Total Return Swap Hedges of Deferred Compensation Plan Liabilities in 2021 - Year in Review
Nonqualified Deferred Compensation Plans (DCPs) are provided by over 90% of Fortune 1000 companies. While they help attract and retain talent, they can cause earnings volatility. 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.
How Material was the Volatility in 2021?
The following table illustrates the quarterly returns of a typical DCP liability last year. As an example, a $100 million plan liability would have created a negative impact to earnings of $6.4 million in the first quarter.
One popular option to mitigate this volatility is the use of a Total Return Swap (TRS). The TRS is a relatively straightforward transaction where a company pays a bank SOFR plus a spread and receives the returns of its DCP. The transaction is typically settled in cash on a monthly basis to limit credit exposure and reweighted monthly so plan liabilities and the TRS are continuously correlated.
The table below shows the same quarterly DCP returns in 2021, after the offset from TRS gains/losses. For a $100 million plan liability, this converted the negative impact to earnings of $6.4 million to a positive impact of $0.1 million (due to the outperformance of low-cost ETFs within the TRS hedge basket versus actively managed strategies in the DCP):
The favorable economic impact of a TRS was also material, as companies paid SOFR or LIBOR plus a spread and received the returns of their DCP liabilities, which were materially in excess of LIBOR or SOFR plus spread. In addition, TRS gains, losses, and expenses may be deferred until benefit payments are ultimately made to participants – a significant tax benefit that companies appreciate.
Volatility in the investment markets continued in 2021. TRS hedges of DCP liabilities effectively mitigated this volatility while providing substantial economic value.