Is ‘Leverage’ the new Paradigm for Achieving Competitive Executive Compensation Plan

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Bob Birdsell explains how by using a S&P 500 Indexed Universal Life Insurance Policy, a Third Party Bank Loan, and a modest Company Investment, an organization can provide a very attractive program available to their most senior executives without incurring a new expense.

00 birdsell marchLast month I discussed whether leverage was a concept that could be used to enhance retirement assets for executives who desire to increase their retirement income. This month’s article will outline a strategy to accomplish exactly that in a real life example of a public company. Then, in April, we will look at another example of how this solution is viable for a private company.

This scenario involves a large public company (let’s call it “Company Public”) with several hundred highly compensated executives. The company offered a non-qualified deferred compensation (NQDC) plan which was underutilized by the executives. The NQDC plan was informally funded with COLI (corporate owned life insurance); however, most of those insureds were either retired or had terminated. There was substantial cash value held in this COLI asset which the company was not properly utilizing. The company was concerned that its executives were unable to adequately save for their retirement since few were participating in the NQDC plan.

We were asked to explore options to remedy this dilemma.

The reasons for the executives’ failure to participate in the non-qualified plan varied, but the predominate themes voiced were: lack of security, inflexibility in the timing of deferrals, and distribution options that were too restrictive. These drawbacks resulted from the enactment of Section 409A. Also noted were concerns that the executives would face higher taxes when benefits were received and a lack of control over funds during the deferral period. Let’s look at how leverage can be used to “change” and improve the benefit of both the company and the executives.

As Winston Churchill stated, “to improve is to change… to be perfect is to change often.”

Over the years, Company Public had examined various methods to rectify the low participation in the existing deferred compensation plan but none were successful due to challenges arising from excessive financial and tax related risks. Now ,with our guidance, a reasonable and rational solution was identified. We call this new program The Gemini Plan.

Fundamentally, the structure of The Gemini Plan involves well accepted concepts and methodologies that have been used in business and individual financial planning circumstances for years. The only difference is that this arrangement involves combining these well-established concepts into a new and innovative structure never before considered. So what are these innovative yet well-established elements? They are:

• Institutionally priced Indexed Universal Life (IUL)
• Third Party Bank Loan Leverage
• Employer Investment in the Program which involved no new P&L expense.

Let’s first look at how this plan can enhance a participant’s portfolio of benefits, and then we will look at the unique advantages of the elements stated above and how, when combined, they can bridge gaps in a highly compensated employee’s benefit programs.

For example: a 41 year-old, highly compensated employee (HCE) earns $500,000 annually plus an annual incentive award. Let’s look at how the traditional deferred compensation plan can be replaced with The Gemini Plan.

The Gemini Plan will be funded in an institutionally priced Indexed Universal Life (IUL) requiring an annual premium of $100,000 for 10 years. In each of the first 5 years, the participant pays half of the premium ($50,000) and the other half is funded through third party bank loan leverage. With our assistance, the company arranged the bank loans. In the second 5 years of this 10 year period, the plan is funded entirely with bank loans. Over the course of 10 years, $1 million is contributed to the plan and earnings have accrued on the entire amount. No further contributions are required and the loan (with interest) will be paid back from the cash value account in the 15th year.

The participant will derive the following benefits from The Gemini Plan:

• At retirement, the additional income from The Gemini Plan account is projected to be $150,000 annually for 20 years.
• A $2,500,000 death benefit shared by the executive’s beneficiary, the company and the funding source.
• Hedging of the investment in the S&P Index Fund is utilized so that the account will likely never lose money.
• Bank loan leverage of 75% of principal accrues earning in excess of the loan interest rate.
• Loans do not require additional security beyond the principal in the account.
• The investment is in a tax advantaged vehicle (the IUL) which at the end of 15 years is fully owned by the participant when all loans and interest have been paid off.

Why use life insurance?

The type of life insurance contract necessary to accomplish the objectives is an institutionally priced Indexed Universal Life (IUL) contract that is indexed to the S&P 500. One of the unique features of an indexed IUL includes a provision that the contract will likely not lose value. Downside protection is accomplished by purchasing an option on the S&P 500.

The insurance company supporting the contract covers the cost of the option and, in exchange, establishes a maximum and minimum yield on the contract which is typically 13% on the up side and 0% on the down side. This structure allows the owner of the contract (in this case the executive) the opportunity to create leverage.  And keep in mind the following statement from Albert Einstein: “The measure of intelligence is the ability to change.”

Life insurance contains some of the most attractive and well established contractual provisions available to the general public. These contractual provisions have not been marginalized or degraded by laws and regulations affecting many formerly attractive benefit plans.

What is the “optimal amount” of leverage?

The optimal amount of leverage is the maximum amount that can be secured without exposing either assets or income to risk. (Most prudent individuals are not inclined to exchange or expose either their income or assets to excessive risk regardless of the possible benefits.) The Gemini Plan allows the participant to accomplish two important goals: asset protection and income accumulation without personal financial exposure. In fact, the leveraged approach we suggest does not even require a signed loan document or pledging other assets as security for the loan.

As presented previously, the total ratio of investment to loan is 25% out of pocket and 75% borrowed. For the first 5 years, if the total annual premium is $100,000, $50,000 would be paid by the participant and $50,000 would be paid from bank loan proceeds. Then, during the second 5 year period, $100,000 annually is funded through bank financing for a total premium over 10 years of $1,000,000. Of this, $250,000 is paid by the employee and $750,000 is paid from borrowed funds from the bank. The plan is designed to pay premiums for a total of ten years because that is the optimal period to fund the policy. The loan, plus the accumulated interest, will be paid off in the 15th year by a withdrawal from the policy’s cash values.

The cost of the interest on the loan is equal to LIBOR plus 1.75%. Today the interest rate charged would be about 2.31%. The interest expense accrues and will be paid-off at the end of 15 years at the same time the premium loan is satisfied through a surrender of cash value from the policy. This approach is made possible because a consortium of banks has agreed to lend money to the participants of this program without the need for loan documents or any other collateral besides an assignment of the cash value in the policy. And so, the cash value in the policy will be used to secure the loan until it is paid-off by surrendering cash value in the policy to cover the loan in the 15th year.

What benefits will be derived?

Benefits provided to executives include a substantial life insurance benefit and cash for other life events including long term care needs. Perhaps the most desirable benefit will be the increased retirement income. After the bank is paid-off in the 15th year, the participant will have access to the funds that have accumulated in the policy. These funds will be available on a tax-advantaged basis because the plan is supported by a life insurance product that continues to retain attractive tax advantages.

If the losses in the S&P 500 over the last 25 years could be removed (there were 5 years in which there were losses), the average gain over that period of time would be approximately 14%. Even after the cost of acquiring the life insurance policy is taken into consideration, the net return, based on the 25-year look-back, would still yield approximately 11%.

The chart below demonstrates the yield on the S&P when there are both maximum and minimum yields established. It compares these returns to what would have been achieved without the guarantees.

00 birdsell march graph
At this point we have established that:

• A consortium of banks is willing to provide financing to secure an indexed insurance policy that is invested in an index of the S&P 500.
• These banks will provide 75% of the funds necessary to fund the plan for ten years.
• 25% of the funding will be the responsibility of the employee.

What if the Executive can’t afford his portion of the premium?

There remains one consideration that may cause this remarkable program to fail: the highly compensated employee for whom the plan is designed is unable to fund his portion of the premium. Regardless of how attractive the program may be, if this premium is out of reach for eligible participants, the program will fail unless the company funds the premium for all or part of the participants’ share during the first five years.

The challenge is that most large companies are unwilling or unable to support a new executive benefit program because of cost constraints and/or concerns about undesirable P&L costs. Or they may be simply concerned by adverse publicity and proxy issues. However, if the amount paid by the company can be booked as an asset and recovered in the future, no P&L liability would be incurred and the challenges noted above would be eliminated. Also if the company is willing to cover all or part of the premium necessary to fund the plan in the first five years, then all eligible participants will likely participate.

You will recall that Company Public currently owns an asset in the form of COLI that is underutilized. We suggest that this asset be made available to offset the premiums that are the responsibility of the executive. Company Public chose to simply exchange one asset for another: the cash value in the COLI- which is an asset in the form of cash value life insurance- for a like asset: the cash value in the new policies secured to deliver the benefits of The Gemini Plan. The existing COLI would not be surrendered or replaced but simply used as a funding source by systemically borrowing on the cash value which was essentially a dormant asset due to the low level of participation in the existing deferred compensation plan. There would be little or no cost to Company Public because the participants would be charged interest on the monies advanced. The interest charged will be the long term AFR which currently is approximately 2%.

In effect, Company Public would be making use of an inactive and underutilized asset while positioning itself to make a very attractive program available to their most senior executives. The best part though is that this new program can be established without incurring a new expense.

Upon the executive’s retirement, Company Public would be reimbursed from the cash flow received by the participant. The projected retirement cash flow is $150,000 for 20 years and the total advanced by the company during the first five years is $250,000, therefore, $25,000 could be deducted from the cash received by the executive and paid to the company for each of the first 10 years. The executive would receive $125,000 for the first 10 years and $150,000 for the following 10 years. The executive’s only cost to participate is the interest the company charges on the advanced premium.

In summary, there are three components involved in The Gemini Plan:

1. S&P 500 Indexed Universal Life Insurance Policy: containing useful, valuable and well established contractual provisions that have not been marginalized by laws and regulations. Using an institutionally priced IUL contract that is indexed to the S&P 500 and hedged against downside risk provides a guarantee that the contract will not lose value.
2. Third Party Bank Loan Leverage: providing asset protection and income accumulation that can improve the overall yield on the employee’s account by approximately 30% to 40% without personal financial exposure.
3. Company Investment in the Program: booking the company’s contribution as an asset that will be recovered in the future can provide an opportunity for all eligible employees to participate even if premium levels are “out of reach.”
When combined into one program, these components create interesting and attractive benefits.

I fully appreciate that this program is complex but then so was every other new program introduced for the first time, including the 401K Plan, Non-Qualified Deferred Compensation and just about every Stock based compensation plan. Leverage offers the solution for both the Company and its executives.

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