Tax Reform Plan: New Model for Executive Deferred Compensation and Retirement Plans?

Rep. Dave Camp (R-Mich.), Chairman of the Ways and Means Committee, released a draft of the committee’s new tax reform plan last month. The plan proposes significant changes to the tax rules with major changes in how executives save for retirement.

Even though the plan is not likely to pass this year, it gives us a first glimpse into the committee’s thinking and, if we are mindful, a real opportunity to plan our wealth accumulation.

The tax reform plan seeks to reduce and compress current tax rates, increase the standard deductions, expand the child tax credit, and permanently repeal the alternative minimum tax (AMT). Yet the plan also aims to raise significant amounts of revenue to pay for these tax cuts.

The current statutory tax brackets for individuals, which currently range from 10 to 39.6 percent, would change into three brackets: 10, 25, and 35 percent. These changes would reduce individual tax rates near new lows, which could impact executive attitudes toward deferring compensation.

CHANGES IN DEFERRED COMPENSATION RULES

The reform plan would repeal sections 409A and 457A, which provide rules governing nonqualified deferred compensation plans. Proposed changes are similar to long ago changes as they relate to deferring compensation in nonprofit organizations.

The reform plan would limit the ability to defer compensation in nonqualified plans by taxing all individuals when compensation is no longer subject to a substantial risk of forfeiture; thereby eliminating the ability to defer compensation on the basis that the taxpayer does not have constructive receipt of the compensation. If a participant in such a plan vests in his own benefit, he will be taxed, which defeats the purpose of these arrangements.

NEW 401(K) RULES LAY GROUNDWORK FOR GOOD PLANNING

Under current law, employees can defer $17,500. The new reform plan proposes to cut in half this amount to $8,750, the limit that goes into a tax-deferred 401(k), and the remaining amounts required as deferred Roth contributions (after-tax). The same rules would apply to catch-up rules. The advantage with the Roth is non-taxable income in the future. With tax rules forever changing, one should plan accordingly.

THE THREE PHASES OF YOUR MONEY

To maximize your income in the face of uncertain tax rates, it’s important to think of your money across three distinct phases (see Chart I). In planning for retirement income, one should focus on the three phases of retirement income planning: the contribution phase, the accumulation phase, and the distribution phase. Understanding these phases will help you appreciate the ultimate design.

During the contribution phase, a portion of income is set aside for use in future years on a tax-deferred basis. We have always been told that “pre-tax” deferral is better than “after-tax,” but is that really true? By deferring pre-tax, we accept that all distributions at retirement will be taxed as ordinary income. The question is at what rate.

The new reform will limit the amount that can be deferred pre-tax, however, with lower tax rates today do we think they could go even lower in the future? If not, would it make sense to pay out taxes today and receive distribution non-taxable in the future?

The next phase is the “accumulation” or “investment” phase. In this phase, your money grows. We have always been told not to put all of our eggs in one basket during this phase. Truly, investment diversification is important. However, of greater importance is the non-taxable, deferred growth of the money. Roth type investment strategies are important, especially if current tax rates are low as proposed by the reform bill.

The final phase is the “distribution” phase. In this phase, the money is taxed at the time of distribution. This phase is of paramount importance. It is not what you accumulate, but what you are able to keep. This is where tax planning can pay the biggest dividends. See Chart I.

AFTER-TAX STRATEGIES WITH LIFE INSURANCE

What sets these strategies apart from traditional deferred compensation plans, as well as qualified plans, is the way participants are taxed. The participant makes contributions with after-tax dollars, but because of how insurance contracts are taxed, and accumulates all earnings on the pre-tax amount. When money is withdrawn from these arrangements, it could come out non-taxable if structured properly.

*As its funding vehicle, this insurance strategy uses as its funding vehicle an institutionally designed universal life insurance policy that has favorable tax treatment if withdrawals are made up to basis and through policy loan.

WHY THE INSURANCE STRATEGY?

The insurance strategy was designed on the premise that some percentage of your retirement savings should be in a vehicle that can generate non-taxable income during retirement, and remains safe from creditors of the sponsoring organization.

The important thing to remember and repeat is this: “It’s not how much you make, but how much you keep.” The distribution phase could be the most important phase of your retirement planning. No one knows what income tax rates will be when you retire (Chart III).

Going from a 35 percent tax bracket to a 50 percent tax bracket reduces your retirement income by approximately 25 percent. The insurance strategy distributes income at retirement without taxation, thus taking the future tax risk out of the equation. Based on the history of U.S. top income tax rates (again Chart III), how likely is it they will continue to decrease?

The insurance strategy provides the power of pre-tax savings without the contribution limits or age restrictions of qualified plans. To get the maximum value from retirement accumulation, participants should first maximize their pre-tax contributions into their 403(b), 457(b), and 401(k) plans. With the new reform bill proposing to limit those contributions and eliminate the advantages of pre-tax nonqualified plans, this maximization could be a good alternative.

HOW THE INSURANCE STRATEGY WORKS

The insurance strategy achieves its tax-advantaged status through an institutionally priced universal life insurance policy. ”Institutionally priced” means that the policy’s charges are significantly lower than comparable retail products. For example, the policy could have 100 percent cash value in year one and with no surrender charges. The cash values could be invested in a basket of mutual funds (called separate accounts) or could be used in a special fund that provides a market upside with no investment downside; that is, the S&P 500 with a cap of 12 percent and a zero return is S&P is negative. These types of funds are found only in insurance contracts.

Further, the insurance strategy is unique as a wealth accumulation plan because the policy loan feature allows a participant to take a “tax replacement” policy loan to make up for the taxes paid on the amount of any after-tax deposit. This flexibility is accomplished with key features inside the policy, along with other arrangements through third-parties.

Here is an example of the mechanics of the insurance strategy. Let’s say you were to receive a $100,000 bonus as income. You owe approximately $40,000 in taxes, which leaves about $60,000 left to invest. You could elect to invest the money in mutual funds, and assuming you were to earn 7 percent annual return, you would have to pay taxes on some portion of the gain depending on how the money was invested. Therefore, you would pay taxes each year on your gains.

With the insurance strategy, you would deposit the $60,000 in your account, and the policy loan feature would increase your balance to $100,000—the pre-tax amount of your bonus. Assuming you were to earn the same 7 percent return, your Insurance strategy cash values would accrue the gains on the entire $100,000 with no current taxation. Also, any asset reallocation between sub-accounts (investment choices in the policy) is not subject to taxation.

Later, you could make non-taxable withdrawals of both principal and interest. In addition, the insurance strategy provides the participant with a non-taxable life insurance benefit. Unlike your qualified plans, you are not forced to take the money at certain ages.

The policy loan to restore the taxes would be deducted from the policy’s death benefit, along with the capitalized interest. This deduction reduces the death benefit somewhat, but the approach still compares favorably with the mutual fund investment example, which does not provide a death benefit.

This illustration depicts the flow:

CLOSING NOTE

With the ever-changing tax rates, every executive should develop a comprehensive strategy toward wealth accumulation. One size doesn’t fit all. We should have three buckets of money to maximize the amounts we withdraw at retirement – taxed as ordinary income – taxed at capital gains – non-taxable. I encourage you to seek out a knowledgeable advisor who can help you plan your future.

See you on the upside, Bill

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