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Deferred Compensation for Directors
“That’s your final offer?”
Baseline Corp.’s head of the nominating committee shifted again in his chair. “That’s what the company has paid its directors for the last five years. Some complain a little. No one ever does anything about it. Director comp is publicly disclosed.”
The board candidate leaned forward, disregarding the nominating committee chair’s personal space. “I serve on two other public boards. Both have compensation packages 20 percent higher than Baseline. That’s combat pay for the added workload not to mention the risk I’m undertaking as your director.”
A light went on inside the nominating chair’s head. He too leaned forward. With noses just a foot apart he said, “What would you say if I told you I can increase the amount you net from the cash component by at least 40 percent without raising Baseline’s out of pocket cost? At the same time, I can make you better off than if we just threw some more cash at you right now. What would you say?”
* * * *
Director compensation
To be sure, directors don’t serve just for the money. They site intrinsic satisfiers such as prestige, interesting work, business contacts and keeping one’s hand in the game as reasons for serving on boards. Still, money is the most quantitative measurement of how a company values its directors’ contribution. With proxy advisory firm, Institutional Investor Services (IIS), recommending withholding votes for directors serving on more than six public company boards, competition for qualified directors is rising. Money is one of the factors that sets the bar for companies competing for qualified directors.
The cash component of director compensation comes in six parts:
Cash Component
US public company annual median
Annual retainers*
$50,000
Board meeting fees
$1,500
Committee meeting fees
Retainer for audit committee chair
$12,000
Retainer for compensation committee chair
$10,000
Retainer for other committee chairs
$6,000
Source: Mercer Human Resources Consulting Survey, Director Compensation Trends, 2005.
*Annual retainers are for on-going general oversight by directors.
The Mercer survey cited above pegs overall annual median director compensation at $155,000. Stripping out equity grants still leaves a relatively significant cash component with which the compensation committee can work to benefit both parties concerned (the company and the director).
Mechanics of deferred director compensation
The objective is to increase the director’s overall compensation without increasing the total cost to the company. When undertaking a deferred compensation program at a public company, we want it to be transparent and understandable to all reading the public documents in which it is filed. We also want the associated expenses to be comparable to any other director compensation program. Additionally, we want it to give the company the most bang for its director compensation dollar.
The mechanics are simple: A dollar received today is not worth nearly as much as the same dollar invested in a tax-deferred instrument redeemed at a future date. Things we want to consider include:
Cash flow timing
The company does not have to pay out the director’s cash component as it is earned. This deferral increases the company’s disposable cash. However, neither can it recognize the amount deferred as compensation expense. This drives up taxable income today, driving down disposable cash by the foregone tax deduction. The net of tax effect is still an overall increase in disposable cash.
Some plans net from the director’s deferred income the lost earnings on the foregone business expense deduction. This makes the company whole on the opportunity cost of not being able to deduct the director’s compensation in the year it was earned. Of course, this comes back to the company when they pay out the deferral account.
Affect on total compensation
What if the director leaves?
Most plans provide for this event in their documentation. Avon Products, Inc. allows their directors to elect a lump sum payment on January 15th of the year following their termination as a director. Alternatively, Avon directors may elect any number of consecutive annual installments up to fifteen. This allows the remaining account balance to continue its tax deferred compounding.
Coca-Cola Enterprises Inc. also allows a lump sum payment of either annual or monthly payments of the director’s deferred compensation account balance up to just five years—the minimum period allowed under Internal Revenue Code section 409.
What if the company goes under?
Since this plan is a non-qualified plan [unlike a 401(k) plan and other retirement plans which are qualified], the participant directors become unsecured general creditors of the company in the event of insolvency. Taking the money in a single lump sum reduces the risk of time after the director leaves service but not during the time he’s a director. Alternatively, a particularly wary director could purchase a surety bond that guarantees payment. However, these are rare and expensive.
Most plans where financial stability is an issue install triggers that require the company to achieve pre-defined financial benchmarks. For example, if the company incurs three consecutive quarterly losses, the director has the right to accelerate payment and take the money owed him.
Another protection mechanism is a Rabbi trust. Though not a protection against creditor loss, such trusts do provide protection against the company changing the deal. They allow the director to place a third party (the trustee) between himself and the company. The trustee has a fiduciary duty to the director (who is the trust’s beneficiary) rather than to the company.
Most companies make management of director’s deferred accounts very simple. The investment instruments they use must fulfill every treasurer’s standards of safety first, then liquidity and finally yield. Some cash-rich companies don’t create a fund at all. They simply track the agreed-on account appreciation for each director and pay the proceeds out of corporate cash flow when the time comes. Others create a sinking fund, managed by the treasurer as just another part of corporate cash. The company draws on the sinking fund when the time comes to pay the amounts previously deferred.
Both vehicles allow the directors to compound the value of their deferred compensation accounts on a tax-deferred basis. However, the company still does not benefit from the as yet unpaid compensation expense, creating a mismatch of income and expenses.
A better alternative
Many leading edge companies (both public and private) purchase life insurance policies on their directors as the funding engine for their non-qualified deferred compensation program. The company purchases a life insurance policy on the director with the deferred fees it would have otherwise paid the director. The policy owner and beneficiary is the company. The life insurance cash value compounds on a tax deferred basis during the deferral period.
The premium payments are not tax deductible as a business expense, but the investment income isn’t taxable either. The cash value continues appreciating over the life of the deferred compensation program. At some point in time, the accrued liability the company incurs for the monies it owes its director becomes less than the cash value of the policy. As time goes on this favorable gap continues to increase in the company’s favor—the deferred compensation liability falls while the cash value of the policy rises.
How is the insurance policy liquefied?
A number of options exist depending on payment options the director wants. If a lump sum payment is needed, the company can surrender just a part of the policy equal to the principal and interest owed the director and keep the remainder of the policy in force. Once the director passes, the company receives the death benefits as policy owner and beneficiary. Alternatively, the company can surrender the policy in full and pay the director in full. If the arrangement was structured correctly, both sides come out whole.
What if the director passes prematurely?
Should the director not survive the total redemption time, then the company receives the policy death benefits. The company will likely pay the director’s heirs or estate a preset amount greater than his deferred income because the company has now made a profit from the death proceeds—something no one intended or wanted.
Working example
Let’s assume that the annual cash component of a director’s compensation is $60,000. Both the director and the company are in the 40 percent tax bracket. The company agrees with the director that his deferred account will gather interest at a rate equal to 200 basis points over the 11th District cost of funds. For this example, that computed rate is 6.3 percent. We’ll also assume that the cash value appreciation rate on the life insurance policy used to fund the deferred compensation program is 7.5 percent. In practice, the company need fund the policy at only 60 percent of the targeted payout because there are no taxes to account for.
The company keeps the face amount of the insurance policy as low as possible in order to drive up the cash value. Additionally, we want the policy to be construed as a regular insurance policy rather than a Modified Endowment Contract (MEC). As an insurance policy, the contract is taxed only when money is paid out in an aggregate amount exceeding the cost basis (premiums) paid in. Whereas, a MEC is taxed anytime cash is released.
If the company had no non-qualified deferred compensation program for its directors, the after tax income to the director would be $36,000 ($60,000 X (1-.40) = $36,000). The after tax cost to the company is the same $36,000.
However, the company chose to enhance the benefit of being a director by initiating a non-qualified deferred compensation program. Under this program, the director’s income today is zero. The annual premium cost to the company is $60,000 for the life insurance policy on the director. However, they must pay taxes equal to the expense deduction they would have received had they actually paid the director. Therefore, the actual cash outlay for the company today is $84,000 ($60,000 + [$60,000 X 40%] = $84,000).
If the director retires from the board after ten years the value of his deferred account is about $853,000. Let’s say he elects to take it all in a lump sum at the end of his 10th Net of tax that is about $512,000. Contrast this amount to what he would have received over ten years net of tax as regular cash payments—$360,000, assuming he spends it when received rather than invests it. The deferred plan pays the director about 42 percent more after tax.
The company comes out ahead too. They receive a tax deduction equal to 40 percent of the gross amount paid out during the year of disbursement. In this case, that’s $341,000. This is a greater amount than the $240,000 ($24,000 tax payment X 10 years = $240,000). But wait. There’s more. The company can either cash out and retain any investment profit before tax or it can surrender only the part of the policy required to fund its obligation and keep the rest as insurance on its [now] former director. Due to the tax-free nature of life insurance proceeds, on the director’s passing the company will be that much further ahead. It may well choose to share the proceeds with the director’s estate.
Summary Comparison of Immediate Cash Payment vs. Deferred Compensation Program
Immediate Cash
Dfr’d Comp Program
Annual cash outlay by the company
$36,000
$84,000
After tax annual income to the director
0
Total director income net of tax after 10 years
$360,000
$512,000
Amount set aside by company to fund liability net of tax
$547,000
The death benefit of the policy will enable the company to recover all its costs and to pay any contractual obligations to the director’s estate.
Future trends
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