Best Practices for Managing      Financial Volatility in Non-Qualified      Deferred Compensation PlansMarch 24, 2011© 201...
Discussion   Overview   Current Environment   Securing Executive Retirement Plans       Financing Plan Benefits      ...
Overview   Non-Qualified Deferred Compensation Plans (NQDC)       Salary/bonus deferral       Company matching contribu...
Overview   Allow for deferral of current income to a future date   Participant is unsecured creditor, gains are tax-defe...
Current Environment   NQDC plans are increasingly used by many companies   NQDC plans can be quite large (many plans in ...
Current Environment   § 409A of the Internal Revenue Code   Implementation costs   Financing issues   Financing altern...
Current Environment   Benefit security   Recent surveys indicate approximately 40% of NQ plans have    earmarked assets ...
Current Environment   Most tax-effective and secure strategy is to use a QSERP   While completely tax sheltered and full...
Financial Structure                                                           Cash                                        ...
COLI: The Basics   How does COLI work?   Tax arbitrage is the key attraction of COLI financing   COLI offers no advanta...
COLI: The Risks   Beware of hidden costs and the need for short-term liquidity   Frictional Costs of COLI come from many...
COLI: The Players   Specialized brokers focus on placing large case COLI       U.S. large case COLI market likely $200b ...
Hedging Strategies       Crediting                               Hedging Implications       Rate                     Tax-d...
Hedging Fixed-Crediting Rate Plans   Periodically reset to market rate   Market proxy with spread effectively serves as ...
Hedging 401(k) Mirror Menu   NQDC plans typically offer 401(k) mirror menu   NQDC typically do not offer commingled/coll...
Hedging COLI-Based Menu   NQDC plans typically offer COLI-based menu   Financing implications:       COLI - construct m...
Hedging Company Stock   Treasury stock   Prepaid Forwards   Options   Swapstowerswatson.com        © 2010 Towers Watso...
Concluding Thoughts   COLI products are becoming much more competitively priced and    transparent in structure   More s...
Disclaimer   The information included in this presentation is general information only    and should not be relied upon w...
Contact Details   Pete Neuwirth       525 Market Street, Suite 2900, San Francisco, CA 94105-2708       415-733-4139   ...
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Best Practices for Managing Financial Volatility in Non-Qualified Deferred Compensation Plans

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Best Practices for Managing Financial Volatility in Non-Qualified Deferred Compensation Plans

  1. 1. Best Practices for Managing Financial Volatility in Non-Qualified Deferred Compensation PlansMarch 24, 2011© 2011 Towers Watson. All rights reserved.
  2. 2. Discussion Overview Current Environment Securing Executive Retirement Plans  Financing Plan Benefits  Controlling Plan Costs  Hedging Strategies Concluding Thoughtstowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 2 Presentation2
  3. 3. Overview Non-Qualified Deferred Compensation Plans (NQDC)  Salary/bonus deferral  Company matching contributions (discretionary and/or “401(k) Make-up” Pension benefits  Excess or “Top Hat” executive pension plans  No deferral, company “funded”  Can be either DB or DC Objectives  Talent attraction and/or retention  Make up for qualified plan discrimination testing limitations for highly compensated  Long-term alignment of interest  Potential financial benefits for companytowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 3 Presentation2
  4. 4. Overview Allow for deferral of current income to a future date Participant is unsecured creditor, gains are tax-deferred Company carries balance as liability, gains are taxable “Notional” account balances are typically record kept by outside firm Company determines crediting rate for “notional” account balances Crediting rate decision has material financial implications for company Company realizes positive cash flow, but loses current tax deduction Benefit security concerns for executives is partially mitigated through use of Rabbi Trust Assets are subject to general creditor claims under insolvencytowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 4 Presentation2
  5. 5. Current Environment NQDC plans are increasingly used by many companies NQDC plans can be quite large (many plans in the hundreds-of- millions-of-dollars range) On balance sheet nature of NQDC plans has financial statement implications if not managed properlytowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 5 Presentation2
  6. 6. Current Environment § 409A of the Internal Revenue Code Implementation costs Financing issues Financing alternativestowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 6 Presentation2
  7. 7. Current Environment Benefit security Recent surveys indicate approximately 40% of NQ plans have earmarked assets to fund/hedge NQ liabilities Asset investment returns are fully taxable to the company, though liabilities grow tax deferred Liabilities are marked to market which can result in substantial income statement volatility for the companytowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 7 Presentation2
  8. 8. Current Environment Most tax-effective and secure strategy is to use a QSERP While completely tax sheltered and fully secure, QSERP’s are relatively uncommon Because of QSERP drawbacks noted above, the most common financing approach is use COLI to hedge benefit liabilities, but: About one half of NQ Plans that do hedge liabilities, use COLItowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 8 Presentation2
  9. 9. Financial Structure Cash no tax deduction RABBI Trust COMPANY (Company Asset) EE ER Insurance Premiums Side Fund Deposit Deferrals Contributions Notional account COLI policies Brokerage (liability for company) 1 (insured ees ≠ all participants) Account +/- Returns +/- Returns +/- Returns (Net of Inv. Mgt. Fees) (Net of Inv. Mgt. Fees) (Net of Inv. Mgt. Fees) Less Frictional Company Liability 2 Costs Less Tax Costs Cash Value Investment return (no tax) Death Benefits Distribution liquidity source Distributions 3 (no taxes) (taxable) 1. Policies do not have to be taken out on all participants Death Benefits 2. COLI can be financially beneficial if Frictional costs < Tax costs (no taxes) 3. Side fund, death benefit proceeds, and/or ongoing deferrals are used for distributionstowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 9 Presentation2
  10. 10. COLI: The Basics How does COLI work? Tax arbitrage is the key attraction of COLI financing COLI offers no advantage if:  Insurance expenses exceed the tax savings  Client pays no corporate income tax or is subject to AMT  Returns on cash value are low (say below 4%) or negativetowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 10 Presentation2
  11. 11. COLI: The Risks Beware of hidden costs and the need for short-term liquidity Frictional Costs of COLI come from many sources COLI works best when:  Plan is expected to grow robustly and current annual deferrals offset current cash distributions  Contracts are held until death  Liquidity is available through loans and/or corporate cash  Asset returns are high (typically should be higher than 5% for maximum benefits) Determining the “right amount” of COLI is tricky businesstowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 11 Presentation2
  12. 12. COLI: The Players Specialized brokers focus on placing large case COLI  U.S. large case COLI market likely $200b +  Services provided (varies by broker) Players  Large multi-line consulting firms  Specialty full-service administrative/broker-dealers  Specialty limited-service broker-dealers  Certain insurance carriers will sell directtowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 12 Presentation2
  13. 13. Hedging Strategies Crediting Hedging Implications Rate Tax-deferred (COLI) Taxable (non-COLI) Fixed Rate • Not investable • Not investable • Difficult to hedge • Difficult to hedge • Material A/L volatility • Material A/L volatility • Cost of insurance increases A/L • Taxes increases A/L miss-match miss-match Mutual fund • Correlate or optimize • Mostly direct match with mutual funds “menu” • Imprecise hedge with some A/L • Commingled funds create A/L miss- volatility match • Taxes create A/L miss-match • Derivatives – Beta with some A/L volatility COLI-based • Direct match • Correlate or optimize with mutual funds “menu” • Cost of insurance create A/L miss- • Imprecise hedge with some A/L volatility match • This structure is not often used • Derivatives – Beta with some A/L volatility Company • Highly volatile A/L challenge • Typically informally financed with Stock • Not typically used to finance treasury stock company stock • Derivative strategies are an alternativetowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 13 Presentation2
  14. 14. Hedging Fixed-Crediting Rate Plans Periodically reset to market rate Market proxy with spread effectively serves as additional benefit to participants Hedging strategy is similar to cash balance DB plans  Interest rate sensitivity dependent upon crediting rate reset frequency  Taxes and/or cost of insurance create additional A/L volatility  Asset strategy typically modeled with ALM software  Use of COLI dependent on cost/benefit rationaletowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 14 Presentation2
  15. 15. Hedging 401(k) Mirror Menu NQDC plans typically offer 401(k) mirror menu NQDC typically do not offer commingled/collective funds Financing implications:  COLI - construct correlated portfolio  Mutual funds – construct mirror portfolio using same options  Derivatives – hedge beta exposure with futures or swaps  Design rebalancing strategytowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 15 Presentation2
  16. 16. Hedging COLI-Based Menu NQDC plans typically offer COLI-based menu Financing implications:  COLI - construct mirror portfolio using same options  Mutual funds – construct correlated portfolio  Derivatives – hedge beta exposure with futures or swaps  Design rebalancing strategy Administrative matters:  Communication – custom fund fact sheets  Daily pricing and performance not readily availabletowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 16 Presentation2
  17. 17. Hedging Company Stock Treasury stock Prepaid Forwards Options Swapstowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 17 Presentation2
  18. 18. Concluding Thoughts COLI products are becoming much more competitively priced and transparent in structure More sophisticated hedging strategies are being considered by many companies to address P/L volatility and balance sheet impacts associated with Plan liabilities Significant disruption and change among administrative and COLI brokerage service providers as margins shrink and client sophistication increases Overall higher profile of programs is making compliance with 409A and communication with executives around NQDC issues much more importanttowerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 18 Presentation2
  19. 19. Disclaimer The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.towerswatson.com 19 © 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  20. 20. Contact Details Pete Neuwirth  525 Market Street, Suite 2900, San Francisco, CA 94105-2708  415-733-4139  peter.neuwirth@towerswatson.com Kipp Reck  One Alliance Center, 3500 Lenox Road, Suite 900Atlanta, GA 30326-4238  404-365-1792  kipp.reck@towerswatson.comtowerswatson.com 20 © 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

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