Hedging Deferred Compensation Risk Economically: What Every Executive Must Know

Hedging Deferred Compensation Risk Economically: What Every Executive Must Know

Written by Geoff Gottlieb
Written by Geoff Gottlieb
Originally Published: Financial Executive Magazine | January 2012

The recent turmoil in financial markets has raised significant concerns over non qualified deferred compensation (NQDC) plans for executives and employers alike. If structured properly, an NQDC plan can be a valuable tool for helping executives meet their long-term wealth objectives through the deferral of bonuses and other compensation on a pre-tax basis—and can help businesses recruit and keep key talent.

Yet, with such benefits also come significant expense, liability and risk for the employer or plan sponsor. Therefore, companies need to fully understand their options in order to mitigate the risk. 

A NQDC plan’s cost is driven by an employer’s decision about whether and how to hedge, or fund, the plan’s liabilities. Some employers choose not to hedge at all, funding payouts from operating profits or other sources when due, at considerable risk and uncertainty for the employer. An employer must then decide whether to restrict the plan’s investment menu to low return/low risk choices, thus limiting the potential value to its participants, or choose to hedge the plan’s liabilities.

By hedging or funding the plan, the company earns income by using an employee’s deferred compensation to offset the changes in the value of the plan’s liability and the associated profit and loss volatility. For income tax-paying companies, the primary cost of deferring employee compensation arises from the corresponding deferral of the tax deduction. If an employee defers $100,000, the company has an additional $100,000 in current taxable income on which it will pay income tax of approximately $40,000, leaving $60,000 “available” to fund hedging investments.

However, hedging risk can be expensive because it uses an employer’s capital, incurs current taxation on gains and income and needs to be funded when the deferral has created an additional tax liability.

Optimizing NQDC Plan Cost

Employers traditionally have hedged or funded NQDC liabilities either through direct investments chosen by plan participants, or through corporate-owned life insurance (COLI), where the cash value of the policy is invested in funds that serve as proxies for the reference investments chosen by participants.

Companies that opt for direct investment informally fund the deferral distribution at the outset. This approach is expensive because it uses potentially scarce balance sheet capacity for investments not directly related to the company’s core business. In addition, the promise to the employee is credited with tax-deferred earnings while the company is subject to taxation on realized gains and income incurred on the investments.

Taxable events occur whenever the company moves funds from one investment to another in response to employee decisions to rebalance their deferred account portfolios—a direct and significant out-of-pocket employer cost. An alternative is to invest a grossed-up amount to cover the tax on the gains. Since that additional amount is not available from the initial deferral pool, it would need to be “borrowed” back and the interest on that loan represents the core cost of hedging on a direct basis.

To avoid the high costs of direct hedging, many companies have resorted to using COLI. COLI is essentially an investment contract with a life insurance wrapper. This structure is advantageous because the policy’s cash value returns are tax deferred and the death benefit is tax free. As long as the investments inside the COLI policy are managed to approximately mirror the composition of the liability, the cash value and accounting treatment of the COLI serve as an effective hedge. Since proceeds from COLI are not taxable and the deferral obligation generates a tax deduction at distribution, it’s only necessary to fund the after-tax deferral amount.

However, COLI does have limitations:

  • Very long-term investment with the full benefit of the policy being accessible only when death benefits are paid. A deferred compensation obligation has a shorter duration, typically from five to 20 years. The employer must cover the hedge’s shortfall on the distribution date due to the reduced accessibility of cash value within the insurance policy. During this gap, COLI continues to impose market risk
  • It has to be managed within a pre-specified tracking error (the gap between the COLI’s cash value and the NQDC plan’s liability). First, many plans allow participants to rebalance their accounts more frequently (e.g. daily) than a COLI policy administrator is willing to rebalance the COLI asset account (e.g., quarterly). Second, publicly available mutual funds and alternative investment funds cannot be used within insurance products. Insurance-dedicated funds (IDFs) must be used.
  • A relatively inflexible hedge. It’s difficult to change the investments offered by the policy in line with changes to investments offered within the NQDC plan.
  • The life insurance component of the COLI policy is not free. The company pays upfront premium loads and ongoing asset-based fees for the death benefit and other policy-related expenses.

A Better Option: The Total Return Swap Solution

A Total Return Swap (TRS) is a highly effective and economic option for hedging NQDC plan liabilities. Rather than funding the deferral obligation with the same or similar direct investments, the TRS hedges the market risk in a tax-effective way and eliminates the need to use expensive capital.

The TRS is capital-efficient, minimizes friction costs, provides favorable tax treatment supported by a private letter ruling and can be tailored to match the NQDC plan liabilities. The TRS enables more flexible and efficient NQDC plans, delivering higher value to participating executives at a lower cost to the plan sponsor. The TRS solution has several uniquely attractive characteristics:

  • Cost is similar to a borrowing rate, and not linked to equity performance. This is consistent with plan participants’ status as general creditors of the company.
  • Flexibility permits the company to initiate and cancel the TRS at its discretion without upsetting the underlying tax treatment of the hedge, and funds can be added or removed with ease.
  • For companies with strong credit ratings, the swap can be an unfunded arrangement.
  • It can be a perfect hedge with no tracking error:
    • TRS is marked-to-market for accounting purposes, which corresponds precisely to the accounting treatment of NQDC obligation;
    • The timing of taxation of TRS gains is aligned with the timing of the company tax deduction for deferral distributions;
    • Applicable to the exact same set of funds offered within the NQDC plan
  • The TRS can also be applied to funds managed by the plan sponsor, non-public funds (alternative investments) and offshore and non-USD denominated funds.
  • The TRS is not limited to US participant liabilities and can be applied globally.

Most important, the unfunded nature of the swap means that the after-tax deferred compensation is available for use by the company to invest for the duration of the deferrals. The returns on that investment will partially or even fully offset the TRS costs. The key variable is the plan sponsor’s choice of the rate of return to be credited to the freed up capital.

This rate should be somewhere between a corporate bond rate for the term of the deferral and the company’s weighted average cost of capital (WACC). As such, it is possible for the company to generate returns that fully offset the costs of the TRS without increasing risk to the overall business.

Hedging a NQDC plan with a TRS reduces and fixes the cost of offering the plan, neutralizes its potential financial volatility and permits the plan sponsor to provide its executives and key employees a powerful incentive without diluting shareholders. The swap hedge’s flexible, unfunded nature and tax-deferred benefit, permit the plan sponsor to offer a high value NQDC plan at the lowest (perhaps even negative) cost with reduced risk to the company.