Corporate Benefit Exchanges–A Second Bite At The Golden Apple
My topic, I believe, has the potential of producing significant new premium for all of us. We will review all the financial, economic and accounting issues surrounding benefit exchanges. Additionally, we will discuss the mechanics of the “exchange” transaction and review the potential constructive receipt issues with particular attention to why most practitioners agree no constructive receipt occurs.
As a preamble to this presentation, it is appropriate to discuss the genesis of the majority of the benefits targeted for exchange.
IRC sections 401(a)(17) and 415 limit the retirement benefit available to highly compensated executives from their corporate qualified plans. It is not uncommon to find that highly paid executives retire at only 20%-35% of their final pay while rank and file employees retire at 60%-100%.
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Many employers, in a effort to treat executives at least as well as rank and file employees when it comes to retirement income as a percentage of final pay, have adopted non-qualified deferred compensation programs and Supplemental Executive Retirement Programs.
Deferred compensation plans are designed to allow executives to defer the receipt of current income to create a viable retirement benefit. These plans are often designed to allow a true 15% of total compensation without regard to the current $170,000 ceiling on recognized compensation in a qualified plan.
The SERP is generally a defined benefit approach to the same goal. It might say that the employer promises a retirement benefit of 60% of final pay offset by 100% of the benefit provided by the employer’s qualified plan.
Both of these generic plans require a liability accrual by the employer to reflect the value of the promise. There is generally a partially offsetting asset account called a deferred tax credit that recognizes the fact that payments, when made, will be tax-deductible to the employer. Public companies disclose the existence of non-qualified retirement benefit programs in their proxy statements in the section dealing with executive compensation.
A simple example might be helpful. An employer promises a benefit of $100,000 a year for 15 years at a retirement age of 65 to a 45-year-old executive. The value of the benefit promise at age 65 is equal to the present value of $100,000 per year for 15 years discounted at some interest rate. For our purposes, let’s use 6%.
This benefit promise has a value of $1,029,498. The employer is required to accrue a liability of this amount over the 20 years between now and the maturity of the benefit promise. The result is an accrual of $17,013 in year one, offset by a deferred tax credit of $6,805 for a total year one charge to earnings of $10,208.
By age 65, the annual liability accrual increases to $51,475 with an interest cost of $55,475 for a total charge of $106,835. Again, this is offset by a deferred tax credit of $42,734 for a total net charge of $64,101. The net accrued liability at age 65 is $617,699 representing the gross accumulated benefit obligation of $1,029,498 offset by the accumulated deferred tax credit of $411,799.
The executive to whom the SERP promise was made may also have participated in corporate stock option and other financially lucrative bonus programs. He or she may have become wealthy beyond their wildest dreams. The SERP promise of $100,000 per year for 15 years may no longer be a meaningful benefit for this executive. In fact, this executive’s primary goal may now be to channel assets to future generations rather than to enhance retirement income.
Let’s assume our 45-year-old executive is now 63 and looking forward to a comfortable retirement at age 65. Income and estate taxes will reduce the value of the SERP to future generations. Assuming a total income tax rate of 40% and an estate tax rate of 55%, and further assuming the executive’s desire to channel this income and the value it produces to future generations, the result is as follows:
Value of accumulated SERP Income at 10% gross age 80: $1,480,351.
Value at joint life expectancy (age 88) at 10% gross: $2,810,148.
Net value to heirs: $1,545,582.
Total gross income received in retirement was $1,500,000. It was accumulated at 10% gross and allowed to continue accumulating until the death of the second to die. If no income or estate taxes were assessed, the value of the SERP at age 88 would be $8,749,737.