Market volatility in recent weeks has been unprecedented. As a result, we thought this would serve as an opportune time to look at how the most prevalent strategies for hedging non-qualified deferred compensation plans have performed recently.
On-Balance-Sheet Strategies
Some companies hold non-operating investments in mutual funds, ETFs, and corporate-owned life insurance (COLI) on their balance sheets to hedge this exposure. A key concern is, while plan expenses flow through SG&A, earnings of these on-balance sheet assets flow through Other Income – resulting in a material mismatch for financial reporting.
The following table illustrates the material volatility in SG&A/Operating Earnings since 2018, due to a $60 million DCP liability that has $50 million allocated to an S&P 500 fund and $10 million allocated to an intermediate duration U.S. bond fund.
As an example, in Q1 2020 SG&A was positively impacted by $12 million while the following quarter (Q2 2020) SG&A was negatively impacted by $9.5 million – resulting in a total swing over the two quarters of $21.5 million. Note that this earnings impact persisted, even if the company was hedging with mutual funds or COLI.
Beyond the earnings volatility, hedging with COLI also resulted in a material negative impact to Net Income for many companies during the market downturn, because the COLI is not tax deductible when it declines in value. Large companies hedging with COLI have had to highlight this issue on 2020 earnings calls, as illustrated by the quotes from three Fortune 1000 CFOs below:
“The higher effective tax rate was driven by…the change in the market valuation of our company-owned life insurance related to our deferred compensation plan.”
“The high GAAP tax rate was driven by the nondeductible effects of changes in the value of our deferred compensation plan.”
“The non-GAAP tax rate was 14.6% and above the company’s long-term tax planning rate of 13% due to negative capital market impact on expense deductions in the company’s employee deferred compensation program.”
In addition to these earnings issues, these strategies also result in corporate capital being committed to hedge benefit obligations, potentially reducing alternative investment “opportunity” for corporate capital.
Off-Balance-Sheet Strategies
Many companies instead hedge this volatility with a Total Return Swap (TRS). A TRS is a relatively straightforward transaction where a bank agrees to exchange (or “swap”) the total return (capital appreciation/depreciation) of an asset or basket of assets for a fee. The accounting “geography” is particularly favorable as TRS gains and losses flow through SG&A directly offsetting the P&L impact of plan liabilities (i.e., compensation expense).
Note that the favorable economic impact of the TRS is also material as deferrals do not need to be used to purchase physical assets– but can instead be reinvested at potentially higher rates of return. Taxes on TRS gains can also be deferred until benefit payments are made to participants.
Conclusion
The market volatility in recent weeks has highlighted the potential cost of hedging deferred compensation plans with on-balance-sheet strategies. The impact to corporate earnings can be material. Atlas is happy to assist companies with the evaluation of the different strategies, including detailed financial models specific to each company’s individual fact pattern.
By Benjamin Eisler
Managing Director, Atlas Financial Partners