Jun 5, 2014

Is There a Free Lunch in Executive Compensation?

Proposals for low or no cost funding of nonqualified executive benefit plans continue to proliferate.

If there existed a list of truisms with which almost all financial executives could agree, the list would include: “Pension plans are expensive” and “Cash value life insurance is a poor investment.”

Top management regularly finds stacks of plan proposals on their desks intended to provide substantial retirement income and wealth accumulation benefits (via deferred compensation) for highly compensated executives, always with the caveat “little or no cost to shareholders.”

How do the makers of these proposals expect to fund these plans? Corporate-owned life insurance (COLI)? What are the underlying costs? Usually little, if anything. If not entirely a free lunch, it’s awful close.

For context, let me share several design styles of executive benefit plans:

  • Consider a voluntary nonqualified deferred compensation (NQDC) plan, which allowed executives to defer compensation over and above the company’s 401(k) plan limits set at $17,500 in 2014. The executives received 14 similar investment fund choices. Design-wise, the plan carried no cost to the company, even after an allowance for the time value of money.
  • In another “performance base” plan, the company made annual contributions between two and eight percent of the executive’s annual cash compensation, based on return on equity (ROE) set by the company. This plan, like the deferred compensation plan, allowed the executive to invest the company contributions into a family of mutual fund type investments. Plan design carried no costs, other than expected cost of money.
  • And finally, a supplemental executive retirement plan (SERP) provides a benefit equal to the executive’s average final five years of income. COLI is used to recover the after-tax cost plus company’s cost of money.

APPEAL LIES IN TAX DEFERRED WEALTH ACCUMULATION BENEFITS

The principal appeal of these plans, and others like them, lies in the tax-deferred wealth accumulation. Executives are rightly concerned about the government limitations of qualified pension plans and their inability to tax defer dollars for later retirement.

The limits governing contributions to a 401(k) plan make it only marginally valuable to highly compensated executives. They cannot accumulate adequate retirement savings solely as a percentage of their annual compensation solely through their 401(k).

To address this inequity of government limitations, as well as provide a valuable executive compensation benefit, companies began to offer savings plans considered “nonqualified,” which refers to their exemption from ERISA’s* requirements for qualified plans. Since these programs do not have to meet ERISA or other technical requirements applicable to broad-based retirement plans, they can focus narrowly on an employer-defined top management group.

DECEPTIVELY ATTRACTIVE?

When the above advantages blend with the extremely low cost represented, the attraction can seem overwhelming. Skeptical financial executives ask how it’s possible to provide significant benefits for executives since plans allow the insurance company to earn a profit on the funding policies, as well as marketing and program administration which makes a profit on its investment. Low cost? Everyone seems to win, and nobody pays.

Further, the executive knows the broad-based pension and other employee benefits are expensive, and he is also mindful of the reputation of cash-value life insurance as a poor investment. How is it all possible?

Determining the answers require an intriguing inquiry into perceptions of cost in funded employee benefit programs, and into the economics of buying COLI policies as an investment rather than for traditional insurance protection motives.

DEFERRAL ELECTION AND INFORMAL FUNDING

In a typical deferral plan, employees are given the option to defer a portion of their annual cash incentive pay, their base salary, or both. Make elections sufficiently in advance of the time the payment is otherwise due; then, you conform with IRC 409A and avoid current taxation. The amounts deferred and interest earned records as a liability by the company on its books. In order to offset this liability, companies often choose to “informally” fund their NQDC plans by using the cash from the executive’s deferrals.

Formal funding, as required with qualified plans such as the 401(k), occurs when a company sets the money or investment vehicles outside of its general assets. In other words, the company can’t touch the monies earmarked for payout under the plan. Should the company become insolvent, creditors cannot make claims against monies in formally funded programs.

Nonqualified plans are informally funded when a company sponsoring such plan decides to take some or all of the money it receives through the executive’s deferrals and invest it to help ensure that when the time comes to pay out funds, those funds will be in place. A company may invest in a wide range of instruments to accomplish this goal, but the most common choices are mutual funds and COLI.

COLI VERSATILITY

COLI products are quite prevalent among the Fortune 1000 because of the tax advantages they provide to the corporation. Typically, policy cash value invests in mutual fund investments, similar to your 401(k) plan. A company can allocate the cash value among these accounts to mirror employee elections under the deferral plan. Furthermore, the allocation can be changed and rebalanced without triggering realized gains. Any investment gains, dividends or interest earned within a COLI insurance contract (held until maturity/death of the insured) remain tax free to the company. On the other hand, if the company funded with mutual funds, most gains would be taxable.

SIMPLE MATH OF INFORMAL FUNDING

As mentioned earlier, the two methods most often used to informally fund deferred compensation liabilities are mutual funds and COLI contracts. Tax-paying status and cash-flow timing drives a company’s decision on which method to select.

Companies that do not pay taxes due to loss carry-forwards or NOLs (Net Operating Losses) almost always informally use mutual funds to fund their NQDC plans. The gains from mutual fund investments are taxable, but since the company isn’t a taxpayer, those gains do nothing to increase the company’s liability.

However, if the company is a tax-paying entity, then COLI should be considered for at least a portion of the funding. Gains that result from investments inside of an insurance contract, owned by the corporation and held until maturity (death of the insured), accrue tax-free to the company. There are costs associated with purchasing a COLI contract and a portion of those costs provide a death benefit. The executive participating in the plan becomes the insured; the beneficiary is a company (or a trust) that owns the policy.

The math is simple: The company needs to weigh the cost of the COLI against the cost of paying taxes on the mutual fund gains. Chart I compares the difference in long-term net after tax return for a mutual fund with the return for COLI invested in the same fund. In this example, the return (net of management fees) is 7.0 percent.

With mutual funds, the investment earnings are taxed as realized. Some of the taxation can be deferred by using passive index funds or by qualifying the funds as a hedging transaction; however, gains eventually are realized when the funds are liquidated to pay benefits. In the example, the annualized after-tax rate of return with mutual funds is 5.03 percent compared with COLI expected return through death (assumed age 85) of 6.37 percent.

As you can see, COLI has a clear advantage due to the favorable tax treatment, even despite any slippage due to expense charges for insurance. Nine percent of the gain on COLI was used to pay insurance cost verses 28 percent of the gain from mutual funds for taxes. When you adjust the return to 4 percent, COLI insurance costs are 16 percent compared to mutual funds still at 28 percent.

COLI VS. MUTUAL FUNDING/INVESTING SCENARIO SUMMARY EXEC AGE 45

Numbers in the above chart are hypothetical and should not be relied on for making an investment decision. Mutual funds and COLI have the same net investment rate in each scenario (you should review management fees in your analysis). Mutual fund assumptions: 7:00% return, 2:00% in ordinary dividends, 4:00% in capital gain dividends. 10% rebalancing per year, 70% dividend exclusion.

STRESS TEST YOUR COLI CONTRACTS

As we discussed above, COLI is advantageous when a company is in a tax-paying position and when it can use its own cash to fund benefits. Any COLI analysis should include stress testing. A number of factors can influence the returns from COLI contracts:

  • Company tax rate
  • Investment returns from the mutual funds (separate accounts) in COLI
  • The company’s cost of capital
  • The level of premium vs. executive deferrals
  • How the company funds the benefits (out of cash flow or policy)

What’s more, a company should consider the trade-off between tax efficiency and liquidly. When a company pays benefits out of current cash, while holding the COLI until the insured’s death (assumed age 85 in our example), it could find itself with excess funding.

Also, executive deferrals normally are not level as we illustrated, causing a mismatch with COLI funding.

Chart 2 below illustrates the funding mismatch when COLI premiums equal annual deferrals. Here we used the exact amount of executive deferrals to pay premiums on the policies (this is how the majority of companies fund their plans). Most brokers will write a policy to accept the full premium ($100,000 in our example) and never adjust the policies or consider split funding with mutual funds.

Funding mismatch is a common problem and is the reason COLI policies don’t perform to the original illustrations the broker provided. Using our example in Chart I, based on the deferrals and premiums in Chart 2, 21 percent of the return will be lost to insurance charges verses 28 percent to taxes in mutual funds. This differential makes mutual funds seem more attractive.

To avoid this mismatch, COLI is best used as a funding vehicle for a plan with continued growth or to be used in concert with other asset classes. You need to make sure your policies are always optimized to take advantage of the benefits provided from COLI.

Do not replace existing contracts with new policies. If a broker suggests this, it should be a big red flag. You need to find an independent advisor to analyze the suggested replacement or work directly with the carrier being replaced to give them a final chance to “right size” the policies. Replacing will cost you, even though the broker’s illustration will say differently.

PERCEPTION OF COLI AS A BAD INVESTMENT

Unfortunately, COLI comes in many shapes and sizes. Various forms of COLI have had some negative press. Today’s generation of COLI represents a highly sophisticated, competitively priced contract allows a company to choose investment managers of separate-account mutual funds whose strategies more closely match a company’s liabilities.

Prevalence studies show a decline in COLI usage mainly due to the need to examine other assets to fund the company’s future benefit obligations. Many companies simply do not have the time or expertise to do such an examination.

Benefit Funding Group utilizes a proprietary Optimizer™ technology process created by American Financial Services. Optimizer analyzes various funding alternatives and blends the assets to meet the company’s funding objectives. This process is an excellent due-diligence tool.

Of course, COLI purchases also should follow best practices. U.S. Reprehensive Thomas M. Reynolds, R-NY helped introduce H.R. 2251, the COLI Best Practice Act of 2005 in the U.S. House of Representatives, which helps to reform the use of COLI. The legislation preserves COLI as a valuable tool for employers seeking to fund employee benefits. Most firms consulting on COLI follow these best practices, however, many do not look at coordinating them with other assets to optimize the funding of these plans.

NET TAKEAWAY

As we know, there is no such thing as a free lunch. Because executive benefit plans empower organizations to attract and retain talented employees, those who contribute to corporate growth, some cost is clearly justified. Fortunately, COLI and other funding assets can help lower that overall cost.

Don’t forget, you need to use a proven process to ensure optimal funding that reflects company objectives and applicable assumptions.

See you on the upside, Bill