Feb 28, 2014

The Next Frontier: ETFs in NQDC Plans

In 2010 McKinsey & Co. released a white paper entitled, “Winning in the Defined Contribution Market of 2015.” McKinsey suggests that recordkeepers, asset managers, and wealth managers who aspire to be leaders in the Defined Contribution (DC) market need to focus on these key imperatives:

Focus on client segments and products that benefit from new market certainties:

  • Fee disclosure
  • Investment due diligence
  • Exchange Traded Funds (ETFs) advantages over mutual funds

Retool sales/operating models to meet client demand for more institutional services:

  • DC recordkeepers face pressure to cut fees amid razor-thin margins
  • To survive recordkeepers must address questions of cost and competence

Investigate core areas for building business in major growth categories:

  • 2/3rds of DC assets are invested in plans using services of an investment advisor
  • Recognize 3 (38) investment managers bring added benefits to fiduciaries
  • Managed Accounts equal $ 124 billion in 2013

The Center for Retirement Research at Boston College conducted a study which found that the design and pricing of domestic equity mutual funds held in retirement accounts take a significant toll on the returns. The study’s conclusion: By shifting the investment options of a retirement plan from mutual funds to ETFs, the average 401(k) plan can reduce its annual fees and trading costs by 0.70 percent or more of assets. Clearly, the opportunity to invest in low-cost ETFs will increase a participant’s retirement savings in contrast to investing in high-cost mutual funds.

NONQUALIFIED PLAN FUNDING

These studies are all being driven by client needs. As companies strive for transparency and efficiency in their qualified DC plans (401(k)s), they must also turn that focus to their nonqualified plans, especially the funding and administration aspects. You’ll find our downloadable NQDC guidebook quite helpful. A nonqualified deferred compensation (NQDC) plan with $10 million of assets may have a cost of ten times what the company pays for its 401(k) plan with $100 million of assets.

Nonqualified plans, according to prevalence data, have been primarily funded with mutual or corporate- owned life insurance (COLI). According to a 2011 Mullin/TBG study, mutual funds outpaced COLI by more than 10 percentage points (52.6% vs. 42.1%). This trend was also confirmed by a 2013 report, “A Three-Step Approach to Nonqualified Plan Financing prepared by CAPTRUST”, indicating 44 percent of companies fund plans with life insurance compared to 55 percent with mutual funds. One percent of companies leave plans unfunded.

In many COLI policies, the mutual funds (called separate accounts) held inside the policy can carry an additional 20 to 40 basis points of additional cost to mutual funds held outside. Even with mutual funds, the corporate sponsor should use institutional funds for their nonqualified plans.

The way companies fund their nonqualified plans has a major future impact of the participant’s accumulation, as well as the company’s overall cost.

BUNDLED PROVIDERS

Unlike the now transparent 401(k) market, many plan sponsors with nonqualified plans are dealing with a black box when it comes to understanding the true cost. Most bundled providers use COLI as the major funding vehicle, plus charge additional fees for plan administration.

Unlike 401(k) plans, the cost of many COLI policies is front-end loaded, therefore, when service goes bad in a few years, there is no incentive to make things right. What typically happens is the sponsor puts their plan administration out for an RFP, and the new administrator wants to replace the COLI, which was not the issue.

This move is a mistake many companies are making as I write. The mistake costs participants and, more importantly, costs shareholders. These policies may need to be right-sized at some point, but not replaced. The problem lies in the revenue model adopted by the bundled provider.

You should ask for complete disclosure, so you know exactly the total cost of the plan.

Today most 401(k) providers offer full-service platforms for nonqualified plans; there is no need to bundle your services. Reducing plan administration fees or, in many cases, eliminating them altogether, saves companies and gives participants a seamless experience with their total retirement services.

CONSIDER ETFS IN NONQUALIFIED PLAN FUNDING

As discussed earlier, ETFs can be a good alternative over mutual funds. It is a funding strategy worth considering for all or a portion of your nonqualified plan assets because it offers an additional benefit to the plan sponsor.

ETF taxation is driven by its underlying holdings. Since funds are structured differently, according to how they gain exposure to the underlying asset, an exchange-traded product’s tax treatment inherently depends on both the asset class it covers and its particular structure. Because the company holder-for purposes of funding the nonqualified plan-is the plan sponsor, ultimately the tax will be ordinary income (corporate tax).

The major advantage in holding an ETF is no taxation on the accumulation until the fund is sold. Conversely, when holding mutual funds, you must pay tax on the realized gains each year. And COLI allows you to take advantage of its special tax treatment until the death of the participant, which could be 30 or 40 years.

If the sponsor uses an ETF to hedge its nonqualified liabilities and coordinates it with participant deferral elections, an advantage occurs. For example, if a participant defers income for five years, and then elects a short-term payout option simultaneously, the accumulation tracks the liability. The corporation pays tax on the ETF sale while at the same time taking its tax deduction for the amounts deferred. Example below: $100,000 one-time deferral for five years).

CHANGE HOW YOU FUND THE PLAN

When nonqualified plans were growing in popularity, the majority were funded with COLI, as established earlier. Why? The industry created the demand.

Today, there are more resources available and new funding concepts that offer additional advantages. As a firm, we recommend you follow a four-step process to evaluate and manage your nonqualified plan funding.

1. EVALUATING BENEFIT LIABILITIES

As a first step, we urge sponsors to understand the nature of the benefit liabilities, as well as proper timing for cash flow to meet benefit payments.

Today, many plans offer short-term distribution features that require companies to make benefit payments short term.

A company should do a comprehensive financial model to project future benefit cash flows and plan liabilities. This evaluation will allow the plan sponsor to determine when benefit payments are made (cash flow) and when deferred tax benefits are realized (accounting) to establish its current position. Such an analysis will then illustrate how the plan sponsor’s current funding strategy interacts.

2. FUNDING METHODOLOGY

To determine plan funding methodology, we recommend working in concert with the third step in the process, which is to outline the company’s objectives. This identification of overall funding methodology is critically important. Typically, companies fund their nonqualified liabilities in one of these three ways:

  • Contribution Matching – Matches the investment cash flow to the plan’s net contributions and distributions.
  • Asset Liability Matching – Matches investment asset value to the benefit liability. Often, a plan will commence on the contribution matching methodology then as the plan matures cross over to asset liability matching.
  • Cash Funding – Targets a periodic investment that will produce positive cash flow timed to offset benefit distribution.

3. STATED GOALS & OBJECTIVES

Be sure to weight the importance of various modeling assumptions, such as P&L impact; cash flow; NPV of both benefit obligations; and funding. Next, take the results of step one above and model out your plan assets, according to the objectives set and the methodology selected.

4. FUNDING ASSETS

As we have discussed throughout this paper, no “one size fits all” exists for informal funding strategies. COLI does play an important role for some organizations, but not all. If you currently use COLI, I urge you to optimize and right size your existing COLI contracts.

Let me emphasize, this does not mean replacement with another carrier, as that only benefits the broker in the long run. Each asset carries advantages and disadvantages, and needs to fit within your objectives and the methodology you have selected in funding.

NET TAKEAWAY

As an employer, it is critical to help your top executives build sufficient retirement security with future-defining incentives like nonqualified plans or risk your talent to a competitor who does. Equally important, you must create well-funded plans that do not drag on the long-term financial vitality of the company.

Now is the time to investigate the many compelling reasons to look at asset classes. In addition to traditional COLI funding, it is important to look at more efficient vehicles such as exchange-traded funds. Seek out the assistance of a seasoned independent firm in NQDC funding, and begin a new and cost-effective chapter in your executive benefits history.

See you on the upside, Bill

Feb 14, 2014

How To Design Your NQDC Plan for Competitive Advantage

The word “competition” has taken on a whole new meaning for American business. For one, there’s more of it. For another, it’s far more fierce. And finally, to win requires a lot more than just delivering a great product or service at a great price.

As if that wasn’t hard enough. Winning today requires a distinct competitive advantage.

Today’s senior executives must maintain a 360-degree view of business. They must become experts in areas never dreamt of in an ever-expanding job description. Any misstep can alter that course, and it is a long walk back to get on track.

The good news: Every decision made can lead to a competitive advantage.

Nine times out of ten it is the people that make the difference. And, although it may not be politically correct to say in some circles, it is your key executives and managers that are the key to victory. Not that everyone in the workforce isn’t important, but some are unquestionably more important than others.

ATTRACT AND RETAIN THE BEST

In order to attract, retain and reward key executives and managers, the Fortune 500 have, for years, provided a benefit that allows highly compensated individuals to accumulate wealth on a tax-deferred basis. These plans, also referred to as deferred compensation plans, when designed properly offer a win-win-win scenario for companies, shareholders and participants. These plans are now available to companies of all sizes.

Deferred compensation plans are “nonqualified” plans, (NQDC) meaning that they are not subject to the ERISA (Employee Retirement Income Security Act) and IRS (Internal Revenue Service) regulations governing qualified plans, such as 401(k) plans. Because of their nonqualified status, deferred compensation plans offer advantages that cannot be overstated and should not be overlooked.

  • Selectivity – NQDC plans allow you to discriminate. What the plan provides to one, need not be offered to another.
  • Discretionary – Companies may decide to make contributions to the plan, or they may not. Contributions one year and not the next. Impose vesting schedules to create “golden handcuffs” or “non-compete cuffs” or offer immediate vesting to create a powerful recruiting tool.
  • Flexibility – Companies can structure deferred compensation to meet their individual situation and objectives.
  • Costs – The cost of providing a deferred compensation plan benefit, depending on how you choose to structure it, is extremely low by any standard. No other executive benefit costs so little yet provides so much.

You can design and implement a NQDC plan from start to finish in less than a month if you’re quick; two to three months, if you’re not. A lot depends on the plan design and what funding vehicle you use.

KEEP IT SIMPLE

The most successful deferred compensation plans all share one important characteristic: Simplicity. Plans that are easy to understand and interact with receive higher levels of participation, and don’t add to the burdens already placed on internal human resources and finance departments.

The most successful plans are developed by specialists in the field who know how to uncomplicate the process. For example, our firm, Benefit Funding Group, specializes in NQDC plans, and brings many resources to your table:

  • Experts in plan design
  • Accounting administration
  • Simple funding alternatives
  • Communication and implementation tools

A dedicated team leads you through the process of designing your plan, taking the responsibility for all the legwork so that your internal resources are not overly taxed implementing the plan. The team interfaces with your human resource team, finance and payroll function, along with any external advisors or counsel.

EDUCATION

Before beginning the design process, you need to understand how deferred compensation plans work and how to use them to achieve your company’s objectives. That’s why we created a guide to understanding nonqualified plans and plan design, funding, security, and administration: Designing Nonqualified Deferred Compensation Plans to Competitive Advantage.

THREE PARTICIPANT DECISIONS

In a deferred compensation plan, participants are given the opportunity to defer a portion of their compensation in order to save and invest on a tax-deferred basis, much as they are in a qualified plan such as the 401(k). The amounts deferred simply stay in the company’s coffers until needed to satisfy scheduled disbursements. We will discuss later what the company does with those deferrals from a funding standpoint. The three decisions:

  • How much to defer;
  • Which investment option to tie returns to;
  • When to receive payouts from the plan.

Most deferred compensation plans introduced today allow participants to defer up to 80 percent of salary and up to 100 percent of bonus compensation. The 80 percent salary cap allows for any payroll deductions like FICA and other benefits.

DEFERRAL OF 80% SALARY AND 100% BONUS COMPENSATION

INVESTMENT BENCHMARKS

Which investment benchmark options will you offer to plan participants? Most deferred compensation plans offered today allow participants to choose from a variety of benchmark investment options. Others offer only a fixed crediting rate, which is not as prevalent today. In addition, some plans mirror the options found in the company’s 401(k), while others provide a completely new menu of funds.

A lot of this variation is driven by the broker or consultant establishing the plan, and based on their funding recommendations. If the broker is selling corporate owned life insurance (COLI) he or she may suggest you use a different menu, as they can’t match your 401(k) exactly. You should not let the funding decision drive your objectives for fund selection.

If you are looking for simplify, weather matching the 401(k) or a separate menu you should consider using mutual funds and exchange traded funds (ETF) as the overall cost is less. COLI should be considered as an asset only if you have large deferrals that continue to grow and the benefits are long term (i.e. people deferring until retirement which is several years out.

PROS AND CONS OF MATCHING 401(K) MENU

PLAN PAYOUTS

When will the participant take money out of the plan? Years ago it was not uncommon to see deferred compensation plans that allowed participants to withdraw their funds only at retirement or close to retirement, such as age 62. Today, however, most plans being designed allows participants to schedule withdrawals while still employed by the company sponsoring the plan.

Before you start considering what your plan should allow, there are a couple of rules that apply:

  • Participants must schedule their withdrawals at the time they elect to defer.
  • Withdrawals should be at least two years after the election to defer was made.
  • If participants want to re-defer, it has to be at least five from the date of the original election (409A requirement). For example, original election 2018 must re-defer to at least 2023.

Another issue to consider is whether to allow withdrawals to be received in installments or whether amounts can only be paid as a lump sum.

Hardship withdrawals are permitted without penalty (must follow 409A guidelines) and, naturally, if a participant were to die while in the plan their beneficiary receives the entire account balance.

So what should your plan allow? Withdrawals while still employed or will participants have to wait until retirement? Or of course, should you set the rule somewhere in between? The arguments pro and con follow:

SHOULD THE PLAN BE INFORMALLY FUNDED?

When you informally fund a NQDC plan you take some or all the amounts deferred by participants and set them aside for the express purpose of paying the plan’s future liabilities.

Participants like to hear that you actually took their deferrals and set them aside to pay their benefits in the future. Plan participation goes up tremendously when companies informally fund their plans.

Also, most companies that informally fund their plans use a Rabbi Trust, a vehicle that protects participants from the company’s choosing not to honor the terms of the plan, as could occur were there a change in control or ownership. The use of a Rabbi Trust essentially means that participants will receive their distributions in all cases, but the company’s insolvency, in which case the assets of the trust are subjected to the claims of creditors.

HOW SHOULD THE PLAN BE INFORMALLY FUNDED?

Assuming you have chosen to informally fund the plan, you now must decide how the plan will be informally funded. In general, companies that do informally fund their plans invest those monies in either mutual funds or corporate owned life insurance (COLI) policies owned by the corporation, some companies also use their company stock.

According to the 2011 Mullin/TBG Executive Benefits Study “companies continue to favor mutual funds (52.6%) and COLI (42.1%) to informally fund their NQDCPs. Used by 48.8% of respondents in 2010, mutual funds experiences a significant jump in prevalence. COLI usage rose slightly – 41.3% of respondents selected it in 2010.”

In truth, companies are now using multiple assets to fund their plans. The following chart summarizes advantages and disadvantages of the three most popular funding options:

IMPLEMENTING THE PLAN

Finding an independent and knowledgeable consultant is key to success. Bundled providers that have a turnkey solution may prove to be more expensive and less flexible. When you use some of the boutique firms who offer nonqualified plan design, funding and administration, you will find their revenue model is supported by the sale of COLI products. COLI is a good funding asset for long term deferrals, however, funding the entire plan with that asset may not make good sense.

An independent advisor can help with the process. We recommend the following steps and resources.

  • Finalize plan design using the consultant and outside legal counsel. The consultant should be able to provide a specimen document that is 409A compliant to minimize your cost.
  • Create a work plan to layout events. Again, your consultant should be able to provide this plan.
  • Use a Registered Investment Advisor (RIA) with the consultant to select the fund menu and determine the informal funding model.
  • Select the enrollment and administrative platform. Here you should look to lower company cost and provide a seamless experience by reviewing current providers such as your 401(k) provider or payroll-company. No longer is there a competitive advantage with boutique providers. In fact, these types of firms could be more expensive, based on how you funded.
  • The consultant can assist you with administration selection and help you coordinate key activities with payroll.
  • Enrollment today is mostly provided online; the consultant and administrator should have several options for you that work in concert with the plan.
  • It is essential to provide reporting to accounting for the liability and the assets held. The administrator should provide daily feeds to accounting, and to the trustee (assuming you are using a Rabbi Trust) or the RIA can provide asset values.
  • Finally, the consultant can be a resource to the committee for communication updates.

NET TAKEAWAY

A nonqualified plan is a valuable tool to attract and retain key employees. Know that it doesn’t have to be a financial or resource burden on the company. With the various types of providers available, many of which you are already working with, combined with the knowledge of the right independent advisor, you can design, fund and administer a plan to create a cost-effective, competitive advantage in the intense market for top talent.

See you on the upside, Bill