Volatile Markets Have Deferred Comp Plans in the Headlines
Benjamin R. Eisler
The last two years have been among the most volatile in recent memory for the markets. The S&P 500 Index roared ahead in the first 9 months of 2018, then dropped about 20% in the last quarter of 2018, before shooting back up about 20% the first quarter of 2019. This volatility has for many companies resulted in significant increases in operating expenses, caused by their Nonqualified Deferred Compensation Plans. These increases have been so significant that they have been highlighted recently in many headlines and earnings reports.
This past January, one article was entitled Morgan Stanley Burned in Q4 2018 by Deferred Comp Program. On Becton-Dickinson’s Q2 2019 earnings call, CFO Christopher Reidy, highlighted that the company’s SSG&A reflected “additional deferred compensation expense due to stock market performance in the quarter.”
DICK’s Sporting Goods CFO Lee Belitsky noted on the company’s Q1 2019 earnings call that a substantial portion of Non-GAAP SG&A expenses was “attributable to expense recognition associated with the change in value of our deferred compensation plans.”
In some cases, the companies that have highlighted this issue on earnings calls were not hedging this exposure at all. In other cases, they were using traditional “hedging strategies” that do not actually directly hedge the compensation expense or SG&A expense exposure.
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.
Historically, companies have hedged the market volatility from their plans by purchasing physical assets. If an executive allocated $1 million to a mutual fund, the company would purchase $1 million of that fund. But interestingly enough, at least one of the companies mentioned above was doing precisely this, and it clearly did not eliminate the volatility in operating expenses. This is because while the plan expenses are recorded in Compensation Expense, the earnings from the assets hedging the plan are generally recorded in Other Income. This so-called “hedging strategy” is therefore not a direct hedge.
As a result, even companies that utilize this strategy must explain significant increases in operating expenses in earnings reports. Beyond the accounting issues, using physical assets to hedge a plan is costly. It ties up capital that could earn higher returns in the core business. Earnings on mutual funds are also taxed currently.
Fortunately, there is a solution to this issue – one that provides optimal accounting treatment, is relatively inexpensive, and is used by many large companies in the marketplace today. The solution involves utilizing a Total Return Swap (TRS). Rather than buying physical assets, a 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.
The gains on the TRS are recognized in the same line as the plan expenses – so operating expense volatility is reduced. This solution also does not tie up capital, and gains on the TRS are tax-deferred, so it provides economic value. A Columbia Business School study found that in one company’s case, the Net Present Value of moving to this solution was so large, it could have paid for 62% of the compensation owed to executives under the plan! And, there is no consumption of internal resources to administer the solution, as it can be cost-effectively outsourced.
Due to the recent market volatility, hedging deferred compensation plans has become front-of-mind for CFOs and their teams. Companies may wish to consider utilizing a Total Return Swap solution to optimally mitigate this market risk.