In his article, “A New Look at Executive Retirement Plans,” Phil Currie of Fulcrum Partners explains why current downtrends may be compelling organizations and compensation committees to revisit a venerable standby in the benefit plan lineup: DC SERPs: the hardest-working component in a retirement plan line up.
For decades, corporations have been freezing qualified defined-benefit pension plans. The 401(k) defined-contribution plan is, and has been, center stage as corporate America continues to move away from an entitlement mentality by placing more retirement responsibility directly onto employees.
Once, an ability to “fog the mirror” was enough to ensure an adequate retirement income. No longer. The steady rise in benefit costs, proxy disclosures and prevalence of activist litigation underscores employer commitment to shift investment retirement and risk to plan participants.
Understandably, few defined-benefit supplemental executive retirement plans (SERPs) are being put into action today because as a category, defined-benefit plans have plummeted. In 1980, 60 percent of workers were covered by DB pension plans and just 17 percent relied on defined-contribution plans, such as 401(k)s, according to the Center for Retirement Research at Boston College.
Many employers are stretched to the limits with their employee benefits budget; they need to create initiatives to align shareholder, company and executive interests to increase returns of budgeted dollars. Defined-benefit SERP programs can be converted to defined contribution SERPs to create alignment.
In 2013, 30% of Fortune 100 companies offered a defined benefit plan to new salaried employees. That’s down from 32% at the end of 2012, 37% in 2010 and 43% in 2009, according to a Towers Watson & Co. survey.
The reality of this downtrend compels revisiting a venerable standby in the benefit plan lineup: DC SERPs. Nonqualified SERPs permit a firm to provide an additional retirement benefit to executives. Generally, it is a promise by the corporation to pay a future retirement benefit to an executive, separate from any qualified retirement plans that the company may sponsor.
A SERP is a nonqualified benefit plan that doesn’t defer an employee’s current salary and/or bonuses; its cost and funding is carried by the plan sponsor. Typically, SERP benefits are selectively granted to key executives for the purpose of recruitment, retention and reward. Among the principal reasons to establish a SERP include the plan’s ability to:
• Restore benefits lost by legislative or regulatory enactments;
• Provide a salary-continuation plan;
• Fulfill a particular income target at retirement; and/or
• Create an additional wealth-accumulation opportunity at retirement.
The differences between a DB SERP plan and a DC SERP plan are simple but far-reaching. The distribution amount is defined in a DB SERP; a contribution amount is defined in a DC SERP.
DB SERPs provide a fixed monthly income at retirement; DC SERPs provide a variable or fixed monthly retirement. Under a DB SERP, the annual accrual is based on a percentage of final cash compensation and years of services at the company. A DC SERP is participant-directed with choice and flexibility regarding the plan’s diversification.
Finally, there is no participant investment risk in a DB SERP, while there may be come risk in a DC plan.
Advantages and disadvantages can be found in both strategies. But the deciding factor may hinge on a company’s appetite for liberality or efficiency. There are logical and psychological reasons to offer an executive team a supplemental and competitive benefit package. There are also reasons of fiscal prudence and outright cost restrictions to withhold such benefits.But companies can serve two masters with a win-win alterative structure. Here’s how:
Case for Replacement
A DB SERP can be replaced with a DC plan with enhancement and no participant takeaways. Importantly, there is no additional cost for providing these enhancements.
The cost of a DB plan is a combination of service and interest cost. The sum of these two elements is referred to as the FAS 158 expense. The expense is calculated on an annual basis and is based on the benefit formula, participant details, mortality and discount rate assumptions.
The cost of a DC plan is a combination of the company’s contribution amount, plus the earnings on the account balance. A DC plan will achieve the same benefit payment and employer cost as a DB plan if the interest rate is the same in both and the service cost is equal to the company contribution amount.
When comparing costs between DB and DC plans, the benefit payment results will be identical if, for example, both plans achieve a 6 percent rate of return. In fact, a DC plan could pay out even more if, for example, the executive is able to direct his or her account balance into mutual funds that return 10 percent annual rate of return. In other words, the participant’s total retirement benefits can be significantly increased without the company having to increase its contribution to the plan.
In the above example (increasing the annual rate of return from 6 percent to 10 percent), a plan participant’s total retirement income payout over 15 years could increase by 51 percent. (Of course, lower returns would result in a lower benefit.)
DC SERPs can also provide a clearer participant understanding of the benefit amount delivered by the plan sponsor. Though it is difficult to determine the current value of a DB plan, the value of a DC SERP is straightforward, since DC SERPs have account balances that participants can usually view via online account management.
The next step is to eliminate the company expense associated with the earning on the account balance by funding the liability. With a funded plan, the interest income the funding generates offsets the interest expense. The plan sponsor purchases the same investment options offered to participants as a hedge.
If the company is a taxpayer, the investment options can be held inside of a corporate-owned life insurance program to achieve tax-deferred accumulation, which mirrors the tax treatment of the participant’s account balance.
Best of Both Worlds
Oftentimes, the participants prefer DC plans during the benefit-accumulation years but prefer a defined-benefit structure during their distribution years, which can offer the best of both worlds.
To offer both structures, the plan should adopt a hybrid design so that the account balance at retirement could be converted to an annuity. To comply with Section 409A of the Internal Revenue Code, a distribution election must be made in advance of the company-contribution service period and should not apply to prior balances.
By replacing a DB SERP with a variable-rate DC SERP, companies inject high octane into their benefit strategies. The DC plan gives participants an opportunity to earn more for retirement, albeit with more investment risk.
SERPs can take advantage of vesting schedules and performance-based elements. This kind of plan can be easily tied to a corporate performance whereas a DB SERP cannot. A DC plan can include performance targets similar to a typical long-term incentive plans.
For example, if an executive achieves 150 percent of the performance plan metrics, he or she may receive a discretionary DC SERP contribution of 150 percent of target. Better still, the vesting schedule can include a performance-based element. And, this arrangement can mirror the concepts used in performance-vested equity plans. Vesting may be accelerated for performance, unlike the DB SERP.
For public companies, DC SERPs offer more straightforward disclosure optics (under the 2006 U.S. Securities and Exchange Commission proxy rules) than DB plans. DB SERPs give only the appearance of entitlement and are disclosed in the Pension Benefits table, while a DC SERP is disclosed in the nonqualified deferred compensation table. If the defined-contribution SERP has performance elements, this is disclosed.
Arguably, the capability of DC plans to help companies tie benefit contributions to executive performance is by far the most persuasive feature of all.
Long-term incentives (LTI) form the basis of human-capital preservation and executive productivity. And, performance-based SERPs can add substance to the framework. Performance based SERPs extend the design of a traditional DC SERP. Almost all U.S. public companies report having a deferred compensation plan, according to The Newport Group’s 2011/2012 Edition of “Executive Benefits – A Survey of Current Trends”; however, a relatively small number of companies link long-term incentive plans and their performance measures to their traditional nonqualified deferred compensation plans. Obviously, this approach brings long-term impact on corporate performance compared to cash-based alternatives.
Defined-contribution SERPs offer participants distribution options unavailable in defined-benefit plans.
This flexibility brings freedom of choice to decide when and how much to withdraw based on the individual’s retirement objectives.
In the end, many participants want to manage their own accounts. Another advantage of the DC SERP is that it offers participants additional distribution options unavailable in DB plans. This welcomed flexibility brings freedom of choice to decide when and how much to withdraw based on individual objectives.
With a DC SERP, there is also the advantage of using a state-of-the-art administration system to give the executive complete Web-based access. Real-time access to actionable information in a technology friendly and secure environment eliminates the need for employees to walk down to the human resources office with questions.
As retirement planning trends toward greater individual responsibility, choice, control and convenience is paramount to both participants and plan sponsors.
By Phil Currie email@example.com
Securities offered through ValMark Securities, Inc. Member FINRA, SIPC, 130 Springside Drive, Suite 300, Akron, OH 44333-2431, Tel 1-800-765-5201 or NFP Advisor Services, LLC a Broker/Dealer, Member FINRA/SIPC and a Federally Registered Investment Advisor. ValMark Advisers, Inc. is an SEC Registered Investment Advisor. Fulcrum Partners LLC is a separate entity from ValMark Securities, Inc. and NFP Advisor Services, LLC.
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This article is based on “A New Look at Executive Retirement Plans,” by Phil Currie, originally published in the December 2008 issue of Financial Executive. This article was most recently published in the October issue of PSX: The Exchange for People Strategy.