A total return swapTM (TRS) is a popular financial vehicle commonly used to hedge market exposures of non-qualified plan liabilities in order to mitigate the impact of market volatility on corporate earnings. Numerous Fortune 500 companies—such as Microsoft, Cisco, General Mills, Abbott Labs, IBM, and Ball—presently utilize a TRS to hedge DCP liabilities.

How it Works

A TRS is a transaction in which a major financial institution (e.g. Bank of America, Bank of New York, Barclays, BNP Paribas) agrees to exchange or swap the total return (capital appreciation/depreciation) of a “basket” of assets for a fee, typically LIBOR plus a spread.

The basket of assets is constructed to mirror/hedge the DCP liabilities. We work with the company to determine which liabilities should be hedged, thereby managing exposure to market volatility and TRS cost. We also work on behalf of the company to negotiate TRS pricing. Current competitive spreads range from 50 to 60 basis points, depending upon the market exposure of the liabilities to be hedged.

Favorable Accounting Treatment

The accounting for swap gains and losses flows through operating earnings (SG&A), directly offsetting the P&L impact of plan liabilities. Financial reporting is typically recorded as “derivatives not designated as hedging instruments.” Note that any taxable gains can be deferred until benefit payments are made to participants.*

Unfunded or Funded Plans

A TRS can be an effective vehicle for companies that choose not to commit, or seek alternative uses of, corporate capital to fund a deferred compensation plan. However, a TRS can also work in concert with a company’s current funding and hedging strategy, while adding the significant benefits of using a swap.

For companies with existing corporate-owned life insurance, the COLl policies can be optimized and repurposed to hedge a portion of existing DCP liabilities. We identify specific asset classes and investment managers within the COLI to pair favorably with specific market exposures of the DCP liabilities, thus further mitigating TRS cost and exposure to market volatility.

CapAcuity provides this patented hedging strategy to sponsors of executive benefit plans. CapAcuity provides this patented hedging strategy to sponsors of executive benefit plans. For more information, contact us or call 407-949-6889.

 

* Treasury Reg. 1.1221-2(b)(2) and section 1221(b)(2) of the IRC.