Non qualified Plans Offer Added Rewards.

Financial executives are increasingly being called upon to help their companies cost-effectively build top-notch executive teams. By understanding the important role that nonqualified, supplemental retirement benefits play in executive compensation, CFOs, treasurers and other financial executives can provide companies with innovative solutions for attracting and retaining management teams that will maximize shareholder value.

Companies face many challenges in establishing superior executive teams. The labor market for talented managers remains quite tight, and is expected to stay this way for several years. At the same time, it has become more difficult to cost-effectively compensate key executives. The stock market's recent performance has made options a less attractive incentive. It is clear that while executives are often able to determine a company's financial performance, they are seldom able to determine the value that the equities markets place on that performance.

Moreover, many companies now are concerned about the potential shareholder dilution created by options. A recent study by the Investor Responsibility Research Center (see "Business Briefs," May 2001 issue) found that at S&P 500 companies, average potential dilution jumped to 13.3 percent in 2000 from 11.4 percent in 1999 and just 9.2 percent in 1995. (Average potential dilution is determined by dividing the total number of shares and options reserved by the company for use in equity-based incentive and compensation plans by the total voting power of shares currently Outstanding.) In addition, negative publicity surrounding options repricing is a major barrier for many companies contemplating expanding option grants.

While cash compensation can be used, of course, this approach has limitations and downsides. Current cash payments don't provide an incentive for executives to stay with the company long-term. Furthermore, with key executives typically paying marginal tax rates above 40 percent, a sizable amount is often required for cash compensation to help retention.

Why Plans Are Important

For many executives, nonqualified, or supplemental, retirement plans can be a larger component of retirement income than qualified retirement plans (i.e., pension, profit sharing, and 401(k) plans). Nonqualified plans are in place at the vast majority of large and medium-size companies and typically cover the top 3 to 5 percent of executives.

These plans are increasingly vital because of the wide array of federal government restrictions on what executives can contribute to, and receive from, qualified plans. For example, in 2001 the maximum contribution that can be made to a qualified 401(k) plan is $10,500, or 5.25 percent of the compensation of an executive earning $200,000 a year.

The government limitations create significant shortfalls on what executives can expect from qualified retirement. How significant is the shortfall? A 1997 joint study by the Weatherhead School of Management at Case Western University and The Todd Organization [R] found that 8O percent of top executives in Fortune 501-1000 corporations could expect to receive less than one-third of their final income from Social Security and qualified plans. Nonqualified retirement plans bridge the gap.

Reviewing a Plan

Financial executives are often called upon to review a company's nonqualified plan(s). This seemingly straightforward task can quickly become quite complicated. Many companies have a hodgepodge of plans that were implemented for different divisions, or for executives at companies that were acquired. Information on these plans may not be in a central repository, and there could be several plan providers.

Some companies have promised executives that they are covered by plans, but have never taken steps to finance or safeguard these obligations. In addition, many companies have expanded the number of executives participating in their nonqualified plans without adequately gauging the financial impact.

Unlike with qualified plans, companies are not required to finance nonqualified retirement obligations or to place the money in trust. However, ignoring these steps creates a long-term liability -- i.e., executives' retirement benefits will have to be paid from the company's future earnings. This can be troubling to executives now with the company, and it does little to help attract key managers, who may perceive that the company may renege on these important obligations.

Some key questions that financial executives should ask when reviewing a plan include:

* Which executives are covered? How well informed are they of the program?

* How much of an incentive is provided?

* Is the plan financed? If so, how and at what cost?

* What is the most effective way to finance a plan(s)?

Companies have vast flexibility in designing and implementing a plan. Nonqualified benefit programs can be designed as seamless extensions of defined benefit and defined contribution plans. Executives can be rewarded with a larger benefit if they help the company exceed return on equity targets. Nonqualified plans can also provide vesting incentives for executives to remain with the company for a given period of time, or retire at a certain age.

Financial executives should also make sure that the nonqualified benefit is safeguarded by a fully financed "rabbi trust." Such a trust will ensure that the benefits are paid to executives in the event that the company is acquired. It also prevents future management (even if an acquisition does not occur) from arbitrarily rescinding the benefits.

While nearly all nonqualified plans implemented over the past five years have been accompanied with a rabbi trust, many older plans don't have this feature. Today's sought-after executives will place little value on a nonqualified plan that is not protected by a rabbi trust.

Plan values should be regularly communicated to executives so they know the value of these benefits and can fully appreciate them.

Financing Alternatives

Today, plans are typically financed through mutual funds or corporate-owned life insurance. There are several factors that financial executives should review and keep in mind.

With mutual funds, the company is liable for taxes on dividends and capital gains in the value of the securities, which are marked to market, pursuant to Financial Accounting Standards Board Statement No. 115. If executives expect a higher amount than the company has allocated (net of this tax payment), the company will have to provide additional funds, thus hiking its costs and potentially hurting corporate earnings. However the company can immediately take a tax deduction for dollars placed in the mutual funds for nonqualified plans.

To avoid these problems and meet nonqualified benefit obligations in a more predictable and manageable manner, many companies are turning to corporate-owned life insurance (COLI), particularly variable life policies, which can mirror mutual funds. COLI offers companies tax-free investment earnings that are not taxed as they grow and can be used to pay retirement benefits. Executives will pay taxes on the nonqualified benefits when they receive the funds, and the company can claim tax deductions at that time.

Companies that institute well-thought-out supplemental retirement plans can cost-effectively attract and retain key executives at a time when the competition for such talented professionals is exceptionally strong. Given today's environment, these concepts can go a long way toward ensuring not just better performance, but survival.

Robert L. Scharff Jr. is a principal of The Todd Organization of St. Louis LLC and chairman of The Todd Organization Inc., a firm specializing in the design, financing and administration of executive benefit programs.

Five Key Questions

Companies should scrutinize their nonqualified retirement plans at least every two years. Some key questions to ask include:

* Is the plan(s) competitive with what other companies, including direct competitors offer?

* Do executives understand and appreciate the benefits of the plan?

* Is the plan cost-effectively financed?

* Are there provisions in place to safeguard the executives' benefits in the event the company is acquired?

* Are documents for the plan in a central repository, and is information about the plan (including account balances) regularly communicated to key executives?