any assets of the rabbi trust must remain subject to the claims of the plan sponsor’s creditors.
Poor Hedging Benefits: There are other challenges with funding as well. The funding does not reduce operating earnings volatility caused by the plan, because the earnings from mutual funds and COLI must be recorded in Other Income (while the plan expenses are booked as operating expenses in SG&A). Some forms of funding – such as COLI – are also extremely illiquid and costly to unwind.
That said, we speak with many companies that already have funding in place – and may continue to fund any additional liabilities under their plans. This raises a question: could the plan sponsor fund the rabbi trust with company shares? The answer is yes! This is an economically-efficient strategy that does not tie up the company’s balance sheet in nonoperating funding assets, and it does not negatively impact participants. Trustees typically consider Company Stock to be a sound and liquid replacement asset. As outstanding shares, the stock can be freely marketed – subject to SEC rules for a company buying and selling its shares.
The company stock in the trust is accounted for much like Treasury Stock. The Stock’s value continues to be carried at cost (or par value), as a contra-Equity balance. The Stock is not marked-to market. However, the shares are now deemed to be outstanding (as they are held by a separate trust entity) and included as such for dividend and, in some instances, fully-diluted EPS calculations (a properly structured program may allow the plan sponsor to avoid any EPS impact). The resulting impact on EPS is typically immaterial and could be accretive – while the number of outstanding shares may increase modestly, the company’s earnings would also increase from liquidating the assets in the trust and reinvesting resulting cash.
For tax purposes, any gains or losses arising from trading the company stock is exempt for taxes. The use of company shares is also now included in the IRS Model Trust framework (https://www.irs.gov/pub/irs-drop/n-00-56.pdf).
Companies have been using Treasury Stock to fund rabbi trusts for many decades. In one recent case, using company shares to fund a rabbi trust created significant benefits for plan participants. The company found itself in a bidding war and was acquired at a premium price, causing the rabbi trust to become overfunded by $60 million.
The use of Treasury Stock to fund a rabbi trust allows a company to avoid using non-operating assets such as mutual funds or corporate-owned life insurance while using the Total Return Swap Hedge Strategy to hedge P&L volatility for its nonqualified deferred compensation plans. This generates positive accounting (both P&L and geography), economic (both cash flow and NPV), and tax results for the company.
Once the plan is funded with Company Stock, the company can hedge the P&L volatility with a Total Return Swap solution, which if designed and executed appropriately, can provide optimal accounting and tax treatment, as well as material economic value.
The use of Company Stock is just one alternative strategy for funding Rabbi Trusts – in future articles we will discuss others that accomplish this goal in a cost and earnings effective manner.