SEC Finalizes Pay Ratio Rule -- Read the Plain English Description Here

Wednesday, after much controversy over the last five years, the Securities and Exchange Commission (SEC) released its final rule under Dodd-Frank Section 953(b) sometimes known as the Pay Ratio Rule. I have friends who are executive compensation attorneys and if you need legal advice on this rule, I can recommend any number of them to you, but I am going to write about it from a practical standpoint in plain English. What happened?

First, I'd like to commend the SEC. The statute on this rule has been very controversial. The SEC, in my opinion, has taken an approach that remains largely faithful to the exact wording of the statute and fully faithful to the intent of the statute (I'm not here to argue if the statute is worthwhile) while at the same time being sensitive to the concerns of employers with regard to the potential cost of compliance. It's rare that a government agency handles such a quandary this well.

Back in 2013, the SEC released a proposed rule on this topic. Since that time, the SEC received 287,400 comments on the proposed rule. More than 285,000 of them were form letters, but that still means that roughly 2,000 people took the time to write customized comments. To the credit of the Commissioners, they appear to have considered every last one of them. What they have crafted is practical, assuming that you find the result of the work practical.

What does the rule say? Here we go.

In its definitive proxy, each registrant shall disclose three items (at least since the rule says that the disclosure may be augmented):

• The pay (as defined for proxy purposes) of the PEO (generally known as the CEO or Chief Executive Officer),
• The pay (same definition) of the median-compensated employee of the employer, and
• The ratio of the first item to the second expressed as some number (integer will work) to 1.

Identifying the median compensated employee can be a very costly process. Consider a company with 1001 employees. The median compensated will be the one whose compensation is more than that of 500 others and less than that of 500 others. In order to determine this (by the letter of the law), one would need to determine the annual total compensation (that's the proxy compensation) or ATC for each of the 1001. They would need to be ranked and then we would find the 501st person. That is a lot of work.

The final rule allows for two significant simplifications for purposes of determining the median employee:

• Companies may choose to use sampling techniques in order to reasonably determine who the median paid employee is, and
• Companies may use and consistently applied measure of compensation from payroll or tax records.

While the first of those may be more trouble than it is worth, the second should be a big help to lots of companies.

Further, once a company establishes a median employee, it may use that same employee for three years provided that there have not been significant changes (undefined term) in the compensation practices or the makeup of employees. If that employee terminates, then the company may reasonably select a similarly situated employee as a replacement.

Many commenters were concerned about the disclosures for multi-national companies especially those with significant numbers of employees in lower cost-of-living countries. Certainly, for example, $50,000 per year goes further in Kyrgyzstan than it does in the US. The final rule allows companies to adjust (on a nation-by-nation basis) compensation for cost-of-living differences.

Calculating proxy compensation can be cumbersome. It includes other than just cash compensation. So, for companies with defined benefit plans and broad-based equity compensation arrangements, it is entirely possible that multiple outside experts would need to be engaged. While that remains the case, the final rule allows companies to make reasonable estimates of components of compensation.

The statute makes clear that an employee is every employee worldwide, whether full-time, part-time, temporary, or seasonal of the controlled group. The final rule allows for all of these simplifications or adjustments:

• A determination date applied consistently within 3 months of the end of the fiscal year
• Only subsidiaries included in the consolidated financial statements need be considered
• Employees where data may be unattainable due to national (or EU) privacy rules may be excluded
• De minimis numbers of employees (up to 5% in total) may be excluded on a country by country basis

Let's look in more detail at those last two. Suppose the number of employees excluded under the privacy rule exception exceeds 5%. Then you are done with your exclusions. On the other hand, if your privacy exclusions are exactly 2% of your total population, then you may exclude other countries whose total employee population is less than an additional 3% of your total population. If, for example, you can't find another country with fewer than 3% of your total employees, then you are done with your exclusions.

In preparing these disclosures, companies will make lots of assumptions, simplifications, and estimates. All must be disclosed.

In somewhat of a gift to employers, additional disclosures and ratios are permitted, but not required so long as the additional disclosures and ratios are no more prominent than the required ones. I think this could be useful.

Consider a company with its management team and sales force in the US, but the bulk of its production facilities in third world countries (I'm not weighing in on whether this is a good or responsible practice or not). Because manual labor is particularly inexpensive in Burkina Faso, for example, Everybody's Favorite Company (EFC) has an extremely high pay ratio, say 10000 to 1. Its CEO had total compensation of $10 million and most employees in Burkina Faso earned only $1000. And further, EFC can't find cost-of-living data for Burkina Faso, so it is not able to do that adjustment. EFC is perhaps rightfully concerned about its pay ratio disclosure, so it elects to do a second pay ratio disclosure limited specifically to US employees. In this case, the ratio declines to 100 to 1.

A second company with a December 31 fiscal year end, everest.com, does a massive holiday business. As a result, Everest has a high pay ratio reflective of its hiring each year of seasonal employees. In fact, in a typical year, Everest has more than twice as many employees from September 1 through December 31 than it does the rest of the year. As a result, Everest reports a pay ratio of 750 to 1. Everest doesn't like this, so it chooses to determine an additional ratio of all but seasonal employees. The company is much more pleased to find that this ratio is only 175 to 1.

Generally, companies are required to report the pay ratio for any fiscal year beginning on or after January 1, 2017 (there are exceptions for certain new filers and emerging companies). This means that the first required disclosures (companies are encouraged to disclose before then) will generally be in the early months of 2018.

The final rule is long and complex. There are many legal issues around it and for those you should contact an attorney. 

There are also issues that are far more consultative in nature. They will generally require quantitative acumen, actuarial knowledge, and comfort with executive compensation, as well as a focus on business issues. For those, you should just click here.

Bloomberg Article on CEO Compensation

Proxy Hysteria Arrives -- I Was Right

I told you it would happen, didn't I? I said that companies whose executives participate in defined benefit (DB) pension plans, especially nonqualified plans were going to report massive increases in CEO compensation. I said that there would be a big name company for which the increase in CEO compensation due in large part to the amount from pensions would create hysteria.

It has happened. Bloomberg reported in a video and an article that GE CEO Jeffrey Immelt was rewarded with an 88% increase in compensation despite sluggish performance. The company attributed the compensation increase to his reshaping of the company and to an increase in the value of his pension.

In my opinion, this could have been handled better. They could have focused on the message from my January 7 post. It said right there what was going to happen. I wouldn't lie to you and I wouldn't lie to GE.

Let's digress for a moment and think about how executive compensation is disclosed for the named executive officers (NEOs), including the CEO, at a public company. The company discloses compensation generally in the Summary Compensation Table (SCT) of the proxy. In the Compensation Discussion and Analysis section (CD&A), the company is afforded the opportunity to discuss its compensation practices, procedures, and policies. As the CD&A is a narrative, the company is required to discuss its rationale for its policies, but it is certainly not precluded from explaining changes. In fact, this is a great place for the company to explain what happened.

According to the Bloomberg article, Immelt's total compensation was approximately $37.3 million. I am neither condoning nor condemning that level of compensation here; that's not my point. Bloomberg says that that amount represents an 88% increase in compensation. Using that figure suggests that Immelt's compensation in the previous year was approximately $19.8 million. Further, Bloomberg says that GE noted that without the pension increase, Immelt's 2014 compensation would have been $18.9 million.

Opportunity knocked, but nobody opened the door. Apparently, GE did give Immelt a roughly 6% increase in base pay apparently from $3.2 million to $3.4 million. There appear to have been no other changes in compensation structure or policy with regard to the CEO.

Suppose GE took the step of explaining the pension increase. The pension plans in which Immelt participates did not change. He wasn't granted a massive benefit increase resulting in his total compensation doubling. What happened was that his 2014 compensation replaced his 2009 compensation (remember 2009 was a horrible year for the US and global economies) in a 5-year average, pension discount rates dropped (this increases the present value of pension benefits), and the Society of Actuaries released a new mortality table (I suspect GE adopted it) reflecting longer life expectancies in general.

What could GE have controlled in an effort to keep Immelt's disclosed compensation relatively steady? They could not have controlled discount rates as they are based largely on the high-quality corporate bond market. They could have chosen, subject to the approval of their external auditors, to not update the mortality table to use for the calculations, but that would only have been obfuscating the issue and frankly, the updated table is likely more appropriate for them. Finally, 2009 happened in 2009. It can't be undone. Incentives paid out more in 2014 than they did in 2009. That's true for almost all companies. What it is reflective of, that corporate performance has improved, is true for many companies and it's a good thing.

So, GE and Immelt didn't do anything evil. Their crime, so to speak, was not an error of commission, so much as it appears to have been one of omission.

GE had to know that this "increase in compensation" would set off alarms. Bloomberg appears to have received or at least heard statements from GE. Why did GE not prepare its spokesperson to address this? The fault was not in changes to their compensation program; the fault was in their lack having a prepared message.

I don't expect that they will be the only company to face this issue. I can help you craft the message. Get out ahead of this problem.

You'll thank me later.

Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

Executives Need Retirement Education, Too

It's been a long time since I blogged. I needed a break. I needed some fresh ideas. I didn't feel like writing on anything technical. I didn't feel like offering my opinions. I just needed to stop writing for a little while.

This morning, however, I saw an article in the News Dash put out by Plan Sponsor. It stressed that plan sponsors feel that perhaps the biggest issue in nonqualified plans is participant education. Citing from the article, one in five said that education was a top challenge while 18% cited participation and appreciation. I think that they are essentially the same thing, so that makes 40% (rounded) and that's enough for me to conclude that this is a major issue.

Why is this? Executives generally make a lot of money (whatever a lot is). They are generally used to dealing with financial matters. They already have their qualified plans. What makes these plans so different?

There's a lot. Taxation is different. They usually don't have a real pool of assets that they can play with. They don't get the same level of disclosures. They don't understand Code Section 409A. And, they generally don't know if what they are getting is good compared to what their peers at other companies are getting or not.

What's the answer?

I suggest rewards education for executives. In my experience, it is rare that this can be done internally. Internal people are often considered to have a bias or an agenda. It comes better from the outside.

Who or what should that outsider be? It should be an independent person, one who has no horse in the race, so to speak. It should be a person who can speak to all facets of executive rewards -- cash compensation, deferred compensation, equity compensation, retirement compensation, change-in-control agreements, and the like. Unfortunately, there are not too many of them around.

Oh, wait, I can do all that!

Treasury Modifies Section 83 Regulations

The Treasury Department recently issued revised final regulations under Code Section 83. While Section 83 regulations are longer and more complex, this was a short document that focuses specifically on "substantial risk of forfeiture."

So, what do these new regulations do? They add a paragraph that explains that you cannot create substantial risk by putting something in a plan document that is not going to happen and say that it creates substantial risk. In fact, they specifically say that a forfeiture provision that is not likely to be enforced (based on all the underlying facts and circumstances) does not create substantial risk.

Generally, the litmus test that is being applied is whether receipt of the property is conditioned upon performance of future services. So, for example, if nonstatutory stock options vest only if the executive works for the company for 5 years after the grant date, then there would (my read, but not a legal opinion by any means) be substantial risk of forfeiture until the options vest.

Interestingly, this regulation has retroactive applicability relating to property transferred after January 1, 2013.

A Service to Go with a Sad Story

I am going to pitch a service here that all employers should consider. If you are spending money to provide additional benefits for your executives, that money should go to them and not to the government.

Sometimes a good idea comes out of a sad story. And, I'm happy to report that in this case, it's sad because a company wasted money providing a generous benefit for its executives and then didn't tell the executives the pitfalls, but it's not sad in the context of someone going bankrupt or suffering a tragedy.

I got a call yesterday afternoon from someone who found me on the internet, probably through this blog. His wife is a participant in a SERP. Her employment with the company ended in July (I don't know how or why, I just know that it ended).

In early 2007, the wife received a communication from her employer. It told her that her SERP was being split into two pieces -- a 409A-grandfathered piece and a non-grandfathered piece. This was a not uncommon strategy. In addition, the non-grandfathered piece had a default payment of a lump sum of the present value of the accrued benefit payable six months after termination. A participant could elect a different form and or timing of payment (within limits defined in the plan). All of this is very normal in the world of SERPs post-409A.

Apparently, that is all the communication told her. It didn't explain the complexities of 409A. From what I could gather, her employer didn't want to give too much information because they were worried about potential litigation. So, they probably figured that giving no guidance at all meant that they gave no incorrect guidance.

When I answered the phone, the unhappy husband told me that he and his wife assumed that she could change her option when she terminated. So, she accepted the default and went on her merry way. Now, she will be receiving a lump sum that they don't really need right now and paying about half of it to various governments in the form of taxes.

Here's the idea. An employer could choose to go all the way or just do part of this.

Get an outsider like me who understands executive rewards and the 409A and other tax implications to help communicate to your executive group. In what I would term a perfect world (assuming that the employer chooses to not do the communication themselves), here is what would be entailed:

• Provide the outside consultant with the plan provisions and data for all the parts of the rewards package that you would like covered (SERP, deferred compensation plan, equity compensation, cash compensation, severance, change in control, etc.)
• Invite your executive group to a meeting. In that meeting, the outside consultant presents to the group generically on those elements of the rewards package. In that meeting, each executive, will get a summary/informal statement of their rewards package showing values and costs. The executives will place greater value on their rewards packages when they know how much they are worth and how much you are spending on them.
• With signed waivers (consulting, not legal, tax or accounting advice), allow executives to have individual meetings with the outside consultant after the group meeting. Let them ask questions about what they can change and when, what are their options, and what are their restrictions?
• These meetings can cover as much or as little of the executive rewards package as you would like, but the idea is to use the money that you are spending on executives for executives, not for the government.

Consider it. Let me help.

Populating Your Web Site

So, you're in a business related to benefits and or compensation. You have this really nice website. It's pretty glossy and glitzy, but you don't have enough substance on it. You need some technical or opinion articles, but either you don't have the time or you just don't like to write.

Have you ever considered specifying what you want on there and have someone else write it for you? You're here reading my blog. You know that I write on a wide variety of topics.

So, have me do it for you.  Contact me and we'll work out the details.

MAP-21 and SERP Funding, Now May be the Time

If you work with US defined benefit (DB) pensions and you haven't been living under a rock, then you are probably familiar with MAP-21, the law passed this summer whose more formal name is Moving Ahead for Progress in the 21st Century. It was positioned as a highway bill, but you are too smart for all that and know all about positioning. Where building highways costs money, lowering corporate deductions for pension plans raises money (or gets scored that way by the Congressional Budget Office). So, MAP-21 included pension funding relief.

In a nutshell, MAP-21 allows plan sponsors to use significantly above-market discount rates in the determination of funding requirements for their qualified pension plans. The trade-off comes in increases in PBGC premiums. But, while the first of these items is optional, the second is required.

So, where am I going with this? If you read the title of this post, you may be wondering.

Flashback to late 2004. Congress passed and a different president signed into law another act supposedly designed to create jobs. This one had a much more in-your-face title, the American Jobs Creation Act of 2004. With that innocuous name, however, came a new section of the Internal Revenue Code, Section 409A that among other things removed distribution and funding flexibility for DB SERPs. Since that time, many executives have wondered how to get their benefits, or at least portions of them, out from under the dark veil of 409A.

For some companies, MAP-21 may have provided an answer.

WARNING: before considering an option such as what I am about to describe, plan sponsors should very carefully consider the underlying risks.

The time may be right to consider a QSERP. Briefly, a QSERP is a means to transfer certain nonqualified benefits to a qualified plan. You can read about them in more detail here.

So, why might now be the right time. MAP-21 has given companies the ability to use higher discount rates in funding their pension plans. This means that any restrictions that might have arisen due to low funded statuses have likely disappeared. So, companies have the opportunity to fund this obligation in a qualified plan without having to fund it all at once.

Risk managers might tell you not to do this and there are good reasons. Paramount among them is that temporary use of above-market discount rates does not change the "true" funded status of a plan.

Other risk managers might tell you that you should do this and you should do it now. Why? Let's consider a simple example. Suppose you have agreed to pay your CEO an additional $100,000 per year (for life starting at age 65) from the SERP. This is over and above what he will get from the qualified DB plan. The present value of that obligation is the same whether that benefit is in the qualified plan or in the SERP. But, in the qualified plan, you get these advantages and many others:

• The benefit will not be subject to 409A
• You could efficiently fund the benefit immediately and generally get an immediate tax deduction for that funding
• That tax deduction may be taken at a higher corporate tax rate than it will be in the future
• When the CEO retires, his benefit can be paid out of a large pool of assets rather than creating a cash flow crunch

This is a complex process and there is much to consider. But, for the right company, now is the time. You'll only know if you are the right company after careful analysis. Ask an expert.

Connecting Executive Rewards

After all these years, I find it amazing. Consideration of executive rewards is still split up into pieces. And, those pieces are handled by different internal functions and by different consulting constituencies.

In a fairly typical case, cash, long-term incentives and equity are handled by the executive compensation function and by the executive compensation consultants. Executive retirement programs are typically handled by the retirement function and by the retirement consultants (frequently actuaries).

This is not a problem. The problem lies in the fact that the left hand and the right hand don't communicate with each other. And, they don't have compatible methodologies.

Let's look at retirement first. Traditionally, executive retirement packages have been designed to replace some targeted percentage of the executive's base plus bonus in their last few years before retirement. That methodology is not wrong. In the typical executive retirement study, consultants are asked to benchmark the plan design. Does it align with current trends and practices?

Consider executive compensation. Here, consultants look at such this as total cash compensation and total direct compensation. They benchmark this against the organization's peer group regressing (adjusting) for differences in size (and sometimes complexity). They develop medians and percentiles. That methodology is not wrong.

Suppose a Board chooses to pay its CEO at the 60th percentile. Perhaps they feel that their is complexity to their organization that belies its size. Suppose they also have an executive retirement program that their consultants say is pretty mainstream. I am going to tell you that almost to a degree of certainty, the retirement consultants have not considered the level of the CEO's pay in determining that the retirement program is mainstream. Isn't deferred compensation a part of compensation?

What would happen if we used the same approach for retirement benefits as we do for other forms of executive compensation? Suppose we calculate an annual value for such benefits and add it to other forms of compensation before doing that regression. Something tells me that the results might be surprising. In some cases, it might justify that rich SERP for which the proxy analysts have such disdain. In other cases, we might find that the company is perhaps inappropriately inflating TOTAL compensation -- the sum of the value of the entire rewards package.

In order to make this work, the executive compensation people need to talk to the retirement people and conversely. They need to speak each other's languages. Today, there are many gaps. There just aren't enough of us who are bilingual in this regard.

Perhaps we need to be.

Higher FICA Taxes on the Horizon

Health care reform in the guise of the Patient Protection and Affordable Care Act (PPACA) came to us with many new benefits. In order to pay for those benefits, the government had two options -- cut costs or raise revenue (spelled T-A-X). Here we talk about one of those new taxes.

Beginning January 1, 2013, high earners will be required to pay additional HI (Medicare) taxes under the FICA program. The additional tax is 0.9% of compensation in excess of $200,000 for individual filers or $250,000 for couples filing jointly. The employer portion of FICA will not increase.

First, this is going to need to be administered differently from traditional FICA taxes which generally are paid through payroll deduction. Here, your employer has no obligation to know how you file (in fact, you don't need to decide until you actually file), and your employer has neither the obligation nor the right to know your spouse's income. So, presumably, higher earners will simply have an additional tax tacked on to their Form 1040.

Think about this. What are FICA wages. Generally, they are compensation first vested and reasonably ascertainable in a year. For most deferred compensation plans, the amount of compensation that has been deferred is reasonably ascertainable. However, for plans such as defined benefit SERPs or for certain stock plans, this may not be the case. Regulations under Code Section 3121(v) allow taxpayers to early include such deferred compensation. In the case of individuals with significant SERP benefits in particular, they may want to discuss the possibility of early inclusion with their employers. While the tax hit for 2012 could be meaningful, it may lessen the long-term blow.

On the other hand, we don't yet know the outcome of the 2012 presidential election. Mitt Romney has pledged to repeal PPACA if elected. Its repeal would eliminate this tax.

Planning isn't as easy as it used to be.

Asymmetric Risk Situations

These days, a good bit of my consulting practice is dedicated to defined benefit pensions and executive benefits and compensation. Over the last several days, in reading the news, it occurred to me the significant asymmetries in the two practice areas.

For those who have been living under a rock, certainly, at least in my opinion, the biggest business news has been the trading debacle at JPMorgan. Ina Drew, a long-time employee of JPMorgan who oversaw the trading unit is being held responsible. According to JPMorgan's proxy issued this spring, Ms. Drew earned approximately $14 million last year (frequent readers may know that the total annual compensation disclosed in a proxy may not be an excellent representation of the actual amount earned) making her, according to the proxy, the 4th highest compensated employee of the bank.

By all publicly available information that I could find, Ms. Drew has a reputation as being one of the best at her field. This from a Reuters article, "Until the loss was disclosed on Thursday, Drew was considered by some market participants as one of the best managers of balance sheet risks."

For full disclosure, I was once an employee of JPMorgan. I became one when my employer at the time was acquired by a JPMorgan unit. My employment there ended when the division of which I was a part was sold by the company. As a result of JPMorgan's incentive compensation plan which requires certain employees to defer parts of their incentive compensation ( the plan has previously been disclosed publicly), I have control of a relatively small number of shares of JPMorgan stock. This post is neither intended as approval nor condemnation of the company or its employees. JPMorgan happens to be in the news, currently, but on a different date, I could have chosen a different company.

So, where am I headed with this? Pension plans and individual (executive or commissioned) compensation represent entirely different risks. Each is asymmetric, but in opposite directions. So, this post is about behavioral risk management. It could easily be extended elsewhere, but I have no expertise in social psychology, for example (you may argue that I have none in the fields that I am writing about either, but I am going to defend that I have some, at the least).

Under current US pension law (see for example, Internal Revenue Code Sections 430 and 436), if we leave out transition rules and there are many, non-governmental qualified defined benefit plans typically get treated differently at funding levels of 60%, 80%, and 100%. Speaking in significant generalities, if your plan is less than 60% funded, there is not much that you can do with it. Participants generally cannot accrue new benefits, the plan sponsor can't improve the plan; essentially, all you can do is fund it, and the funding rules for plans less than 60% funded are pretty onerous (not judging the appropriateness of this part of the law here). Once a plan gets over 60% funded, but less than 80%, things get somewhat better. Restrictions are less. Between 80% and 100%, things are generally pretty uniform and a plan sponsor can operate on a normal ongoing basis, so to speak (this is not intended to be a course in pension funding law; it's illustrative). If your plan is better than 100% funded, it may be unusual these days, but funding gets easy. Note that there is no nice threshold in excess of 100%.

What does this tell us? If your plan is less than 60% funded, there are no more downside thresholds. The sponsor, oversimplifying significantly, has little downside risk. Between 60% and 100%, there is both upside reward and downside risk, and while they are not identical, there is certainly a degree of symmetry. Once your plan is better than 100% funded, there is almost no upside reward, but there is downside risk.

These risks and rewards should inform the asset allocation decisions. They should inform the fiduciary decisions and, in my experience, they often do.

Let's turn our discussion to compensation, specifically that of two types of individuals: 1) top executives whose incentive reward potential often dwarfs their base pay, and 2) commissioned salespeople whose commissions have the potential to exceed their base pay or are their entire compensation.

Here are some facts about the compensation of many of the people in both of those groups:

• There is little, if anything, that applies in practice that limits the upside of their incentive compensation. Even to the extent that it is limited, those limits are very rarely reached. (Some plans are not designed this way, but many are.)
• Unless a plan has clawbacks (a means for recovery of compensation for various reasons, often related to fraud or other criminal activity), employees don't receive a negative bonus. At least, I have never seen it.

In the context that we used for pensions, there is plenty of upside reward potential, but there is little downside risk. Suppose I am a commissioned salesman. Further suppose that my compensation is entirely based on a percentage, 3% for example, of my sales. The smallest that my compensation can be is $0. I cannot sell less than nothing. The most that my compensation can be is 3% of infinity. That's a big number. I have an incentive to take risks. 

In their best-selling book, Freakonomics, authors Levitt and Dubner discuss this in the context of real estate agents (excerpts can be found here). Oversimplifying, a real estate agent can sell two types of homes: someone else's or their own. When selling someone their own home, an agent has an incentive to sell for the highest price. For each additional dollar of sales price, the agent receives nearly 100 cents (their broker and the agent on the other side each receive something). When selling a client's home, out of every additional dollar of sales price, the agent gets about 3 cents. According to Levitt and Dubner (and I agree), the agent selling your home has an incentive to get sell your home quickly. If they can get an additional $300 for getting you an extra $10,000 in sales price, the system motivates them not to do it because $300 doesn't mean anywhere near as much to them as $10,000 does to you. Speed is more important. But, if they are selling their own home, that $10,000 represents more than $300,000 in sales of other people's homes. If they can afford to, that system motivates them to hold out for more.

Executive compensation is not quite the same. But, often, it's closer to the real estate agent model. Incentive payouts for many CEOs and their direct reports is discretionary. It may have theoretical limits, but according to dozens of proxies that I have examined (you can get proxies at the SEC website),an executive who has a fantastic year may have their compensation exceed even the upper limits specified in a plan. Upper limits are often more than twice a target. The incentive is there to take risk. 

Why do people play the lottery? It's a losing proposition ... for all except the winners. The upside is huge, however. But, it's a game of chance. You know that going in. And, if you play, you are willing to risk some amount for a huge potential upside. 

Should you treat your pension plan as a game of chance? I don't think so. The system has been set up against it. The system has rules and those rules should, in my opinion, inform your behavior. Whether the current system is the correct one is irrelevant. It is the current system.

Should your executive compensation program be a game of chance? Should it contain asymmetric incentives? When I am a shareholder with an opportunity to vote my shares, my bias is against it. I prefer the companies of which I am an owner to not take inappropriate risks. It's human nature. Even for an incredibly ethical person, incentives matter. If you give me an asymmetric bet, and that bet is in my favor, if I use the logical part of my brain only, I should take it. We would like executives to use logic.

When we give them an asymmetric risk opportunity, are we not asking them to take perhaps inappropriate risks? Are they risks that you wouldn't take in your pension plan?

Do You Have a Top-Hat Plan?

Recently, the 6th Circuit Court of Appeals ruled in a top-hat plan case, Daft v Advest, Inc. This case adds to the litany of top-hat decisions rendered by different appeals courts. Most of them are similar in their conclusions. No two are the same.

The good news is that I have two potential remedies: 1) The US Supreme Court could hear one of these cases and give us a litmus test to live by in determining who is eligible to participate in a top-hat plan; or 2) More than 37 years later, the Department of Labor could write regulations on the topic.

We might not like either one, but at the very least, we would have some certainty. People making business decisions like certainty. As a consultant, and I'm sure it's the same for an attorney, it's not a good client relationship technique to tell a client that their eligibility criteria are probably okay, or that they seem to comport with the current law in the circuits in which they operate. Should be and seem to are horrible consulting words. Since I can't give a legal opinion, though, they may be the best I can do.

So, at least in the 6th Circuit (Kentucky, Michigan, Ohio, and Tennessee), Daft gives us a four-prong test (sort of):

1. What percentage of the workforce is covered by the plan? 
2. What is the nature of employment duties of the participants covered by the plan?
3. What is the compensation disparity between members of the plan and non-members of the plan?
4. What does the plan language say?

Unfortunately, or perhaps fortunately, Daft does not give us a bright-line test for any of 1, 2, 3, or 4. In fact, Daft doesn't even give us a hint. 

Think back to your school days. One of your friends is good enough to steal the test questions from the teacher (I do not condone this) and give them to you. The problem is that every question is subjective and you don't know the teacher's thoughts.

Alas ...

Another Knife Stabs COLI

Most of us have heard of it -- corporate owned life insurance (COLI). In the 80s and part of the 90s, it was one of the ultimate gimmicks. It had great tax treatment and great accounting treatment, and yes, it often performed well. But, over time, COLI began to get a bad name. Battling for tops among the reasons were two: brokers of COLI products were making what were viewed by many as unconscionably large profits selling the product; and many companies were buying what was known in the pejorative as janitor's insurance. That is, they were buying life insurance policies on everyone down to the janitor to fund perquisites and benefits for top executives.

Well, over time, these benefits of COLI have eroded. Someone could write a book on just that, but that discussion is for a different day here. But, in the latest blow to COLI, the IRS has released Revenue Ruling 2011-9 . What, you may ask is this, and what does it do? It adds particular teeth to [Internal Revenue] Code Section 264(f). So? What in the world is Code Section 264(f) and why do you care? Be patient, dear reader.

Section 264 is entitled Certain Amounts Paid in Connection with Insurance Contracts. Subsection (f) deals with expensing certain related interest costs on a pro rata basis.

Here is why this matters.


As COLI laws have been tightened, companies that purchase COLI have become more and more concerned about having an insurable interest in the individuals on whom they purchase insurance. So, for example, if Microsoft purchases life insurance on Bill Gates, even the most cynical among us would probably argue that Microsoft does, in fact, have an insurable interest in his life. But, suppose instead, Microsoft purchased insurance on the life of Horatio Hornblower [Note: to the best of my knowledge, they have neither done this nor considered it]. Even the most fervent COLI supporters among us would likely argue that there is no insurable interest there.

Where this turns grayer is with regard to policies held on past employees, or when a policy on a past employee is exchanged for one on a current employee. I digress. Code Section 1035 generally allows a policyholder to exchange one bona fide policy for another without creating a taxable event. So, as the insurable interest rules have tightened, many companies have routinely exchanged policies on employees who have recently terminated for policies on employees who have recently joined. That sounds innocent enough, doesn't it?

Now, let's look at Section 264(f). It says that, in general, a portion of a taxpayer's interest deduction based on the ratio of the sum of the unborrowed cash values on life and annuity contracts it owns to the adjusted basis of all of the taxpayer's assets is disallowed. Notably, Section 264(f)(1) provides an exception for officers, directors, employees, and 20% owners at the time of policy issuance. So, if all of your COLI is held on the exempted group, you get your full interest deduction. Right?

Not so fast. There is a good chance that some of the policies that you hold on the exempted group were not originally held on the exempted group. In other words, some of these policies were acquired through the use of Section 1035 Exchanges. And, the exchanges were likely (a euphemism here for perhaps 100% certain) done after the original insureds were no longer in the exempted group.

According to this ruling, both new and old policies that were acquired through a 1035 exchange after the original insured was no longer in the exempted group are not exempted. This would say that an employer needs to contemplate the termination of an employee and perform the exchange prior to that employee's termination. I think most would say that this is not practical.

From a reality standpoint, here's what this does. When COLI no longer has its most favorable tax treatment, it becomes what is sometimes referred to as an underperforming asset.. According to the revenue ruling, if an exchange is not done on a timely basis, either the interest deduction goes away because of the untimely exchange or the company now holds a policy on an individual who is no longer exempted. What did Joseph Heller call his book: "Catch-22"?

What should companies do about this? Companies that hold COLI need to check all of their policies to see which ones no longer get them the presumed deduction. Then, they need to make decisions with regard to those policies to see if they should somehow unwind them and use the assets for other purposes. Worse yet, the stated proposal of the current administration is to take away the exemption in Code Section 264(f)(1).

We can help you wade through this mess.

But, as always, neither this author nor his employer provide tax, legal, or accounting advice. This can only be obtained from someone licensed to provide such counsel.

Exec Comp Design in 2010 and Beyond

Executive compensation design in 2010 and beyond is not what it used to be. Sarbanes-Oxley and its stepsister, Dodd-Frank, are changing all the rules, all the standard practices, and the public's view of what's right. Here are 10 of the worst practices we see in executive compensation design and some comments on fixing them:

1. Single trigger and gross-up on golden parachutes - For the uninformed, a golden parachute, loosely described is a special package given to an executive in the event of a change-in-control. Golden parachutes are covered in Section 280G of the Internal Revenue Code. Excise taxes on excess parachute payments are covered in Section 4999 of the Code. A single trigger is an arrangement whereby a golden parachute pays out upon change-in-control, regardless of loss of employment for the covered executive. A gross-up occurs where the company pays all the taxes on an executive's parachute payments, and these can be massive. A payout of 2.99 times pay for an executive in the event of a change-in-control and loss of employment is very sufficient.
2. Perquisites - Perquisites, also known as perks or perqs are not inherently evil, but they have gotten way out of hand. In giving perquisites to executives, ensure that they have a business purpose. So, while use of the company airplane by the CEO may have good business reason, a chauffeur for the CEO's spouse probably does not. Special health care benefits (especially executive physicals) for the top executives may be important to the risk management processes of the organization, but multiple company-paid country club memberships likely are not.
3. Exchange of Underwater Stock Options - Suppose you granted a whole bunch of stock options to your executives in 2007 and now the company stock is selling for much less than the strike price of the options, then those options are said to be underwater. In recent years, a number of companies have been exchanging such options for ones that may be more likely to have value to those executives. Gee, do the shareholders who bought the stock in 2007 get to similarly exchange their shares? They had nothing to do with the stock price declining, don't they deserve a deal at least as good as what the executives?
4. Excessive Share Dilution - Authorizing too many shares for executive compensation programs may dilute shareholder value. While we would say never say never, doing this too often is a sign that your company is putting its executives ahead of its shareholders.
5. Evergreen Employment Contracts - I've never had a rolling, self-renewing employment contract, have you? You're not sure. Perhaps the best examples of such contracts are found in college athletics. Hometown U hires Coach Goodplayer and gives him a 5-year contract to coach the football team at a salary of $2 million per year (plus perquisites of course). At the end of each year, Coach G's contract automatically resets to be a new 5-year deal, unless Hometown U decides to cut off the evergreen part. Finally, in 2013, when Coach G has a bad season and the alumni say to get rid of him, Hometown U owes him 4 years of salary and perquisites just to make him go away.
6. Severance for Failure - The real live cases are well known. Living in the Atlanta area, the best known case here was Bob Nardelli's deal at The Home Depot. Under Mr. Nardelli's leadership, HD stock price fell precipitously. After 6 years at the helm, he resigned under pressure with a severance package valued at roughly $210 million according to http://money.cnn.com/2007/01/03/news/companies/home_depot/index.htm
7. Disconnects in Incentive Payouts and Timing - Incentive payouts should make sense. Executives should be expected to perform at high levels. Paying out a bonus for poor performance, for example, should be viewed as taboo. Consider a circuit breaker whereby the switch flips to off if an executive hits less than 80% of his or her target. Does that seem to harsh? If an executive is not hitting 80% of target, think about what is happening to the poor shareholder.
8. Discretionary Incentive Designs - In days of yore, most discretion on incentive payouts was reserved for the CEO, and not the CEO's bonus. That is, the CEO had the discretion to unilaterally increase (yes a discretionary decrease was available, but rarely if ever happened in practice) the bonus of any of his or her direct reports beyond what the incentive plan design would have recommended as a bonus. In the new world of executive compensation, such discretion lies only with the Board, and the Board's discretion exists to ratchet incentive payouts downward.
9. Poor Goal-Setting that Motivates Imprudent Risk-Taking - Be very careful how you design a set of goals or an incentive plan. Poor design might motivate behaviors that are against the goals of the organization. Think about the crisis in the financial services sector. Think Bear Stearns, Countrywide Mortgage, AIG, and others. News reports certainly suggested that executives at each of these organizations were being well-rewarded for taking incredible risks -- risks that eventually led to corporate downfall. Take steps to ensure that taking risks beyond those that the company (and its shareholders) would consider acceptable be de-motivated.
10. Design Based on a Mis-Chosen Peer Group - The peer groups for many companies have historically been chosen by the executives at those companies. How did they choose them? Many chose them very reasonably, but some cherry-picked that peer group. In other words, they picked companies that looked somewhat like theirs, but that they knew were underperforming. The peer group should consist of high performing companies of similar size and divisional peer groups should be based on companies and their segments of similar size. Companies that are known to be underperforming should be left out.

So, there you have it ... my Top 10.

Nothing in this post or this blog should be construed to represent legal, accounting or tax advice, and while this is thought to be generally correct, nothing herein represents consulting advice for any specific organization.

Converting your DB SERP to a DC SERP (Part 2)

In Part 2 of this series, originally published in September, we look at the 409A implications of converting a DB SERP to a DC SERP.

View the article here: http://www.aon.com/attachments/dbdcserp_409A_sep2010.pdf

Converting your DB SERP to a DC SERP

Here is an article (first in a series) that I co-wrote back in August this year on nonqualified plans. As many companies freeze and terminate their qualified defined benefit plans, they similarly change their nonqualified offerings from DC to DB.

You can find the article here: http://www.aon.com/attachments/dbdc_serp_aug2010.pdf