The Role of Plan Design in Limiting Hedge Tracking Error

Ryan D. Kelley

Nonqualified Deferred Compensation Plans are provided by over 90% of Fortune 1000 companies. While they help attract and retain talent, they can 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.

Many Fortune 500 companies hedge this volatility with a Total Return Swap (TRS) solution. The company enters into a TRS with a bank, whereby the company pays the bank a fee and the bank pays the company the highly-correlated returns of its Deferred Compensation Plan. This is a very popular strategy for many reasons – it provides economic value (most companies expect the returns of their plan to exceed the fee they pay to the bank over time), as well as optimal accounting and tax treatment.

Once the strategy is executed, the company must manage the tracking error (i.e. the difference between the gains/losses from the TRS vs. the plan liability). This can be done through various strategies that include:

· Monitoring plan investment balances daily relative to swap notional positions and reweighting as necessary

· Ensuring recordkeeper promptly communicates significant plan events

· Verifying correlations in basket of ETF’s/mutual funds recommended by bank counterparty

· Testing data and independently calculating reweights to avoid errors

· Ensuring trade orders are done promptly to minimize time between plan valuation and reweight

· Verifying accurate execution of reweight trades by bank

That said, some plans, due to their design, create some degree of tracking error with the hedge that is unavoidable. Companies may wish to consider this when designing their plan – specifically, they may want to omit features of the plan that aren’t critical, and that may prevent the hedge of the plan from operating optimally.

Atlas Financial Partners has assisted one particular Fortune 100 technology company with executing a TRS hedge of its deferred compensation plan for 12 years. Over this extended period, the total tracking error has been (a positive) 2 bps of the total hedge size. On a $100 million plan, this is a total tracking error over 12 years of about $23k – very strong performance indeed.

This company utilizes the strategies above to limit tracking error. But it also has designed its plan to maximize the effectiveness of the hedge. Specifically, the plan investment lineup was designed in such a way that it can be easily mirrored by the TRS. This is among the most important things a plan sponsor can do to improve the effectiveness of the hedge, and it means specifically limiting insurance-based funds and actively managed funds in the plan investment menu lineup.

Beyond plan menu design, this client has payrolls occurring bi-weekly and aligning with TRS reweights. There is also substantial coordination with the plan recordkeeper – the recordkeeper is well-educated about what information must be communicated to the company and TRS administrator, and when.

There are many strategies companies can employ to minimize the tracking error of their hedge and nonqualified plan. Minimal tracking error, however, may only be achievable by also designing the plan in a way that works well with the hedge.

Atlas is happy to share additional specifics on achieving optimal hedge results – contact information is on our website.

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