How Letters of Credit Can Provide Material Benefits to Companies Funding Deferred Compensation Plans

Many Fortune 1000 companies fund their Nonqualified Deferred Compensation Plan (DCP) liabilities with assets (typically mutual funds) in a Rabbi Trust. While this may provide a small amount of benefit security to participants, it typically leaves the company exposed to market risk that can cause unpredictable swings in operating earnings. Many CFOs of Fortune 1000 companies have had to highlight this issue on recent earnings calls. Additionally, Rabbi Trusts can materially increase the cost of offering the DCP, as the company is tying up significant amounts of corporate capital.

One tool to effectively mitigate these issues is a specially structured Letter of Credit (LC). Subject to approval by the Trustee, a Plan Sponsor can substitute a LC for the assets (i.e., mutual funds) in the Rabbi Trust. The DCP market risk is then hedged using a Total Return Swap.

This approach may allow the company to “free up” the cash currently tied up in the Rabbi Trust – without sacrificing benefit security for participants. When structured appropriately, one leading Trustee concluded the LC provides as much benefit security to participants as mutual funds. This approach also eliminates the accounting geography mismatch that results from hedging DCP liabilities with physical assets, solving the issue raised by CFOs on recent earnings calls.

It is important to note that the LC must automatically renew, and if the bank chooses not to renew, the Trustee must either find an alternative bank or draw on the LC. The bank that issues the LC must also be of strong credit. The LC is sized based on the balance of the DCP liability and adjusted periodically (i.e., annually).

Companies with funded DCP liabilities may wish to consider a specially structured Letter of Credit. When utilized in combination with a Total Return Swap, it can provide substantial economic and accounting benefits.