When Should A Company Hedge Its Deferred Compensation Plan?

By Robert Polansky, Atlas Senior Advisor and Former Assistant Treasurer, General Mills

A Total Return Swap (TRS) is an efficient economic hedge of a company’s Deferred Compensation Plan (DCP).  The primary advantages of the TRS include:

• reduces net cost of the deferred compensation plan – in most cases, the market leg of the swap pays more than the floating leg of the swap which reduces the hedged cost of the DCP

• reduces reported income statement volatility – market volatility from DCP investment returns is replaced by a short-term floating interest rate cost plus a spread

• requires no upfront capital investment – the TRS is a financial swap requiring no upfront investment

• deferral of cash taxes on TRS gains/losses creates a substantial economic NPV benefit.

But an important question remains: “When should we hedge?”

There are two aspects to this question:

• When should a DCP hedge be considered?

• Timing of when to enter into a hedge

Size

The financial impact of an unhedged Deferred Compensation Plan is recorded in the Compensation Expense line of the income statement.  The expense recognized is the change in Plan liability driven by the market investment results of funds selected by plan participants.  Investment results will be driven by the rates of return on domestic equity indices, international equities, the bond market, company stock and any other investment fund offered in the DCP.   Because returns on capital markets are unpredictable, unhedged DCP expense is unpredictable and unrelated to underlying company business results.

When is the impact on Compensation Expense line or the overall income statement large enough to make a difference to a company’s reported results?

For some companies, volatility in the Compensation Expense line item is enough to cause internal concerns.  This P/L line will be important to either HR or whatever corporate department has responsibility for the cost of the DCP.  For some companies, a large unpredictable change in DCP expense can cause unwanted visibility on the entire income statement.  Atlas’s research shows CFOs prefer not to discuss their DCP during a quarterly earnings release, and would prefer to have this volatility mitigated.

Unwanted volatility from reported DCP results being “large enough” to make a difference will also vary from company to company based on its internal risk appetite for earnings volatility and the expectations of the company’s investors and lenders.

From a dollar size perspective, of Atlas’s Fortune 100 clients, one-third implemented the hedge with a TRS notional of less than $50 million, and the majority implemented with a TRS notional of less than $80 million.

The question of when the impact of a DCP is large enough to be hedged is best answered through an analysis of historical unhedged reported results compared to the results if a TRS had been hedged.  For plans of a size of $50 million or more, a noticeable reduction of the cost of the DCP and reduction of the quarter to quarter P/L volatility can be achieved.

Timing

The other important question about implementing a TRS hedge strategy is when to enter into the swap.  Does the timing matter?  Should a company wait for the market to go down before beginning to hedge?

The question of timing of a hedge of an unpredictable market risk is not unique to hedging a company’s DCP.  Many companies hedge their interest rate risk and foreign exchange risk.  Often hedging policies for interest rates or FX will include a hedge ratio (fixed/float or percentage of FX exposure hedge coverage) that is consistent over time because market timing has proven to be unsuccessful.  The same is true of hedging a DCP.  Because of the advantages of the TRS hedge to mitigate volatility and the reduction of cost over the long term, it is best to implement the TRS hedge of the DCP as soon as possible.

Research by Atlas using the past 25 years of data shows that the TRS will reduce reported DCP plan costs in 67% of quarters and 75% of years.  Using a longer horizon, the TRS reduces costs 80% of the time over 5-year periods, 87% of the time over 10-year periods and 100% of the time over a 15-year horizon.  Quarterly income statement volatility is reduced by 90% by the TRS hedge because capital market exposure volatility is replaced by short-term interest rate exposure.

Summary

A company should evaluate the advantages of a Total Return Swap any time after the DCP is put in place, not just when the DCP results are creating income statement volatility. The hedge may be put in place after internal evaluation of the financial reporting and tax treatment is complete and without waiting for the impact to be felt in the income statement or for a market dip.  The TRS reduces cost over horizons consistent with the long-term lifespan of the Plan itself and should be implemented when the company has the resources for the analysis and approvals in place.

Additionally, Atlas provides a fully outsourced implementation and administration of the TRS, reducing the resources required by the client to manage the hedge on an ongoing basis.

Atlas Financial Partners and its associates do not give legal, accounting, tax, or investment advice. Please consult with your own advisers. Atlas is not an third party control person under CFTC Regulation 23.402(c); a designated evaluation agent under CFTC Regulation 23.434(b) nor a qualified independent representative under CFTC Regulation 23.450(b). Atlas is a third party administrator performing purely administrative functions with respect to the management of the transactions discussed herein. Atlas is not a swap advisor or a swap dealer and will not provide recommendations or advice on swap strategies. Please consult your own advisors.