Deferred Compensation
Traditional deferred compensation arrangements provide executives with an opportunity to defer taxation on a portion of compensation for a pre-established period of time. Under the IRC, in order for compensation to be deferred, the executive may not have “constructive receipt” of the compensation, and the compensation must be subject to a “substantial risk of forfeiture.”
In layman’s terms, constructive receipt means that the compensation is available to the executive without meaningful restrictions. Similarly, a substantial risk of forfeiture exists when the compensation is contingent on future service, dependent on the occurrence of an event, or if the deferred compensation plan is unfunded and unsecured. In short, this means that there must be some meaningful risk to executives that they will not be paid. For example, if the deferred compensation plan is unfunded and unsecured, any assets would be part of the general assets of the company and therefore subject to the claims of creditors. In turn, the executive would be a general creditor of the company if the company became insolvent. While deferred compensation is inherently at risk, executives may not view the risks as greatly concerning unless insolvency is a real possibility.
Executives defer compensation for several reasons. First, companies credit deferred compensation with interest and may allow the executive to choose from a broad choice of investment vehicles within the plan. Executives can benefit from interest compounding on pre-tax amounts since income taxes are not paid until the end of the deferral period. In addition, executives may defer compensation because they expect to face a lower marginal tax rate when they receive the deferred funds at some time in the future. Lower tax rates could result from anticipated changes in the tax code or differences between the executive’s current and future income levels.
In order to implement a deferred compensation plan, your company will have to establish administrative policies covering multiple aspects of the program that address key issues, including:
- Eligible Executives: Decide how eligibility for the plan will be established. Determine if the plan will be limited to executives with a certain level of annual income or to a particular employee salary grade or level.
- Eligible Compensation: Establish what compensation can be deferred (e.g., RSUs, PSUs) and what the maximum deferral is for each pay element (e.g., up to 50% of salary, 100% of annual incentive).
- Investment Options: Determine how deferred funds will be invested. Alternatives are for interest credits to be pegged to a market interest rate, the performance of company stock, investment options under the 401(k), or credited with a fixed rate of return.
- Election Timing: Set up processes around deferral elections by type of vehicle (e.g., timing of deferral election, deferral form, differences across vehicles, etc.).
- Payment Timing: Identify the timing of the payment of deferred funds (e.g., fixed number of years after employment ends, upon termination of employment, a specified date, etc.).
- Form of Payment: Establish whether deferred amounts will be paid in cash or paid in shares of company stock (particularly for share-based deferrals of RSUs and PSUs).
- Funding: Determine a strategy for funding the deferred compensation obligation by setting aside funds for the plan, funding with company-owned life insurance or mutual funds, or using a “pay-as-you-go” approach. Note that assets earmarked to pay for deferred compensation must remain general assets of the company subject to the claims of creditors to avoid current taxation of deferred compensation.
- Executive Protection: Decide if the company will use a “rabbi trust” or “springing rabbi trust” to ensure that the company funds deferred compensation payments in the event of a merger or acquisition of the company. Assets deposited in a rabbi trust will be paid to deferred compensation plan participants by the trustee, protecting the executive from the risk that the company reneges on the promise to pay deferred amounts. A springing rabbi trust is an arrangement pre-funded with a minimal amount of cash prior to a change in control. Upon a change in control, the trustee is instructed to deposit a larger amount (i.e., the money “springs” into the trust) sufficient to pay at least 100% of the deferred compensation obligation.
From the company’s perspective, deferred compensation has both benefits and costs. On the positive side, the company preserves cash in the year of deferral and can use those funds for other purposes (or to fund future deferred compensation payments). However, the company delays taking a tax deduction, thereby increasing current taxes, until the deferred amounts are actually paid out. Additionally, if the company chooses not to fund deferred compensation balances, there may be large cash requirements triggered by the retirement of key executives. Finally, there will be some administrative costs involved in managing the program.
Even in cases where deferred compensation consists solely of amounts that would have been paid currently if the executive had not elected to defer, there can be a degree of sticker shock when an executive leaves the company with a large deferred compensation balance. In these situations, it is critical to clearly disclose that these amounts were earned by the executive over several years and do not reflect severance paid at termination. Even with clear disclosure, the company runs the risk that deferred compensation balances will be described by others as a form of executive severance. We recommend that the committee include the full deferred compensation balance in a tally sheet that is reviewed at least annually, in addition to proxy statement disclosure of non-qualified deferred compensation to avoid surprises. Finally, deferred compensation arrangements are subject to IRC Section 409A, which is such a complex topic that it requires its own chapter.
Key Questions for Committee Members to Ask:
- What are the financial implications of our deferred compensation program? What is the anticipated size of the long-term liability?
- What investment options will be made available to executives participating in the plan? Will any “above-market” interest be paid?
- Is the design unnecessarily complex? Are there aspects that could be simplified?