Generally, companies choose not to fund non-qualified benefit plans because of the cost of capital used for funding and because the tax results can be suboptimal. Deferred compensation plans are actually required to be “unfunded” to satisfy various ERISA and tax requirements.
However, some companies choose to “informally fund” benefit obligations by establishing and contributing to a grantor trust (i.e., a “Rabbi” Trust) that is considered a corporate asset for accounting and tax considerations. The Trust provides a measure of protection to the participants under a change in control, but does not protect the participant in the event of a bankruptcy—participants are general unsecured creditors of the company whether or not there are assets in the Trust.
Rather than funding the trust, companies can also include a Change in Control trigger within the Trust that calls for the company to fully fund the Trust in an amount equal to participant liabilities prior to a Change in Control. This approach can satisfy participant concerns without the cost of funding.
COST OF AN UNFUNDED PLAN
In an unfunded plan, the company retains cash that would have otherwise been paid to the employee who elected to defer a portion of his/her compensation. Instead of paying out cash as employee compensation, the company retains these resources for the company’s operating activities. The expected earnings on the reinvested capital is the company’s average Return on Capital (ROC).
The expected cost of the unfunded NQDC liability will be a blend of returns on the investment fund choices made by the plan participants. This cost may be higher than the company’s average ROC if capital market returns are robust.
COST OF A FUNDED PLAN
In a funded plan, the company must raise fresh capital to invest on behalf of the employees who have deferred a portion of their compensation. The cost to raise this new capital is the weighted average cost of capital (WACC).
Some may think that the cost of raising capital is the cost of debt, which is usually how new capital is obtained. But under finance theory, management must consider the crowding out effect of this new debt on the ability to pay dividends or repurchase stock. Therefore, the WACC rate for this scenario is the current rate that includes both the cost of debt and the cost of equity blended at the relative weighting employed by the company.
Assuming the funding assets are invested to match investment choices of employees, the expected earnings on the funding assets and the expected cost of the NQDC liability should largely offset each other except for any tracking error between returns on the assets and the liabilities. From an accounting perspective, even if the asset returns offset the change in plan liability, the investment results and the change in plan liability are not reported on the same line on the GAAP income statement, creating a reporting mismatch.
HEDGING AN UNFUNDED PLAN
The most efficient method to hedge the market risk of an unfunded plan is to use a Total Return Swap (TRS) derivative strategy. In a TRS, the company does not need to raise additional capital. Under the swap arrangement the company receives the rate of return on a pre-determined basket of assets correlated with the NQDC liability and pays the counterparty a floating rate leg (most often LIBOR or SOFR). The TRS has efficient GAAP accounting and tax accounting treatments, and provides significant positive economic NPV when returns on the notional basket of assets are in excess of the floating leg.
HEDGING A FUNDED PLAN
A TRS can be used in conjunction with a funded plan. One approach is for the funding assets to be converted to a low risk fixed income portfolio which can fund the floating leg of the TRS. The TRS provides market risk mitigation.
The impact of corporate costs of this strategy is a combination of the low risk fixed income portfolio and the TRS overlay hedge.
CONVERTING FROM FUNDED PLAN TO PARTIAL FUNDING OR UNFUNDED PLAN
The Company may choose to liquidate a funded portfolio of assets in order to convert to an unfunded plan. This step must be analyzed carefully with respect to the plan document, HR policy and any potential signaling to plan participants.
Liquidating an existing funded portfolio may return significant assets to the company, which can be deployed into ongoing or new business opportunities or returned to shareholders.
• Reinvesting in the company’s operating activities reduces the cost by the company’s ROC.
• The freed-up capital can be used to pay down debt or equity, thereby effectively earning the WACC rate assuming the company pays down capital in its current debt/equity proportion.
The cost of a NQDC plan can be material and exposes the company to capital market returns on both its GAAP financial statements and from an economic perspective. A Total Return Swap hedge very efficiently mitigates the economic risk and can create positive economic value.
By Robert B. Polansky
Senior Advisor, Atlas Financial Partners