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