The problem with COLI in a down market
From January 1st through March 18th 2020, the S&P 500 index declined by about 25%. This will cause material issues for many companies that are hedging their deferred compensation plans with Corporate-Owned Life Insurance (COLI).
VOLATILITY FROM DEFERRED COMPENSATION PLANS
Nonqualified Deferred Compensation (NQDC) Plans cause volatility on the Income Statement. Executives often select from the same menu of investment options offered in the 401(k) plan. As the notional investments that executives select rise or fall, the company’s Compensation Expense is directly impacted. To mitigate this issue, many companies have purchased Corporate-Owned Life Insurance (COLI) to fund/hedge the plans. COLI is often described as a portfolio of investments with a life insurance wrapper. Companies pay insurance charges, and in exchange, the COLI earnings are tax-free.
TAX AND ACCOUNTING ISSUES WITH COLI IN A DOWN MARKET
While there are tax benefits available through the use of COLI, there are also significant drawbacks that companies should understand. For the purpose of this article, we will focus solely on the tax and accounting problems that can result from COLI in a down market.
As an example, assume:
$100 million plan
$100 million of COLI
COLI expenses of 100 bps
Tax rate of 25%
Plan liability and COLI decline 20% (gross of COLI fees) in the quarter
A SIGNIFICANT NEGATIVE IMPACT TO NET INCOME
In this case, the plan liability declines by $20 million less a deferred tax asset of $5 million for a positive net income impact of $15 million. On the other hand, there is no deferred tax liability established for COLI. Therefore, the COLI cash value declines by $20 million, less COLI expenses of 100 bps – for a net income decline of $21 million. The resulting negative impact for the quarter in net income is significant: -$6.0 million.
AN EVEN GREATER SWING IN OPERATING EARNINGS
In addition, there is a particularly adverse operating earnings impact as the deferred compensation plan flows through operating earnings and the COLI flows through Other Income—creating a material “mismatch”. As a result, there is an operating earnings swing in this example of the full $15 million from the plan, in the quarter.
One of the most popular solutions is known as the TRS Overlay strategy:
Company allocates its COLI cash value to a fixed rate or stable value fixed income alternative
Company then hedges volatile portions of its NQDC plan with a dynamically re-weighted Total Return Swap (TRS HedgeTM); company pays LIBOR + spread and receives the returns of the plan
Eliminates issues described above—TRS gains/losses are tax-deferred and match the plan, and are also recorded in compensation expense, eliminating the accounting mismatch
Other solutions that involve restructuring the COLI are available as well.
COLI can cause significant earnings issues for companies in down markets. Fortunately, there are solutions to this issue. Atlas would be happy to consult with companies on identifying the optimal strategy based on their specific fact patterns.