Reprinted by permission from Atlas Financial Partners:
Banks and other financial institutions are required to hold a certain amount of capital to reduce the risk of insolvency. The amount of capital each bank must hold is determined by the risk level of its assets. This has become costly for the many banks that are hedging their Deferred Compensation Plans (DCPs) with physical assets, such as mutual funds. It is not uncommon for 75% of the hedge assets to be allocated to equities, to “mirror match” the DCP. Equities have a high risk-weight and require the bank to tie up significant capital.
Freeing Up Capital With a TRS
To solve these issues, many banks now use a Total Return Swap (TRS) to hedge their Deferred Compensation Plans:
- The bank pays SOFR plus a spread and receives the returns of its DCP.
- The transaction may be settled in cash on a monthly or quarterly basis to limit credit exposure.
- DCP liabilities are typically monitored daily and the TRS is reweighted as necessary, so the TRS and plan liabilities remain highly correlated.
The use of a TRS allows the bank to either liquidate the physical asset hedge, and reinvest the capital in its business, or reallocate the existing assets to bank-eligible investment grade fixed income assets. This can free up significant bank capital:
- The fixed income assets attract little or no risk-based capital.
- The TRS, as structured, typically attracts no risk-based capital.
One bank Atlas spoke with recently has a $150 million DCP hedged with $150 million of mutual funds. Due to the equity component, this approach requires $31 million of bank capital. Given that this capital could otherwise be invested at the bank’s return on capital (likely 12%+), the after-tax cost of tying up this capital is $3.7 million per year.
In addition to the cost due to risk-weighting, the mutual funds are taxed currently, and there is an accounting mismatch – the plan expenses are recorded in Compensation Expense, while the earnings on the assets are recorded in Other Income.
The TRS also offers a tax benefit, as taxes may be deferred on TRS gains, losses and expenses until the underlying DCP obligations are paid to executives and an offsetting deduction is received. TRS gains and losses are typically recorded in the same line item as plan expenses as well, eliminating the accounting mismatch.
Atlas Financial Partners is the leading administrator for TRS hedges of DCP liabilities, currently administering $6+ billion for various financial institutions and corporations. Atlas would be happy to put you in touch with experts who could advise you on the legal, tax, and accounting benefits to this strategy and/or to put you in touch with banks which are executing this strategy for corporations.
Atlas Financial Partners and its associates do not give legal, accounting, tax, or investment advice. Please consult with your own advisers. Atlas is not a third-party control person under CFTC Regulation 23.402(c); a designated evaluation agent under CFTC Regulation 23.434(b) nor a qualified independent representative under CFTC Regulation 23.450(b). Atlas is a third-party administrator performing purely administrative functions with respect to the management of the transactions discussed herein. Atlas is not a swap advisor or a swap dealer and will not provide recommendations or advice on swap strategies.