The Hidden Costs of SERPs & Deferred Compensation Arrangements - And What to Do About It!

Diane Doubleday is a Partner of Mercer Human Resources Consulting

Executive benefit programs have quickly become a governance issue for compensation committees. Shareholders, the media, and regulators have begun scrutinizing proxies, tax filings, and court records to reveal the often significant benefits these programs provide. Of the many executive benefits programs, deferred compensation plans (DCPs) are the most common. They cover a broad variety of arrangements, including voluntary salary and bonus deferral arrangements, supplemental executive retirement plans, and even equity plans that incorporate deferral features.

It behooves all companies to evaluate their deferred compensation arrangements to understand how they fit within the total executive rewards strategy and to ensure that the costs – which are often hidden and substantial – are appropriate relative to the benefits provided. In fact, we believe compensation committees should be reviewing the proxy disclosure of these programs to meet shareholders’ expectations about transparency of executive compensation and benefit programs.

In this pointer, we discuss the hidden costs of deferred compensation plans and outline best practices for evaluating these arrangements as part of the total executive rewards strategy. (To help navigate this discussion, we have included a short glossary of terms below.)

Hidden costs of deferred compensation arrangements

Deferred compensation – whether in the form of a plan or an individual agreement – can be an important part of the total executive rewards strategy. The vast majority of large companies offer executives some type of deferred compensation plan the two most common being:

1. supplemental executive retirement plans (SERPs), for their strong retention value as well as for retirement income planning predictability; and
   
   
2. voluntary deferred compensation (VDC) plans, for tax-deferred savings to meet personal financial needs and capital accumulation objectives.

Because companies have broad discretion in designing these plans, plan provisions vary widely. And in some cases, seemingly minor enhancements can lead to substantial and unanticipated increases in the value of the benefit and the cost of the plan. Even "plain vanilla" DCPs can create surprisingly large liabilities not necessarily apparent to compensation committees or investors until the benefits are paid.

To illustrate the challenges that compensation committees face in their DCP oversight, we have included two common plan designs below – a SERP with enhancements and a conventional VDC plan with a favorable rate of return.

Supplemental executive retirement plans (SERPs)

SERPs can range from relatively straightforward designs, mirroring the company’s qualified pension plan, to complex arrangements negotiated with individual executives. A combination of accounting rules, actuarial assumptions, multiple payment scenarios, and projected benefits can make it difficult to understand their inherent costs and benefits. In addition, SERPs may be enhanced over time without a full appreciation of the cumulative impact on plan costs. For instance, the enhancements may not even be intentional, such as when a change in one component of the compensation program indirectly affects SERP benefits.

The chart below illustrates the magnitude of the cost impact of common plan enhancements for a 57-year-old CEO with 20 years of service, earning $1 million base salary and $1 million annual incentive. Applying a fairly conventional formula of 2 percent of final pay for each year of service if retiring today, the CEO would be entitled to a lump sum of $9.5 million. (The lump sum represents the present value of a pension paid for the life of the CEO.)

Lump Sum Value of a SERP

As the chart illustrates, when enhancements are added, the cumulative value grows significantly. These provisions are common: there is no actuarial adjustment to reflect commencement of benefits before normal retirement age or for having the benefit paid over the joint lives of the CEO and spouse. Often, companies credit senior executives with additional years of service, perhaps to take into account previous employment. Including long-term incentive compensation (LTI) in pensionable earnings is less common, but as companies move away from stock options to other LTI vehicles, we may see those benefits pulled into the SERP calculation – at considerable cost. Giving the CEO in our example a more favorable discount rate in the lump sum calculation generated a $22 million windfall.

While there may be a sound rationale in a particular circumstance for these and many other enhancements, it is imperative that the compensation committee understands the implications of any changes. Bottom line: compensation committees should include SERP costs and benefits in their annual evaluation of the company’s total executive rewards strategy. This won’t be as easy as it sounds; to fully appreciate the extent of plan costs and benefits, the review must include projected benefits under reasonable scenarios as well as current accrued benefits.

Voluntary deferred compensation (VDC) plans

The most common form of deferred compensation is the elective deferral of salary and bonus payments. Survey data suggests that three-quarters of large companies offer VDC plans. Companies’ liabilities under elective deferral plans have mushroomed in recent years for a host of reasons, including increases in the amount of incentive pay that can be deferred, the restoration of deferral opportunities limited under qualified savings plans, and a trend to offer tax-deferred savings opportunities to a broader group of highly compensated employees. Plus, many companies require their senior executives to defer any compensation that otherwise would not be deductible because of the million-dollar limit imposed by Internal Revenue Code section 162(m).

The magnitude of the obligation to make future payments to VDC participants is a surprise to some. Contrary to popular belief, deferral programs are not generally cost-neutral to the company. Most plans credit VDC balances with investment returns on a pre-tax basis. This has an inherent cost to the company to the extent the pre-tax crediting rate exceeds the company’s after-tax cost of funds. In the following chart, a one-year deferral of $1 million costs the company $14,400.

Cost of Deferred Compensation

Company cost		Company assets
		$1,000,000	Deferral
($1,060,000)	Pre-tax payment (deferral & return)	(400,000)	Foregone tax deduction on current compensation
424,000	Company tax savings at 40%	600,000	After-tax cash to invest
		21,600	After-tax investment earnings at 4.2%
($636,000)	After-tax cost to company	$621,600	Accumulated asset at end of year
	After-tax cost	($636,000)
	Asset	621,600
	Company’s net cost         =	($14,400)

Assumes a 6% before-tax return and a 3.6% after-tax cost of funds

Over time, these embedded costs can grow dramatically, and the cost is further affected when the compensation committee decides to provide an enhanced rate of return, for instance, using Moody’s long-term bond yields plus 2 percent. The next chart illustrates the projected cost of $1 million deferred for 20 years. The company’s cost has grown to $1.6 million; note the effect of the 2 percent enhancement rate.

Projected Cost of Deferred Compensation

The cost is one side of the equation; the other is the benefits. If, for example, the participant deferred $1 million each year, for 20 years, the deferred compensation balance would reach approximately $50 million (assuming a long-term bond return of 6 percent plus a 2 percent enhancement). The 2 percent enhancement provided by the compensation committee alone would be worth approximately $10 million.

Hedging the liability

About half of VDC plans offer investment choices, and the trend has been increasing over the past decade. This can dramatically increase the embedded costs of an unfunded program when the pre-tax equity market returns far outstrip the company’s after-tax cost of funds. Companies commonly finance this type of plan by investing to match the participants’ choices and minimize exposure to the market. These plans resemble a qualified 401(k) plan, but there are key differences: the underlying investments remain general assets of the company subject to the claims of company creditors, and the company is taxed on the VDC investment returns (while participants’ accounts are generally credited with pre-tax returns).

As a result, many companies are interested in further hedging this liability to reduce both the volatile effect on earnings and the overall cost of the plan. Common financing approaches, such as corporate-owned life insurance, mutual funds, and derivatives, while cost-effective for some organizations, require sophisticated management and are often misused. If improperly structured, these approaches can actually add cost or fail to reduce volatility.

Four steps to transparent deferred compensation plans

To avoid unpleasant surprises and improve understanding of your company’s DCP design and costs, we recommend compensation committees do the following:

1. Incorporate executive benefits – their role and rationale – into a detailed executive reward strategy. This provides compensation committees with a touchstone for evaluating many issues, including provisions on termination of employment, enhanced crediting rates, and funding. It should include the importance (and magnitude) of deferred compensation benefits relative to other components of the executive rewards program, including any retirement programs available to the broad base of employees.
   
   
2. Conduct an annual audit of all deferred compensation arrangements, whether embodied in an individual agreement or a broader plan.
   
   
   • The audit should include a summary of key terms for each plan or arrangement, its annual costs and benefits, and an itemized accounting of the accrued and projected total benefits of the company’s executive officers. In particular, the committee should understand the implications of enhanced benefits and the benefits that would be paid on termination of employment.
     
     
   • The costs of the program should be quantified; these should include the hidden cost of deferring the company’s tax deduction until payment of the deferred compensation.
     
     
   • These plans are subject to several federal and state law schemes; counsel should be asked to comment on any compliance issues as part of the audit.
     
     
3. Consider the effect of any changes to the executive compensation program on deferred compensation arrangements. Whenever a change is made to the executive rewards programs, the implications for DCPs should be analyzed. For example, a recent trend is to shift the emphasis in the executive pay program from equity to cash. Increases in cash compensation almost always increase voluntary salary and bonus deferrals as well as benefit accruals under SERPs.
   
   
4. Evaluate the current financing or funding strategies used to hedge the company’s liability. Too often, we find that the costs of a financing arrangement may be more than the anticipated benefits of hedging the underlying liability. Funding approaches such as corporate-owned life insurance should be analyzed as an investment. Compensation committees should understand the commission structure, the short-term cash flows, and the administrative costs. This analysis should be repeated before purchasing additional policies to ensure that the product offered is the best for the company’s needs.

Think more, not less, on plan disclosures

DCPs are one of the more important executive benefits. When properly structured, they can be used to support important reward strategy objectives. But they are often poorly understood and, because of inadequate disclosure, may be a lightning rod for shareholder dissatisfaction. The required proxy disclosure rules are not suited to the complexity of today’s most common arrangements, and shareholders have been vocal in their criticism of the information available. Best practice today is to disclose more information than is required to give investors a full understanding of the company’s reward strategy, how benefits fit into that strategy, and the accrued and anticipated benefits payable to executive officers.

Deferred compensation reform is on the horizon

The House and Senate both passed bills that include similar deferred compensation reforms. They focus primarily on restricting access to deferred compensation funds, including the flexibility to determine the timing and form of benefit payments. If the reforms are enacted, most plans will need to be amended. Enactment is anticipated this summer or after the fall election, although there are differences to be worked out and other more controversial provisions may stall action. Until a bill is reported "out of conference," much is and will remain unknown, including the effective date, but we will keep you apprised of any action.