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Executives should earn their retirement income.

While executive pay has fueled a fire of controversy for over a decade, considerably less attention has been paid to the growing nest egg executives will receive upon retirement.

Supplemental Executive Retirement Plans (SERPs) are designed to compensate for regulated maximum payouts from qualified retirement plans and/or provide benefits other than those available through basic plans. In 1989, SERPs accounted for 40 percent of an executive's total retirement benefit versus only 10 percent in 1980, according to a Sibson & Company study of 175 Fortune 500 companies.

Keeping the boss whole can come at a high price--in terms of hidden costs and potential conflicts of interest. Future corporate financial liabilities for payments from SERPs and other nonqualified plans will total billions of dollars. Since tax laws preclude funding these arrangements, executives may run the risk of never receiving their retirement payments. And while trusts can protect these funds in the event of a takeover, the currently popular rabbi trust provides no security against loss if company bankruptcy or insolvency occurs. The insurance devices to protect these funds are complicated and often expensive, especially in terms of front-end cash requirements. What's more, while accounting rules generally require accruing the costs for these arrangements, future management and shareholders will still bear a heavy cash flow burden.

Perhaps it is time to rethink executive retirement income and reexamine one underlying fact: defined benefit and defined contribution plans are really forms of capital accumulation, and it is the accumulation of capital for life after retirement that really counts.

We need to abandon the precept that the underlying benefit structure that sets retirement income levels and forms of payments is right for all employees. Executives are different. Their needs and risks are leveraged. They are apt to spend less time with one company. So it is appropriate to base at least a portion of executives' capital accumulation for retirement on the results the executives have helped to produce for shareholders. This is especially true for that portion of benefits that is in excess of what the underlying plan would provide without statutory limitations.

The concept is simple: shift to the executive the responsibility for earning some of his or her own retirement income.

The company's incentive plans hold the potential to make this happen. While the executives' tax-qualified retirement, savings, and profit-sharing plans should continue unchanged, all or some of the excess benefit now supplied by SERPs can be derived instead from incentive plans. The SERPs benefit can be reduced or eliminated entirely. Medium- and long-term incentive devices--such as equity-related plans (stock options and restricted stock) and performance-oriented plans (such as performance-related deferred cash and performance units or shares)--are the most suitable vehicles because they provide the opportunity to accumulate capital over time. When such plans are soundly conceived and constructed, they link personal and company performance with shareholder interests, thereby offering a logical foundation for creating personal wealth.

Of course, it is critical to recognize the historical separation between incentive value and the fixed-income opportunity through the SERP. Since many executives now have both, the size of the incentive reward opportunities must be increased to preserve that relationship. Normally, the potential for greater reward should be provided by the incentive plan to offset the reduction in SERP benefits.

For example, if a SERP is intended to replace 20 percent of a $400,000-a-year executive's pay, or $80,000, the SERP could be reduced to, say, 5 percent. The incentive device should be designed so that the executive could accumulate enough capital to fund the remaining 15 percent--but only, of course, if the company's performance during the executive's time in the job so warranted.

Deriving retirement income from incentive plans rather than from SERPs has a number of material tangential advantages. The company wins because the plans can be tax and accounting effective, and the costs are more closely related to the company's ability to pay. The company gets a current tax deduction when the executive receives the incentive reward, and the accounting hit is made at a time when the company's performance can absorb it. And future management is not encumbered with the possibility of a significant cash-flow drain. Finally, management gains by executives' increased, vested interest in the welfare and continued success of business.

Shareholders win for the same reasons. From the executive's perspective, there are mixed feelings. There is a distinct downside if performance suffers or if the executive fails to do proper personal financial planning. Executives will need to define and plan for their future income needs. But that is the burden of self reliance.

On the plus side, the high-performing executive has the chance to win big. If the company is, or becomes, and continues to be successful, the gains will correspond. Unlike SERPs, which do not vest until retirement (or eligibility for retirement), incentives offer an executive the chance to realize gain earlier and to optimize personal financial planning. Most importantly, when in hand, they are funded. For the same reasons, they are generally less risky than a SERP in the event of a job change.

Companies and executives need to look hard at the issue of retirement income for executives and recognize that the old rules don't apply any more. Retirement addons do not serve anyone's best interest. Capital accumulation involves a variety of sources, and these sources should be examined together within the framework of specific business and personal objectives. The responsible design and use of incentive plans provides one direction, and it can be a beneficial avenue to pursue.
COPYRIGHT 1991 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Kuhns, James A.
Publication:Financial Executive
Date:Jul 1, 1991
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