The U.S. economy, forecasters tell us, may finally be reaching bottom. But the leading financial indicators pointing to a recovery evidently don’t include sales of non-qualified deferred compensation plans. Long a favored vehicle of businesses owners for recruiting, retaining and rewarding senior execs, the plans, sources tell National Underwriter, remain in the doldrums.
“Many businesses don’t have big dollars to put into deferred plans, so they’re more discriminating, covering fewer execs than they have in past,” says Richard Levitz, an executive vice president at GCG Financial, Bannockburn, Ill. “Now they may only cover 5 or 6 execs versus 10 or more previously. The key issue here is cash flow–or the lack thereof.”
Shad Reynolds, a certified financial planner and principal of Capstone Financial Partners, Atlanta, Ga., is more emphatic. “The market for deferred comp has almost completely dried up,” he says. “There is not enough revenue beyond the normal amounts of business being generated to warrant deferred comp for the top-hat guys. A lot of folks are looking at alternative funding vehicles, including executive bonus plans. That’s the direction in which we’ve taken our business.”
Non-qualified deferred compensation–a special benefit for corporate executives and other highly compensated employees that promises a fixed income for a specified period following retirement–is most commonly funded with cash value life insurance. Among the reasons: The policies assure the plan that their benefits will not be endangered by the employer’s cash flow demands. The products also provide a tax-deferred buildup of cash value and tax-free distribution of benefits.
Since the onset of the recession in late 2007, market-watchers say, the plans have become a harder sell, particularly to closely held small businesses. Advisors cite businesses’ increased financial difficulties and the uncertain economic outlook as key reasons for depressed sales. They additionally point to the increased cost of plan administration since the release of the 409A regulations, a section of the Internal Revenue Code governing deferred comp.
Also weighing on business owners and execs, observers suggest, is the prospect of congressional legislation that would make the plans financially unpalatable.
Says Joe Ouellette, CEO at San Diego, Calif.-based Excelsior Financial Network: “There may be less appetite for execs to defer income via deferral plans because of the tax situation and the likelihood that execs will be dealing with much higher marginal rates when they retire. I don’t think this country can go forward with current tax rates given all the money we’re printing.”
Michael Sego a principal of the O.N. Equity Sales Co. (ONESCO), Cincinnati, Ohio, says he’s as much concerned about congressional legislation that would disallow interest deductions for certain businesses. For those companies that depend on such deductions to help fund executive comp arrangements, the legislation would thus be a disincentive to doing so.
Albert “Budd” Schiff, CEO of NYLEX Benefits, a Stamford, Conn.-based arm of New York Life, sees a more nuanced picture. Deferred comp plans, he says, remain in demand among the businesses NYLEX services, including major and mid-size U.S. corporations, professional firms, banks and hospitals. But he notes also that businesses are lending a more conservative tilt to the investment allocations of the funding vehicles. Chief reason: The big hit taken by plan portfolios, many of which are down 40% or more in value since the onset of the downturn.
“Three years ago, when we looked at how people were allocating their accounts, the primary focus was on investment amount, whereas today the main focus is on how I protect my principal,” says Schiff. “So there is a big shift towards conservative investing, more protection and more guarantees on the downside. And given businesses’ greater cash flow challenges, execs are more concerned about securing non-qualified plans from the general creditors of their companies.”
The more conservative orientation, adds Schiff, is reflected in increased demand for fixed-indexed-based life insurance policies to informally fund non-qualified plans. Like their annuity counterparts, the policies are tied to an index, such as the S&P 500, enabling the contracts’ cash value to rise in tandem with the index up to a stipulated market cap. So, for example, if the S&P rises by 20%, the contract value may increase to a 12% cap. But if the market dips by 10%, there’s no loss in the policy’s value.
Businesses are also buying universal life or whole life policies. Many firms that can afford to, says Sego, are also funding the contracts aggressively. The benefit: In the event the business suffers a cash shortfall, it can draw on the cash-rich policies to pay premiums during months in which it needs to skip payments.
One product that has suffered a big dip in sales since the downturn is variable life. “A number of my competitors that market these products for deferred comp plans are feeling sorry they did so because of steep market losses,” says Daniel Balogh, a chartered life underwriter and a principal of the Executive Benefits Group at SWBC Investment Services, San Antonio, Tex. “I’m running into them left and right. The policies are underwater.”
Many execs, says Schiff, also are questioning whether they can expect long-term careers at their firms. As a result, short-term deferred comp arrangements lasting from 5 to 7 years are increasingly the plan of choice among younger execs. Under IRC Section 409A, which governs the plans, execs can elect to extend deferrals for another 5 years before the plans expire.
But sources note there is a downside to short-term plans. For they run counter to a key objective of many businesses: rewarding execs for long-term loyalty to the firm and thinking long-term when undertaking strategic planning.
The economics of the current times, adds Balogh, have also prompted boards of directors to be more active than in past years in determining who among their firms’ managers merit an executive comp plan. This heightened due diligence has lengthened the period of time–typically 18 months to two years–that it takes to develop and implement a plan.
“Company boards in prior years took a more passive role in overseeing executives,” says Balogh. “Now that they’re becoming more involved in the business, I have to engage them more. And this can draw out the process.”
As to tax concerns, Schiff agrees with Ouellette that marginal rates are likely to rise. But, pointing to actuarial studies conducted by NYLEX, he believes the impact on the deferred comp market will be small to negligible. Unless income tax brackets rise to unusually high levels, deferring compensation will be continue to be advantageous.
To be sure, corporate CFOs aren’t just weighing tax rates when deciding on the merits of a life insurance-funded deferred company plan. Also to be considered, says Balogh, is the impact of the funding vehicle on the income statement and balance sheet. The method of accounting for a life policy (as opposed to, say, a mutual fund) may not favor using the policy to fund the plan.
Amid the continuing economic blues, observers see bright spots in the executive comp and planning arenas, if not for deferral arrangements specifically.
Schiff notes that NYLEX has had notable success marketing Roth IRA-like Section 162 executive bonus plans. Under these arrangements, the business funds (post-tax) institutionally priced variable life policies owned by the executives that grow tax-deferred. The participants can then access cash tax-free (up to basis) from the policy through loans or withdrawals; and, upon their death, the contracts distribute proceeds income tax-free.
“So you wind up with the same tax treatment you’d have if you owned a Roth IRA,” says Schiff. “If the company sponsors this plan and qualifies for a COLI-type contract that insures multiple lives and is institutionally priced, then the premium payments will be very low. You can’t do this with an ordinary life policy.”
Among the most senior execs, he adds, defined benefit-like supplemental executive retirement plans are also enjoying an upswing, particularly arrangements that tie compensation to tenure. So, for example, the executive may receive a 2% credit for each additional year of service. Assuming the executive serves for 20 years, the additional retirement benefit would be 40% times the final average salary.
Levitz, for his part, is enjoying heightened interest in key person life insurance. The policies, purchased by businesses owners to help ensure the continuity of their firms in the event of the untimely death of a key employee, are not as expensive as deferred comp plans to fund.
“I’m seeing a lot of key person life sales,” says Levitz. “The products are not so burdensome from a cash flow perspective. And companies recognize they need these policies to deal with some unpleasant contingencies, particularly in the current environment. It’s a hot product now.”