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Secular security for your executive benefits.

Secular security for your executive benefits

In today's volatile business climate, companies can become unwilling or unable to pay for their promised executive benefits. That may mean top talent leaves the company. One benefits specialist says there's a way to secure the benefits--inexpensively. With the changing structure of business, many prominent names in the corporate world have ceased to exist, or have become shadows of their former selves. Some have succumbed to unwanted takeovers. Others have entered into hastily arranged "white knight" marriages. And still others, confronted with extreme economic difficulties, catastrophic liabilities, or litigation reversals, have sought refuge in bankruptcy court or disposed of valuable assets in a struggle for survival.

This has left many executives seriously questioning the security of their benefits. The focus of this concern has largely been on the increased potential for a change in control at almost any company. And it is true that a takeover, divestiture, or other change brings a certain amount of fallout within the executive ranks. However, the risk of a deliberate default may be more theoretical than real.

New management--even "raiders"--probably probably cannot afford to renege on executive benefit commitments they inherit, if they wish to continue to be able to attract and retain top senior talent. In reality, the greatest risk is more likely that the company will not have the resources to make good on its promises, particularly in cases where heavy debt has been assumed in a leveraged takeover.

Why not pay-as-you-go?

Obligations under supplemental retirement and deferred compensation arrangements can last as long as 30 or 40 years, and even financially sound organizations can fall on bad times--whether through business reversals or lawsuits or other significant catastrophic events. The fact that such relatively sound companies as Texaco, A. H. Robins, and Johns-Manville have been the subject of bankruptcy proceedings has heightened many executives' concerns about the financial risk.

Whether or not to fund any executive benefit program is a preliminary issue, separate from how to secure any funds set aside. Traditionally, supplemental retirement and deferred compensation arrangements were pay-as-you-go programs under which an employer simply paid benefits when they became due out of corporate funds. Some employers invested in corporate-owned life insurance to hedge their liability. However, executives remained unsecured creditors, vulnerable to both a refusal to pay and the financial inability to pay, just as if the investment had never been made.

Under traditional financial analysis, taking funds out of a business to place them in a separate funding vehicle, such as a trust or annuity contract, would usually be viewed as presenting an "opportunity cost" becuase the rate of return on funds invested outside the business is less than the business' internal rate of return. However, this traditional analysis may not be appropriate to the situation.

In fact, putting funds into a trust or annuity contract often does not reduce business capital or hurt the company's earnings or cash flow. Not all of a company's funds may actually be invested in its business. Even a company that has no portfolio investments could borrow the necessary contributions (instead of "borrowing" from executives, as it does under the pay-as-you-go approach). As long as the rate of return on the fund is the same as the rate of return on portfolio investments or the company's borrowing rate, as the case may be, there would be no opportunity cost to funding an executive plan.

The pay-as-you-go system worked fine while executives looked to tax-qualified retirement plans for the major portion of their retirement income. However, in recent years, there have been dramatic increases in both the number of employees who are or will be covered by supplemental retirement or deferred compensation plans and the portion of their total retirement income that will be provided by such plans. Many companies that traditionally fully funded their retirement plans, at least for salaried employees, are now carrying multimillion-dollar unfunded liabilities for the employees most important to the success of their businesses.

Conventional approaches to security

As corporate liabilities for such benefits have grown, both management and boards of directors have been looking for ways to increase benefit security. A number of techniques have been tried, including: * Surety and performance bonds--Bonds that guarantee payment in case the employer cannot or will not pay are expensive and may be difficult to obtain. In addition, both their tax consequences and the level of protection they actually provide are uncertain. * "Rabbi trusts"--Putting money into an irrevocable trust protects employees against a refusal to pay--a big advantage over pay-as-you-go programs. But rabbi trust assets are still available to the company's creditors in the event of its bankruptcy or insolvency. Thus, although executives avoid immediate taxation, they remain vulnerable to the greatest risk of nonpayment--financial inability to pay. In addition, the company must bear the expense of all taxes on trust contributions and income until the benefits are actually paid, making rabbi trusts expensive. None of the conventional approaches, therefore, is completely satisfactory. An ideal arrangement would ensure payment of benefits if the company is either unwilling or financially unable to pay. It would also be cost-effective, considering the tax consequences, to both the company and the executive.

A new approach: the secular trust

There is a way to accomplish these objectives of cost-effectiveness and ability to pay--an approach called the "secular trust."

The distinct advantage of this approach over a rabbi trust, or any other approach to paying supplemental retirement or deferred compensation benefits, is that secular trust funds are not subject to claims of the company's creditors. These trusts are also more cost-effective than rabbi trusts.

Here's how it works. The company establishes a trust for employees, contributes money to it, and receives an immediate tax deduction. Vested executives are taxed immediately on all contributions credited to their trust accounts, and on trust earnings in the future, so they receive cash distributions to pay their taxes each year. Subsequent benefit payments to executives are, therefore, tax-free and do not need to be as large as payments from a rabbi trust, which are fully taxable. The contributions, of course, are calculated so that the right amount is left, after the distributions, to pay the same net after-tax benefits to employees when they are due.

The key to the secular trust is that it's an after-tax arrangement, while previous executive benefit arrangements were always done on a before-tax basis. This enables the secular trust to protect employees from both the company's unwillingness to pay for its benefits obligations and its financial inability to pay.

The additional security provided by a secular trust would probably justify additional expense. However, these trusts are actually less expensive for almost all taxpaying companies.

New after-tax economics

Until recently, after-tax arrangements would have been too expensive. It used to be more cost-effective to postpone both the company's tax deduction and the executive's tax liability, because corporate tax rates were lower than individual tax rates. But the Tax Reform Act of 1986 reversed the traditional spread. Now that corporations are subject to significantly higher tax rates than individuals, it pays to trade off the executive's tax against the company's tax deduction.

For example, based on pre-1987 tax rates, a $10,000 cash payment to an executive would have cost a company $5,400 after taxes, at the old 46 percent corporate rate. However, the executive only got to keep $5,000, at the old 50 percent individual rate. The extra $400 ($5,400 - $5,000) was lost to Uncle Sam because the $4,600 value of the company's $10,000 tax deduction was worth less than the executive's $5,000 tax cost.

To make that same $10,000 cash payment now, the company has to make an after-tax outlay of $6,600, at the new 34 percent corporate rate. The executive gets to take home $7,200, at the new 28 percent individual rate--a gain of $600 ($7,200 - $6,600), courtesy of Uncle Sam.

That same economic incentive, to pay compensation that is taxed immediately to the executive and deducted immediately by the company, applies to a secular trust. In a secular trust, the burden of immediate taxability of vested executives is borne in order to obtain the advantage of immediate deductibility for the employer.

In addition, a secular trust generates additional after-tax savings for the employer, because the executives, rather than the employer, pay all taxes on trust income. In effect, the company saves money by lowering the tax rate on taxable trust earnings.

But the trust must make distributions to cover the executives' taxes on trust earnings, as well as on contributions. These distributions deplete the trust fund and reduce the effect on compound interest, so the company must make more contributions.

The additional contributions to, and distributions from, a secular trust have been called a "gross-up" of taxes, but that is a misnomer. Since individual rates are lower than corporate rates, the additional contributions are less than the corporate income taxes the company would otherwise have paid on taxable earnings of the rabbi trust. They also are more than outweighed by the value of current tax deductions for the company's contributions to the secular trust and the concomitant shift of current taxation to the executive. The net effect is to reduce taxes while providing the same net after-tax benefit to the executive.

For instance, the company contributed a total of $20,280 to the secular trust, before taking its deductions, but it paid no taxes on trust earnings. The company's rabbi trust contributions totaled only $20,000, before deductions, but it also paid $340 in taxes on trust earnings. Thus, the company's total cash outflow of $20,340 was greater for the rabbi trust.

The company recoups the $340 in taxes by claiming a larger deduction when benefits are paid out of the rabbi trust. After all deductions, the company's net cash flow over two years is $13,385 ($6,600 + $6,785) for the secular trust, but only $13,200 ($10,000 + $3,200) for the rabbi trust.

However, some of the rabbi trust deductions were deferred, whereas all of the secular trust deductions were taken currently. Discounting net Year 2 cash flows to their present value at the beginning of Year 1 so that the time value of money can be taken into account, the secular trust has a lower after-tax cost ($12,965) than the rabbi trust ($13,002).

For tax-paying employers, a secular trust is almost always less expensive than a rabbi trust on an after-tax basis. Because of the short time span involved in the over-simplified, two-year examples here, the difference in after-tax cost is small. However, the financial impact of either approach would typically be measured over a more extended period, and the difference would be more dramatic.

As long as corporations pay more

The concept of an after-tax arrangement, while a departure from traditional practice, can provide a cost-effective means of fully securing supplemental retirement and deferred compensations benefits. Secular trusts can involve design issues and administrative burdens that rabbi trusts and pay-as-you-go programs do not. However, tax and financial analysis makes considering this approach worthwhile.

Secular trusts will continue to be less expensive than rabbi trusts, even if tax rates increase, as long as corporate rates are higher than individual rates. The secular or after-tax funding approach is worth considering now, while individual tax rates are lower than corporate rates. In the unlikely event that individual tax rates are increased higher than corporate rates, this funding approach should be reevaluated. However, the additional security provided by the secular trust may still make it worth any additional after-tax expense.

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Author:Tauber, Yale D.
Publication:Financial Executive
Date:Mar 1, 1989
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