Why are Companies Moving from Fixed or Declared Rate Plans to Market-Based Plans?

David Marshall, Principal, Atlas Financial Partners

With the hindsight of over thirty-five years of experience in the Deferred Compensation Plan (DCP) industry, we have seen a marked shift away from “fixed” or “declared rate” plans to market-based plans – typically with menus that mirror a company’s 401k plan. There are a variety of reasons for this that we believe are instructive to plan sponsors.

Fixed or declared rate plans typically are designed to credit some spread (50% to 300%) over a base lower-risk rate, such as the 10 Year Treasury Rate or Moody’s Seasoned Corporate Bond Yield Rate. With a current 10 Year Treasury Rate of 3%, this type of plan can generate substantial returns for plan participants with very little volatility. But what can go wrong?

Proxy Disclosure: In 2006, the SEC revised Item 402 of Regulation S-K to capture deferred compensation earned by Named Executive Officers (NEOs). Among other items, companies must disclose in the Summary Compensation Table (column h) (Item 402(c) of Regulation S-K) any above-market earnings on nonqualified deferred compensation from plans that are not defined benefit plans.

Interest on deferred compensation is above-market only if the rate of interest exceeds 120% of the applicable federal long-term rate, with compounding (as per Section 1274(d) of the Internal Revenue Code) at the rate that corresponds most closely to the rate under the company’s plan at the time the interest rate or formula is set (or reset, should the rate be reset). Earnings tied to changes in the value of publicly traded investment funds are not treated as above-market. Only the above-market or preferential portion of the earnings must be disclosed. A company may disclose its criteria for determining above-market or preferential earnings in a footnote or as part of the narrative disclosure.

Compensation Best Practices: In up markets, these amounts can be substantial. During quarterly meetings, executives can be questioned about these amounts in a company’s proxy statement: Why are they above market? Are these types of arrangements available to a broader group? Are they equitable? Does the company 401k plan offer a similar investment? It is our understanding most plan sponsors feel that above-market earnings may conflict with their core values and best practices for compensation, so they avoid these questions altogether by offering a 401k-like investment menu. As indicated above, returns for these options are not subject to proxy disclosure requirements.

FICA Withholding: For market-based nonqualified deferred compensation plans, FICA withholding is applicable to deferral amounts only – and not to earnings. For fixed or declared rate plans, FICA withholding may also be required on some or all of the earnings credited under the plan. This creates onerous plan recordkeeping issues – and creates an additional FICA cost for plan participants.

Cost: If a plan is crediting the 10 Year Treasury Rate plus 250 basis points, the current crediting rate would be 3% for 10 Year Treasuries plus 2.5% or a total of 5.5%. This becomes an additional expense that flows through SG&A. If a market-based plan is implemented, the market volatility can be hedged away using total return swaps that replicate the return of the DCP. The cost for these types of swaps in the current market is SOFR plus spread or approximately 100 basis points. The incremental cost savings from replacing the declared rate plan with a market-based plan would be the difference between the 5.5% credited under the declared rate plan and the cost of the swap – or 4.5% in cost savings each year.