Even those of us who have been hiding under rocks know that late last year, the President signed into law the Tax Cuts and Jobs Act. And, as part of that Act, there was language that amended Code Section 162(m) also known as the million dollar pay cap. After Treasury gave us guidance on those changes in Notice 2018-68, some observers were surprised by a few of the interpretations that the regulators took. One in particular, however, that they didn't quite spell out, meets my criteria for a big surprise gotcha.
I'll come back to that and consider how an employer might get around it, but first some background. Under the old 162(m), deductions for reasonable compensation under Section 162 were limited to $1,000,000 per year for the CEO and the four other highest compensated employees of, generally speaking, publicly traded companies. However, most performance-based compensation was exempt from that calculation and was deductible as it would have been before the cap came into being.
Under the new 162(m), the definition of covered employee has been changed to be the CEO, CFO, and the three other highest paid employees. But, once you become a covered employee, you remain a covered employee. So, by 2030, for example, a company could easily have 25 covered employees. [Hats off to the cynics who know this is a silly example because no law stays in place unchanged for 13 years anymore.] Further, performance-based compensation is no longer exempt.
Like most law changes that affect compensation and benefits, this one, too, has a grandfather provision. Here, the new rules are not to apply to remuneration paid pursuant to a binding contract that was in effect on November 2, 2017, and which has not been materially modified after that date. The keys then relate to what is compensation for these purposes, what sort of modifications might be material, and what constitutes a binding contract.
Compensation is essentially any compensation that would be deductible were it not for the million dollar pay cap. Whether a modification is material remains a bit subjective, but the guidance does specify that cost-of-living increases in compensation are not material, but that those that meaningfully exceed cost-of-living are.
The binding contract issue is the really sneaky one. Your read and your counsel's read may be different, but my read is that if the employer has the ability to unilaterally change the contract, it's not binding. That is problematic.
Consider a nonqualified retirement plan be it a defined benefit (DB) SERP or a traditional nonqualified deferred compensation (NQDC) plan. In my experience, it's fairly common (completely undefined term) to see language that gives an employer the unilateral right to amend said plan, subject to any employment agreements that may overrule. Well, if the company can amend the plan, there would seem to be no binding agreement. And, that means that when that nonqualified plan is paid out to the employee, perhaps none of a large payout will be deductible for the employer. I'm aware of some payouts well into nine figures.
When it's a nine-figure payout, there really aren't great solutions. But, for the typical nonqualified plan, whether it's DB or DC, qualifying some of the benefits changes the treatment. If the benefits can be qualified in a DB plan using a QSERP device, employer funding will be deductible if it is deductible under Section 404. That's far more forgiving and, in fact, it is not at all unlikely that the deductions will already have been taken before the covered employee retires.
Yes, it's still a big surprise gotcha, but don't you prefer a surprise gotcha when it has a surprise solution.
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Showing posts with label SERP. Show all posts
Showing posts with label SERP. Show all posts
Thursday, October 11, 2018
Tuesday, August 9, 2016
409A Audit Could Be Coming to Your Company
All the way back in 2004, Congress passed and President George W. Bush signed into law the American Jobs Creation Act (Jobs Act). While it does not appear to have created many jobs, the Jobs Act added Section 409A to the Internal Revenue Code. The reasons were twofold -- first, to ensure that participants in nonqualified deferred compensation plans (NQDC) would never be advantaged over those in qualified plans; and second, to raise revenue for the federal government.
Thus far, the addition of 409A has done a pretty good job at the first of those goals by imposing a very strict set of rules on participants, usually executives, in NQDC arrangements. With regard to raising revenue, however, 409A has been fairly impotent to date.
Several years ago, the IRS rolled out an audit initiative of 409A plans. It had some teeth, but mostly with regard to larger plans (more participants) of larger companies. While there were exceptions, for the most part, if your company has less than about 5,000 employees or if your NQDC plans in total have less than about 100 covered participants, you've been mostly immune from this audit initiative.
Reports are now that the IRS has stepped up their audits. They are doing more of them and they are investigating more and more plans of companies that did seem immune in the early years of the program. In fact, I heard from an NQDC recordkeeper that a client of theirs with only 19 NQDC participants is currently under a 409A audit. I spoke with that recordkeeper, but between us, we couldn't determine what the pattern of companies that have recently come under 409A audit has been. That recordkeeper's anecdotal evidence, though, suggests that in other than very large companies, the primary target plans have been in order:
Thus far, the addition of 409A has done a pretty good job at the first of those goals by imposing a very strict set of rules on participants, usually executives, in NQDC arrangements. With regard to raising revenue, however, 409A has been fairly impotent to date.
Several years ago, the IRS rolled out an audit initiative of 409A plans. It had some teeth, but mostly with regard to larger plans (more participants) of larger companies. While there were exceptions, for the most part, if your company has less than about 5,000 employees or if your NQDC plans in total have less than about 100 covered participants, you've been mostly immune from this audit initiative.
Reports are now that the IRS has stepped up their audits. They are doing more of them and they are investigating more and more plans of companies that did seem immune in the early years of the program. In fact, I heard from an NQDC recordkeeper that a client of theirs with only 19 NQDC participants is currently under a 409A audit. I spoke with that recordkeeper, but between us, we couldn't determine what the pattern of companies that have recently come under 409A audit has been. That recordkeeper's anecdotal evidence, though, suggests that in other than very large companies, the primary target plans have been in order:
- Nonqualified defined benefit pension plans that do not have the same formula as a broad-based DB plan in which the covered executives also participate;
- Other nonqualified DB plans that simply make up for IRS limits (415 and 401(a)(17));
- Deferred compensation plans that look different from the company's 401(k) plans; and
- 401(k) mirror plans.
In other words, the target seems to be executive retirement plans.
To understand what the solutions might be, your first need to understand the problems. Generally, there are two ways that you can violate 409A -- either by failing to have or failing to have an appropriate written plan document, or by failing to follow both the plan document and the law and regulations.
In either case, the penalties are severe. But, those penalties are not imposed on the company. Instead, they are imposed on the executive, even if he had neither influence on nor knowledge of the defect from which that penalty will arise.
How bad is the penalty? It's this bad:
- An additional 20% income surtax on the amounts deferred and not compliant for all taxable years in which that was the case; plus
- Interest on previously unpaid taxes (due to failure to include the deferred amounts in income in the year in which they were deferred) at the Federal Underpayment Rate plus 1%.
And, that's in addition to ordinary income (and other) taxes that would be owed on those amounts. They add up quickly.
For most 409A defects, however, there are correction methods, structured somewhat analogously to those under the EPCRS program for qualified plans.
Many of you will seek help from counsel and from tax advisers. That may be a good solution for you. A problem that can occur in either case, though, is that it's very possible that neither has significant experience with determination of 409A benefits or with the administration of those benefits.If they do, that's great. But, if they don't, you probably need to look for additional expertise.
Wednesday, March 16, 2016
Is Your Executive Plan Top-Hat?
Most larger companies and some smaller ones provide many of their higher paid employees the opportunity to participate in a nonqualified retirement plan often referred to as a Supplemental Executive Retirement Plan or SERP. The rationale for having such a plan is spelled out in ERISA. The regulations specifically grants "top-hat" status to plans that are limited to a select group of management or highly compensated employees. The plan must also be unfunded (and for those people who say that lots of top-hat plans have assets set aside, that is informal funding in a rabbi trust or through insurance products or some other means).
Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.
So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.
Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.
As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.
Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.
So, knowing that we currently don't know what a top-hat group actually is, why do we care?
Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.
Consider the following scenario.
Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).
If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.
Ouch!
What should an employer do?
I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.
If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.
Looking at a history of case law and DOL opinion on the topic, one might consider these elements:
Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.
So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.
Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.
As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.
Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.
So, knowing that we currently don't know what a top-hat group actually is, why do we care?
Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.
Consider the following scenario.
Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).
If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.
Ouch!
What should an employer do?
I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.
If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.
Looking at a history of case law and DOL opinion on the topic, one might consider these elements:
- The percentage of the workforce in the top-hat group
- The relative pay of the top-hat group as compared to the pay of those people not in the top-hat group
- Whether the top-hat group was selected by the Board as compared to being, for example, any employee with the title Vice President or higher
- Whether individuals in the top-hat group, especially those among the lower-paid in the group, have significant management responsibilities
- Whether individuals in the group need the protection of ERISA
Nobody really knows. But, having an independent analysis might show that an employer is acting in good faith in determining the group. Given the downside of getting it wrong, it may just be worth it to find out.
Finally, I want to reiterate that I am not an attorney and I have no qualifications to provide legal advice. As such, nothing in this post or anything else that I write should be construed as legal advice or as the practice of law.
Monday, January 25, 2016
Expect Reported CEO Compensation to be Down for 2015
Last year, there was an uproar. CEO compensation had gone through the roof. Or, so people thought. I predicted it would happen and I was correct. We heard the cries from all directions. Politicians including presidential hopefuls talked about the millionaires and billionaires and oftentimes, they pointed to executive compensation.
As the 2016 proxy season evolves, perhaps some will tell you that their cries were heard. But, were they?
I predict that reported (in proxies) CEO compensation for 2015 generally will be down from 2014. There are several reasons that you don't hear in the campaign ads, notably:
As the 2016 proxy season evolves, perhaps some will tell you that their cries were heard. But, were they?
I predict that reported (in proxies) CEO compensation for 2015 generally will be down from 2014. There are several reasons that you don't hear in the campaign ads, notably:
- Pension discount rates have risen
- Equity markets generally did not perform well
What does all that have to do with CEO compensation?
People who recall my tirade last year know that many CEOs, especially those who run large companies and do have very high compensation have a defined benefit (DB) SERP as part of their compensation package. And, when discount rates fall as they did during 2014, SERP liability generally increases and that increase is considered by the SEC to be part of executive compensation. Similarly, when discount rates rise, SERP liability generally decreases meaning that the contribution of many SERPs to reported DB compensation for 2015 will be 0 (you're not permitted to report a negative number). When pay ratio reporting finally kicks in, this may be a really big deal.
What does the performance of equity markets have to do with CEO compensation? Again, most large public company CEOs receive sizable chunks of their compensation in stock whether that be in options, restricted stock, or some other form of stock compensation. When the value of that stock decreases, so does the value of that piece of their compensation.
This leads to an interesting question with an obvious answer. Did the economic conditions in 2014 that resulted in extremely large reported CEO compensation meant that CEOs were overpaid in 2014 compared to other years. And, similarly, were those same CEOs underpaid in 2015 compared to 2014?
The answer to both questions is of course not. For most of these people, their pay packages were extremely similar in 2015 to what they were in 2014 and similarly in 2013. It's not that often that we see radical changes in the way that a particular CEO is paid.
But, these external factors drive the numbers and those numbers often drive the conversation.
The final pay ratio rules won't be effective for about 2 years. Of course, companies are being encouraged to disclose earlier and some will. Perhaps this is the proxy season to start. Perhaps this is just the proxy season to understand how volatile it will be.
Wednesday, January 6, 2016
What You Might Find in the Actuary's Bag of Tricks
As actuaries, we work a lot with attorneys. In fact, for the most part, those attorneys are what as known as ERISA attorneys, employee benefits attorneys, executive compensation attorneys, and tax attorneys. Save perhaps intellectual property attorneys/patent attorneys, the ones that we work with would be considered the geekiest by their peers. Some have quite a bit of quantitative ability. Some have actuarial training. A few are credentialed actuaries. For the most part, however, even actuaries who happen to be practicing law don't think the same way that experienced, practicing actuaries do. For their clients, that's probably a good thing as they are engaged to think as lawyers. Similarly, those practicing actuaries who happen to be attorneys as well tend to think as actuaries. And, since that is why they are engaged by their clients, that's probably a good thing as well.
Okay, John, you've written a paragraph saying that actuaries and attorneys are different people. We all know that. Who cares?
Let me illustrate with a case study where the names and numbers have been changed to protect the innocent. And, while those elements are changed, this really happened.
Two similar Fortune 1000 companies were getting ready to merge. Technically, company Y was buying Company Z (they were keeping Z's name, but keeping Y's management team, Z's shareholders would receive stock in Y, and Z's executive team would generally be the beneficiaries of golden parachutes).
The deal was to close on a Friday morning. One of my colleagues was spearheading the benefits and compensation side of due diligence. He was very good at his job, but he was not an actuary. We'll call him Eddie just so that he can have a name.
Late that Wednesday afternoon, I was contacted by Eddie. He told me about the deal he was working with and that he had run into a strange looking SERP. I'll spare you the details, but when he described it to me, it was like none I had ever encountered. He asked if I had some time to look at it which I did.
What had happened was that the old CEO of Z had had a custom-designed SERP and employment agreement and then he went and upset the apple cart -- he died completely unexpectedly. The Board knew who had been intended as the CEO's heir apparent although that was not supposed to happen for a little more than five years. With nowhere else to turn, YRS (young rising star) became the CEO. Frankly, YRS was probably a pretty good choice, but when things are done in a hurry, things can go wrong.
The SERP and employment agreement that the old CEO had had been written by counsel. Counsel said that an actuary had valued the SERP and that the company was comfortable with the costs. So, right along with the rest of the employment agreement, the YRS, the new CEO, got the same package.
The SERP itself wasn't too unusual as it turned out. But, when you integrated the SERP with the employment agreement which was necessary in the event of a change in control, the numbers just exploded.
After determining that the golden parachute payout of the SERP alone was to exceed the entire balance sheet of the merged company (that part is true without specifying numbers), talking to the Chairman of the Board of Y, and working on negotiations with YRS, I did spend some time with Y's management and counsel. I asked them as nicely as I could how they could have given YRS this package without really understanding it. I was informed that an actuary had carefully analyzed the SERP when it was written for the old CEO and he had said there was nothing wrong with it. Therefore, there should not have been a problem giving the same SERP to YRS.
But, the actuary had never seen the employment agreement. And, he had never done his analysis in the context of the employment agreement, a young CEO, and a change in control.
The attorneys in this particular case were good at their jobs. I've worked with them since and seen that. In fact, they are fairly facile quantitatively. But, they think as attorneys (as they should). They don't think as actuaries. And, that was the problem.
So, when you run into a complex quantitative situation where there might be some contingencies involved, save yourself some significant risk and find an actuary who can help.
Okay, John, you've written a paragraph saying that actuaries and attorneys are different people. We all know that. Who cares?
Let me illustrate with a case study where the names and numbers have been changed to protect the innocent. And, while those elements are changed, this really happened.
Two similar Fortune 1000 companies were getting ready to merge. Technically, company Y was buying Company Z (they were keeping Z's name, but keeping Y's management team, Z's shareholders would receive stock in Y, and Z's executive team would generally be the beneficiaries of golden parachutes).
The deal was to close on a Friday morning. One of my colleagues was spearheading the benefits and compensation side of due diligence. He was very good at his job, but he was not an actuary. We'll call him Eddie just so that he can have a name.
Late that Wednesday afternoon, I was contacted by Eddie. He told me about the deal he was working with and that he had run into a strange looking SERP. I'll spare you the details, but when he described it to me, it was like none I had ever encountered. He asked if I had some time to look at it which I did.
What had happened was that the old CEO of Z had had a custom-designed SERP and employment agreement and then he went and upset the apple cart -- he died completely unexpectedly. The Board knew who had been intended as the CEO's heir apparent although that was not supposed to happen for a little more than five years. With nowhere else to turn, YRS (young rising star) became the CEO. Frankly, YRS was probably a pretty good choice, but when things are done in a hurry, things can go wrong.
The SERP and employment agreement that the old CEO had had been written by counsel. Counsel said that an actuary had valued the SERP and that the company was comfortable with the costs. So, right along with the rest of the employment agreement, the YRS, the new CEO, got the same package.
The SERP itself wasn't too unusual as it turned out. But, when you integrated the SERP with the employment agreement which was necessary in the event of a change in control, the numbers just exploded.
After determining that the golden parachute payout of the SERP alone was to exceed the entire balance sheet of the merged company (that part is true without specifying numbers), talking to the Chairman of the Board of Y, and working on negotiations with YRS, I did spend some time with Y's management and counsel. I asked them as nicely as I could how they could have given YRS this package without really understanding it. I was informed that an actuary had carefully analyzed the SERP when it was written for the old CEO and he had said there was nothing wrong with it. Therefore, there should not have been a problem giving the same SERP to YRS.
But, the actuary had never seen the employment agreement. And, he had never done his analysis in the context of the employment agreement, a young CEO, and a change in control.
The attorneys in this particular case were good at their jobs. I've worked with them since and seen that. In fact, they are fairly facile quantitatively. But, they think as attorneys (as they should). They don't think as actuaries. And, that was the problem.
So, when you run into a complex quantitative situation where there might be some contingencies involved, save yourself some significant risk and find an actuary who can help.
Wednesday, January 7, 2015
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?
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?
Wednesday, September 25, 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:
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.
Thursday, January 10, 2013
To Defer or Not to Defer, That is the Question
Last week, I wrote about the American Taxpayer Relief Act more commonly referred to as the Fiscal Cliff deal. While it avoided reversion to the pre-Bush era marginal tax rates for most Americans, it certainly included a lot of tax increases. Here we will focus on nonqualified deferred compensation (NQDC). Does it make more sens to defer or less sense to defer?
First, the withholding rate on supplemental wages in excess of $1 million in the aggregate increased to 39.6%. For supplemental wages up to $1 million, the withholding rate remains at 25%, What are supplemental wages? Generally, they are pay to an employee that is not part of a regular wage. They include overtime, bonuses, and distribution of nonqualified deferred compensation among other things. Ultimately, the taxes that a taxpayer pays are determined based on a number of factors, but the amount that they will see in a check for supplemental wages will decrease for particularly high recipients of supplemental wages.
Second, the OASDI portion of Social Security tax returned to 6.2% after being at 4.2% for a few years. This is the percentage of your paycheck that goes to Social Security on earnings not in excess of the Social Security Wage Base ($113,700 for 2013). The employer portion of OASDI remains at 6.2% of pay. For participants on NQDC plans, this is may be important because Social Security taxes are paid on NQDC generally in the year that such compensation is both vested and reasonably ascertainable. For most plans, that is the date when vested. For certain more complex plans such as DB SERPs, the amount may not be reasonably ascertainable until the participant terminates employment.
Third, the Medicare or HI portion of Social Security taxes has increased largely to pay for the ACA or ObamaCare if you prefer. For single filers with wages in excess of $200,000 or those filing jointly with income in excess of $250,000, the amounts above those thresholds will see an increase in HI tax from 1.45% of excess wages to 2.35% of excess wages. Additionally, there is a new 3.8% surtax on investment income such as capital gains from the sale of stock.
So, how do you know whether to defer or not to defer? It's a difficult question and the math is not as easy as we might like. Generally, the higher the marginal tax rate that you are paying, the more useful tax deferral is. Of course, there are many other factors that may influence your decision including your view of future tax rates, your need for the money in the short term, the investment return you can achieve and other factors that may be particularly germane to you as an individual.
Best of all will likely be compensation deferred in qualified plans such as 401(k), other defined contribution, and defined benefit if you are fortunate enough to have those opportunities.
In any case, for high earners, the new tax rates are more confiscatory than were the old ones, but your guess is as good as mine with respect to where they will be in the future.
First, the withholding rate on supplemental wages in excess of $1 million in the aggregate increased to 39.6%. For supplemental wages up to $1 million, the withholding rate remains at 25%, What are supplemental wages? Generally, they are pay to an employee that is not part of a regular wage. They include overtime, bonuses, and distribution of nonqualified deferred compensation among other things. Ultimately, the taxes that a taxpayer pays are determined based on a number of factors, but the amount that they will see in a check for supplemental wages will decrease for particularly high recipients of supplemental wages.
Second, the OASDI portion of Social Security tax returned to 6.2% after being at 4.2% for a few years. This is the percentage of your paycheck that goes to Social Security on earnings not in excess of the Social Security Wage Base ($113,700 for 2013). The employer portion of OASDI remains at 6.2% of pay. For participants on NQDC plans, this is may be important because Social Security taxes are paid on NQDC generally in the year that such compensation is both vested and reasonably ascertainable. For most plans, that is the date when vested. For certain more complex plans such as DB SERPs, the amount may not be reasonably ascertainable until the participant terminates employment.
Third, the Medicare or HI portion of Social Security taxes has increased largely to pay for the ACA or ObamaCare if you prefer. For single filers with wages in excess of $200,000 or those filing jointly with income in excess of $250,000, the amounts above those thresholds will see an increase in HI tax from 1.45% of excess wages to 2.35% of excess wages. Additionally, there is a new 3.8% surtax on investment income such as capital gains from the sale of stock.
So, how do you know whether to defer or not to defer? It's a difficult question and the math is not as easy as we might like. Generally, the higher the marginal tax rate that you are paying, the more useful tax deferral is. Of course, there are many other factors that may influence your decision including your view of future tax rates, your need for the money in the short term, the investment return you can achieve and other factors that may be particularly germane to you as an individual.
Best of all will likely be compensation deferred in qualified plans such as 401(k), other defined contribution, and defined benefit if you are fortunate enough to have those opportunities.
In any case, for high earners, the new tax rates are more confiscatory than were the old ones, but your guess is as good as mine with respect to where they will be in the future.
Tuesday, October 30, 2012
On ISS and SERPs
We're getting close to proxy season for issuers of proxies under the purview of the Securities and Exchange Commission (SEC). And, especially since the passage of Dodd-Frank which gave us the new concept of the (non-binding, but very important) Shareholder Say-On-Pay (SSOP), one of the most important names that we see is Institutional Shareholder Services (ISS).
In a nutshell, ISS provides a service to institutional shareholders of issuers. By performing their analysis of SSOP proposals, ISS gives its subscribers guidance related to how they should cast their SSOP votes. While I may not sound entirely favorable toward ISS and their opinions in this post, I do think this is a valuable service.
For those people who would like to understand ISS's standards and protocols, they have a fairly detailed website with new practices for 2013 as well as their comprehensive 2012 policies.
Now I quote directly from their comprehensive 2012 policies:
However, ISS appears (emphasis here on appears as compared to has) to have taken the position that having a SERP with a more generous formula than in a qualified plan also constitutes an egregious SERP. Often, they are correct. But, not always.
There is a reason, or at least there ought to be, that SERPs are designed as they are. Some companies, for example, tend to promote from within and their executives will likely be long-service employees who are motivated by retention devices rather than attraction devices. SERPs perform this function well. Freezing a SERP when the qualified defined benefit (DB) plan is frozen may be detrimental to shareholders as executives will no longer be bound by the retention device.
What should ISS do? While I have often said negative things about the Summary Compensation Table (SCT) in the proxy, perhaps the SEC had it somewhat correct when they designed it. While technical pension issues may make the pension data in the proxy less valuable than it otherwise might be, the pension accrual is part of annual compensation.
Now, suppose an executive receives lower direct cash compensation than his peer group (other companies), but receives more in deferred compensation through a SERP. Should this be problematic to shareholders? In my opinion, it should not be. In fact, since direct cash compensation is the proverbial bird in the hand while deferred compensation may not be paid if the company suffers particularly adverse business circumstances such as bankruptcy, the generous SERP in lieu of generous current cash may actually be more desirable. But, it's not viewed that way.
New methodologies allow reviewers of proxies to better make this analysis. I'm working on a paper that will explain this in more detail. Regular readers will see it here.
In a nutshell, ISS provides a service to institutional shareholders of issuers. By performing their analysis of SSOP proposals, ISS gives its subscribers guidance related to how they should cast their SSOP votes. While I may not sound entirely favorable toward ISS and their opinions in this post, I do think this is a valuable service.
For those people who would like to understand ISS's standards and protocols, they have a fairly detailed website with new practices for 2013 as well as their comprehensive 2012 policies.
Now I quote directly from their comprehensive 2012 policies:
I could be particularly troubled by what I see there, but it's not what gives me pause. Generally, granting of additional years of service for top executives is not a best practice. Similarly, inclusion of long-term awards in compensation for SERP purposes is not a best practice.Egregious pension/SERP (supplemental executive retirement plan) payouts:§ Inclusion of additional years of service not worked that result in significant benefits provided in new arrangements§ Inclusion of performance-based equity or other long-term awards in the pension calculation
However, ISS appears (emphasis here on appears as compared to has) to have taken the position that having a SERP with a more generous formula than in a qualified plan also constitutes an egregious SERP. Often, they are correct. But, not always.
There is a reason, or at least there ought to be, that SERPs are designed as they are. Some companies, for example, tend to promote from within and their executives will likely be long-service employees who are motivated by retention devices rather than attraction devices. SERPs perform this function well. Freezing a SERP when the qualified defined benefit (DB) plan is frozen may be detrimental to shareholders as executives will no longer be bound by the retention device.
What should ISS do? While I have often said negative things about the Summary Compensation Table (SCT) in the proxy, perhaps the SEC had it somewhat correct when they designed it. While technical pension issues may make the pension data in the proxy less valuable than it otherwise might be, the pension accrual is part of annual compensation.
Now, suppose an executive receives lower direct cash compensation than his peer group (other companies), but receives more in deferred compensation through a SERP. Should this be problematic to shareholders? In my opinion, it should not be. In fact, since direct cash compensation is the proverbial bird in the hand while deferred compensation may not be paid if the company suffers particularly adverse business circumstances such as bankruptcy, the generous SERP in lieu of generous current cash may actually be more desirable. But, it's not viewed that way.
New methodologies allow reviewers of proxies to better make this analysis. I'm working on a paper that will explain this in more detail. Regular readers will see it here.
Friday, October 26, 2012
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:
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.
Friday, September 28, 2012
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.
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.
Thursday, September 13, 2012
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.
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.
Tuesday, July 10, 2012
Distribution Dilemma in Times of Tax Uncertainty
Recently, I was speaking with a top executive at a decent-sized company. The discussion had much to do with his total compensation, but paramount in his mind was his distribution from his nonqualified defined benefit plan (SERP). You see, due to Code Section 409A and its ties that bind, executives with meaningful amounts of deferred compensation are stuck in a guessing game (more about that later).
409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):
409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):
- Prior to the year in which compensation is deferred, participants must elect both the timing and form of their distribution.
- To the extent that participant wishes to changes his distribution option(s) with respect to money already deferred, he must make that change at least one year prior to the date that distribution would have occurred, AND postpone that distribution by at least 5 years.
- Failure to comply results in significant penalties.
Consider this scenario. You were fortunate enough to be a participant in a SERP. Then, 409A came along and you had to make your "initial deferral election" in that SERP. You didn't know what to do, but you sure liked the idea of the security and favorable conditions underlying a lump sum distribution. Your fellow executives did as well.
That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.
Oops, wrong guess.
There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.
What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?
I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:
That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.
Oops, wrong guess.
There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.
What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?
I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:
- 11 of the 15 had no say in their initial deferral election; it was foist upon them by HR who said that they had made their decision for them based on legal and or accounting advice.
- 9 of the 15 didn't know what the rules were around changes.
- 13 of the 15 have a DB and or DC SERP in which they are scheduled to take a lump sum distribution.
- Given the current economic and tax climate, of those 13, 12 would like to take a different form of distribution.
- Of those 12, 11 said that back when they made their 409A initial deferral election, had they truly understood what they were doing, they would have made a different initial deferral election.
Choosing that distribution option well in advance sure does create a dilemma. There are certainly options, but more people than not don't seem to understand this.
Wednesday, September 28, 2011
How Companies Can Piss Off Shareholders
I thought this might be a provocative title for a blog post: "How Companies Can Piss Off Shareholders". Frankly, if you are expecting a full discourse on all the ways this can be done, you've come to the wrong place. The seminal piece on this is undoubtedly the ISS (Institutional Shareholder Services) 2011-2012 Policy Survey Summary of Results. And, for that matter, if you really want a more thoughtful analysis of the entire survey, I would direct you to Mike Melbinger's latest blog post on this topic.
ISS would never say anything like the title of this post. And, Mike Melbinger, while I love his blog, tends to be more politically correct than yours truly. If you came here to read about this, then you are looking to see someone fall. Knives in the back are fair game. So are sucker punches below the belt. Here, the only rules are the Truth According to Me (apologies to John Irving and T.S. Garp).
So, between the strategically chosen dates of July 6 and August 26 of 2011 (after people came back from celebrating our nation's birthday and before they left to celebrate labor (the kind that you get paid for, not the kind that causes expectant mothers to scream)), ISS asked a whole bunch of questions of both investors (institutional shareholders) and issuers (companies that issue proxies to their shareholders).
Before getting into the nitty gritty, though, I feel the need to digress. Has a body as educated and seemingly intelligent as ISS not made it through 3rd grade math? In their introductory remarks, ISS notes that "[M]ore than 335 total responses were received. A total of 138 institutions responded. ... 197 corporate issuers responded ... ." I got out my handy-dandy calculator which in my case sits somewhere north of my neck (traditional calculators have a tendency in my world to hide themselves under stacks of paper, but my calculator always seems to live in about the same place, covered with some hair in strategically chosen places) and added 138 to 197. Hmm? The total was 335. It was not more than 335. Come on, ISS, this is simple stuff. Editors, though, have a problem with starting sentences with a number, so they use silly terms like more than to mean exactly.
OK, enough on that rant ...
In any event, ISS does an outstanding job with their report. Right up front, they summarize key findings. And, for the upcoming proxy season, the #1 governance issue cited by 60% of investor respondents and 61% of issuer respondents is Executive Compensation. Said differently: if a company wants to piss off its shareholders, the #1 way is to compensate its executives in a manner or amount that does not align with shareholder goals. Other top issues for shareholders were Board independence, shareholder rights, and risk oversight, in that order. For companies, the only issue other than executive compensation receiving more than a 30% vote was risk oversight.
Later on, ISS drills down (I've never used that term in writing before, but I felt the need today). Some of the findings that I found interesting were these:
ISS would never say anything like the title of this post. And, Mike Melbinger, while I love his blog, tends to be more politically correct than yours truly. If you came here to read about this, then you are looking to see someone fall. Knives in the back are fair game. So are sucker punches below the belt. Here, the only rules are the Truth According to Me (apologies to John Irving and T.S. Garp).
So, between the strategically chosen dates of July 6 and August 26 of 2011 (after people came back from celebrating our nation's birthday and before they left to celebrate labor (the kind that you get paid for, not the kind that causes expectant mothers to scream)), ISS asked a whole bunch of questions of both investors (institutional shareholders) and issuers (companies that issue proxies to their shareholders).
Before getting into the nitty gritty, though, I feel the need to digress. Has a body as educated and seemingly intelligent as ISS not made it through 3rd grade math? In their introductory remarks, ISS notes that "[M]ore than 335 total responses were received. A total of 138 institutions responded. ... 197 corporate issuers responded ... ." I got out my handy-dandy calculator which in my case sits somewhere north of my neck (traditional calculators have a tendency in my world to hide themselves under stacks of paper, but my calculator always seems to live in about the same place, covered with some hair in strategically chosen places) and added 138 to 197. Hmm? The total was 335. It was not more than 335. Come on, ISS, this is simple stuff. Editors, though, have a problem with starting sentences with a number, so they use silly terms like more than to mean exactly.
OK, enough on that rant ...
In any event, ISS does an outstanding job with their report. Right up front, they summarize key findings. And, for the upcoming proxy season, the #1 governance issue cited by 60% of investor respondents and 61% of issuer respondents is Executive Compensation. Said differently: if a company wants to piss off its shareholders, the #1 way is to compensate its executives in a manner or amount that does not align with shareholder goals. Other top issues for shareholders were Board independence, shareholder rights, and risk oversight, in that order. For companies, the only issue other than executive compensation receiving more than a 30% vote was risk oversight.
Later on, ISS drills down (I've never used that term in writing before, but I felt the need today). Some of the findings that I found interesting were these:
- 62% of investors find it very relevant (negatively so) when executives are paid significantly higher than their peer group.
- 88% of investors find it very relevant if pay levels have increased disproportionately to the company's performance.
- While issuers generally do not feel compelled to respond to a say-on-pay vote until the dissenting vote has approached or reached 50%, nearly half (48%) of investors feel that an issuer should provide an explicit response when the no votes reach 20% or even less.
Institutional shareholders are very serious about say-on-pay. Companies that ignore this are seeing two phenomena -- contested elections of Directors and shareholder lawsuits against the Board of Directors.
For companies that may be headed down a path of compensation that could get a lot of no votes, they need to do a lot of planning and explain their decisions up front. Right up there near the top of problematic pay practices are egregious SERPs. Sometimes, they are justifiable, and other times, ...
Caveat enditor!
Friday, September 16, 2011
A New Look at an Old Friend
About 10 years ago, they were all the rage for companies that had defined benefit (DB) plans. Lots of DB plans were still in surplus, or at least thought they were, and lots of companies still had ongoing DB plans. Something happened in the interim (OK, a few somethings happened), but that's not the point here. Roughly 10 years ago, lots of companies were looking for an ideal way to fund their DB Supplemental Executive Retirement Plans (SERPs), In my opinion, the most effective way to fund these nonqualified (NQ) benefits was through a qualified plan (QP). This strategy has gone by many names, but the most prevalent in the industry has been the QSERP.
On the surface, the QSERP is simple. An executive has a NQ accrued benefit which is usually composed of a gross benefit offset by a QP accrued benefit. The resultant net benefit is what the executive would get from the SERP. In a QSERP, the QP is amended to increase the QP benefit to include some or all of the SERP benefit, thus (because of the offset feature) decreasing the net SERP benefit by an equal amount.
What does this do for the executive? Here are some of the benefits.
On the surface, the QSERP is simple. An executive has a NQ accrued benefit which is usually composed of a gross benefit offset by a QP accrued benefit. The resultant net benefit is what the executive would get from the SERP. In a QSERP, the QP is amended to increase the QP benefit to include some or all of the SERP benefit, thus (because of the offset feature) decreasing the net SERP benefit by an equal amount.
What does this do for the executive? Here are some of the benefits.
- It generally secures the benefit. Of course, if the plan sponsor goes bankrupt, such security is subject to PBGC limits on guaranteeable benefits.
- It takes the benefit out from under the purview of Code Section 409A.
- While the benefit is still in the plan, it does not fall prey to the doctrine of constructive receipt under Code Section 83.
- If the benefit is payable in a lump sum, it can be rolled over into an IRA further deferring taxation.
- The executive can wait until just before his benefit commencement date to make an election as to the timing and form of benefit distribution.
- The benefit is exempt from FICA taxes.
- The benefit is protected in the event of a change-in-control.
And, for the plan sponsor, here are some of the benefits.
- To the extent that the benefit is funded immediately, the sponsor gets an immediate tax deduction.
- Since the plan is qualified under Code Section 401(a), the trust will be exempt from taxes under Code Section 501(a), meaning that the plan assets grow tax-free.
- Payment of the benefit comes from a trust that holds all of the plan assets, not from the corporate coffers, or a far smaller rabbi trust.
- Qualified plans have better optics than do SERPs.
How about for the shareholder? How does a QSERP affect them?
- In every case that I can think of, implementation of a QSERP has been either income-neutral or income-positive.
- The company is less likely to have sudden cash flow requirements.
- From a risk standpoint, it is far easier to use risk management techniques in a qualified plan than in a SERP.
So, why can companies put in these QSERPs? Generally, from a technical standpoint, it goes to two things in the Internal Revenue Code: 1) the nondiscrimination rules of Code Section 401(a)(4) are highly objective; and 2) the combined limits under Code Section 415(e) were repealed.
Yes, that's highly technical stuff. But, suffice to say that it works. For years, I had the extreme pleasure <cough, cough> of teaching nondiscrimination testing to generally younger and aspiring actuaries. One of the things about the testing that I drilled into their heads was this: if you don't pass, you're not trying hard enough.
Sometimes benefits actually are discriminatory, and there is nothing that any of us can do to change that. But, I have seen some benefit formulas over time that are extremely discriminatory to the naked eye. So, what do we do? We take the employee data and put it in a big pot. We add in the benefit provisions. We stir a bit with the nondiscrimination rules (remember, they are objective; either you pass or you fail.) and out comes a nondiscriminatory plan.
We're late in 2011 now. The funding rules have changed. There are fewer large defined benefit plans, and of those that remain, many are in one state of freeze or another. 10 years ago, there was no 409A. There was no Dodd-Frank,
There is still lots of merit to this approach. Consider it. Talk to us.
Wednesday, December 1, 2010
Your Eyes Are Not Failing You -- We Have GOOD 409A News
The IRS and the Treasury Department have released Notice 2010-80: Modification to the Relief and Guidance on Corrections of Certain Failures of a Nonqualified Deferred Compensation Plan to Comply with § 409A(a) [of the Code]. You can read it for yourself here: http://www.irs.gov/pub/irs-drop/n-10-80.pdf
That's a lot of words, and you might have to be a cryptographer to figure out what it all means, but trust me, this is good news -- very good news. The regulators in Washington have read comments, and while other remarks -- both verbal and in writing -- have gotten no official observance from the regulators, this writer thinks that those remarks have been noticed as well.
So, what's the buzz, tell me what's a happening (apologies to Andrew Lloyd Webber for reusing his Jesus Christ Superstar lyrics in a slightly different context).
Here is a summary of the news:
That's a lot of words, and you might have to be a cryptographer to figure out what it all means, but trust me, this is good news -- very good news. The regulators in Washington have read comments, and while other remarks -- both verbal and in writing -- have gotten no official observance from the regulators, this writer thinks that those remarks have been noticed as well.
So, what's the buzz, tell me what's a happening (apologies to Andrew Lloyd Webber for reusing his Jesus Christ Superstar lyrics in a slightly different context).
Here is a summary of the news:
- Documentary failures under linked nonqualified plans (NQ linked to other NQ and or NQ linked to qualified) are now eligible for relief under Notice 2010-6, so long as the linkage does not affect the timing or form of payments under the plans. For many companies, on a scale of 10, this relief qualifies as an 11.
- Documentary failures for certain stock rights are now eligible for Notice 2010- relief.
- An additional method of correction is now available for certain separation payments that are subject to a release of claims, and this method is very workable.
- There is relief from the extremely onerous service provider (employee) reporting requirements for the Notice 2010-6 transition relief for "freebie" correction under Notice 2010-6.
- There is relief for service recipients (employers) with respect to the information that they need to provide to service providers (employees) for Notice 2008-113 corrections made during the same taxable year.
The fourth and fifth (last two bullets) may look like small potatoes, but I am aware of multiple Fortune 500 companies that chose to have 409A failures rather than go through the 2008-113 or 2010-6 correction processes because of the requirements to provide information. So, these small potatoes are actually bigger than the eye perceives.
On to the nitty-gritty ...
The Linked Plans Issue
In my experience, this was the worst provision of the 409A regulations. No practitioners that I work with saw this seemingly innocent failure coming. Let's consider two fairly simple and common types of failures.
Example 1. Company A provides Executive E with a qualified defined benefit plan under which E is entitled to an annual benefit not to exceed the 415 limit of 1% of 5-year final average pay (not in excess of the pay cap) per year of service. A also provides E with an 'excess' plan (nonqualified) under which E receives an annual benefit under the same formula, but without regard to the 415 limit and pay cap, and further offset by the qualified plan benefit.
Pause for a slap on the wrist.
Now, suppose that E has elected a lump sum payment upon separation from service from the nonqualified plan, but that the amount of this lump sum could be affected by the timing and form of the qualified plan payment. This appears to violate the 409A regulations, and there was no fix available under Notice 2010-6. Notice 2010-80 allows for correction under Notice 2010-6.
Example 2. The facts are the same as in Example 1, except that E does not have a lump sum option in the excess plan, but E also participates in a top-hat plan (SERP) with a richer benefit formula (offset by all other defined benefits) that does have a lump sum option. E has made a bona fide initial deferral election in the excess plan to take a 50% Joint and Survivor Annuity (with his wife as beneficiary) and a lump sum on the last day of his tax year following or coincident with separation from service from the SERP.
Here we appear to have two violations of the 409A regulations, so pause for 40 lashes.
Again, Notice 2010-6 would not have allowed for correction of this 'defect', but Notice 2010-80 amends Notice 2010-6 to allow for such documentary corrections.
Separation Payments Contingent on Employment-Related Actions
This is another biggie. Again, Notice 2010-6 is amended by allowing for additional methods of correction. Suppose the service provider (again, this is usually the employee) needs to complete certain action(s) such as executing and submitting a non-compete in order to receive his separation payments. Paying the benefit upon separation from service eliminates the teeth in the non-compete; that is, the service provider could take his payment and decide to not sign the non-compete. Delaying payment violates 409A.
But now, the fix is in, and it's a good one. The document can be amended to allow for payment [in general terms] either 60 or 90 days following the separation (permissible payment event) so long as in the event that the 90-day period spans two taxable years, the payment will be made during the second of those taxable years.
* * * * * * * * *
There's more -- of course there is -- much more in the Notice, but this should give you an overview of what I think readers may need to know. This stuff is pretty complex though, especially on the defined benefit side, and if you are dealing with it and don't have the in-house expertise (most companies don't), I suggest that you engage someone who is expert in both defined benefit plans and nonqualified plans to help. But, I repeat, this is good news.
Don't wait. Act quickly. Get these things fixed.
The author is not an attorney or accountant and does not provide legal, accounting or tax advice.
Tuesday, November 16, 2010
Beware! Is Your Nonqualified Deferred Compensation Plan Linked to a Qualified Plan
The regulations under Code Section 409A have some strange rules related to "linking" nonqualified and qualified retirement plans, or linking multiple nonqualified retirement plans together. Once upon a time, a fairly typical retirement benefit structure include these plans for executives:
- A qualified defined benefit plan
- An "excess plan" with the same formula as the qualified plan, but designed to provide for benefits above the 415 limit and on pay above the pay cap
- A SERP with a different, usually more generous formula, offset by benefits under the other 2 plans
Often, the SERP had different early retirement benefits and different or more subsidized optional forms of benefit available.
This structure can be particularly problematic under 409A (you can read about it in my article here: http://www.aon.com/attachments/jpm_409a.pdf ).
If you have such a structure, the IRS and Treasury is saying that you cannot fix the problem under the documentary correction programs in Notice 2010-6. Currently, the regulatory position is that linked nonqualified plans can be fixed, but nonqualified plans impermissibly linked to qualified plans cannot be fixed penalty free.
Any advice I would give would vary from situation to situation, but if you do have problematic plans, you will want to fix them sooner rather than later.
This blog does not provider legal, tax, or accounting advice which can only come from a qualified provider.
Monday, November 15, 2010
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
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
You can find the article here: http://www.aon.com/attachments/dbdc_serp_aug2010.pdf
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