Practitioner's Perspectives On Corporate Finance Issues of Nonqualified Deferred Compensation Plans
By Robert B. Polansky, former Assistant Treasurer at General Mills and Senior Advisor, Atlas Financial Partners
Nonqualified deferred compensation (NQDC) plans are provided by over 90% of Fortune 1000 companies. NQDC plans can be significant corporate liabilities that are often overlooked by Treasury, Benefits and the Financial Planning and Analysis team. These plans are provided in order to attract and retain top talent. For plan participants, NQDC plans represent an employee benefit plan which may be used to optimize their personal financial and tax plans by deferring current income on a pre-tax basis, investing in tax-deferred investment strategies and maximizing the returns on their investments.
NQDC plans are not subject to most ERISA rules which gives employers greater flexibility in plan design and funding/hedging strategies. Also, employees must understand that their rights to benefits under these plans are guaranteed only by the company’s promise to pay, putting these liabilities on par with other senior unsecured creditors.
Accounting treatment and impact on earnings
Under a NQDC plan, Compensation Expense is recognized at the time that compensation is due to be paid to the employee. If the employee chooses to defer receiving income, the liability to pay remains on the corporate balance sheet. The plan participant often selects from the same menu of investment options offered in the 401(k) plan as “shadow investments” for the time period from the deferral until the selected payout date.
The change in the amount of the unpaid NQDC liability balance from the rise or fall in capital markets is recorded in Compensation Expense. This fluctuation in expense in a company’s income statement can be large enough to require mention in an earnings release. Corporate CFOs and investment analysts prefer earnings releases to be “clean” with little impact from non-core activities such as benefit plans allowing management to focus the earnings call on operating results and future strategy.
On recent earnings calls, CFOs in the Fortune 1000 have highlighted significant earnings volatility caused by these plans. A CFO of a Fortune 200 healthcare company noted that “higher deferred compensation expense due to strong stock market performance in the quarter also negatively impacted operating margin.” A CFO of a Fortune 1000 financial services company noted “deferred compensation expenses that were up quite materially in the quarter”.
Impact of funding NQDC plan
From an earnings disclosure volatility perspective, the CFO and Treasurer may seek strategies to mitigate unexpected earnings impact from the NQDC plan. One obvious approach is to fund the NQDC liability. The advantage of funding the plan is two-fold:
the earnings on the assets will offset the increase in liability on the income statement
invested assets increases the perceived funding security for plan participants
The disadvantages to funding a NQDC plan are:
funding ties up corporate capital in a plan that by its nature is intended to be unfunded
while the earnings on invested corporate assets may offset the income statement impact of the NQDC plan, the offset is recorded on different lines of the income statement. As mentioned previously, the change in NQDC liabilities is recorded in Compensation Expense. The change in value of invested corporate assets is recorded in Other Income because these investments are not considered core operating results for the company.
investment income on funded assets is taxed immediately while the tax effect on the Compensation Expense caused by the NQDC plan is deferred until payout, creating a tax mismatch.
Cost of funding from a corporate finance perspective
As mentioned above, funding NQDC plans results in corporate capital being committed to hedge benefit obligations, potentially reducing alternative investment “opportunity” for corporate capital. The cost of funding can be considered from three angles:
The cost is at least the WACC rate needed to raise the required capital. The WACC cost is incurred when the company raises new capital to fund the plan. Irrespective of how the funds are sourced immediately, the funding of a long-term liability should bear a full WACC cost under economic theory.
For a company that has already funded the plan and could potentially free up the capital, the cost may be the average ROC. The cost is the ROC assuming that the NQDC funding assets could be released to be invested alongside operating assets, further assuming the company does not change its capital structure. This same company may view the cost as the marginal ROC on its next best operating project available.
If the company has funded the plan and could free up the assets and pay down debt or equity, the cost is the WACC rate assuming the company pays down capital in its current debt/equity proportion.
The cost of funding NQDC liabilities can be high. Funding also leaves the company exposed to GAAP accounting and tax accounting mismatches. This leaves senior executives searching for another solution.
Off balance sheet hedging strategies
Rather than using scarce corporate capital as a means to offset the income statement impact of an NQDC plan, many companies instead hedge this volatility with a derivative instrument called a Total Return Swap (TRS). A TRS is a relatively straightforward swap transaction between the company and a bank counterparty.
The bank pays the company the total return (capital appreciation/depreciation) of an asset or basket of assets
The company pays the bank an amount of interest based on the notional amount of the same basket of assets linked to a floating interest rate index such as LIBOR plus a spread.
The TRS does not require corporate capital. From an economic perspective the company is “renting” the bank’s balance sheet with a cost of the LIBOR floating rate leg. Assuming immaterial tracking error between the gain/loss on the NQDC liability and the gain/loss on the asset leg of the TRS, the net cost of the TRS strategy is the LIBOR leg, far lower than WACC or ROC. The LIBOR leg cost is significantly less volatile than the unhedged capital markets cost of the NQDC plan. The LIBOR leg cost is well understood and can be managed by a company’s Treasury team. Further, the floating leg can be converted to a fixed rate by a fixed for floating interest rate swap.
The GAAP accounting for the TRS is favorable compared to funding the plan as TRS gains and losses flow through Compensation Expense directly offsetting the income statement impact of plan liabilities.
Taxes on TRS gains can also be deferred until benefit payments are made to participants and deducted.
While an NQDC plan has an important purpose as an executive benefit plan, it raises economic, GAAP accounting and tax accounting issues. From an economic and corporate finance perspective, a solution that should be considered is the off-balance sheet Total Return Swap. The TRS has lower cost, better GAAP accounting and tax accounting treatment than funding the NQDC plan with corporate assets. Recent market volatility has highlighted the attention given to NQDC plans.