Executive Deferred Compensation Plans Current Issues in Plan Design, Funding and Administration January 2004 Presented by: William L. MacDonald Chairman, President & CEO About This Report This report contains proprietary and confidential information of RCG. By accepting this report, we ask that you respect our interests and maintain its confidentiality. RCG does not provide legal or tax advice and recommendations should be reviewed by appropriate counsel. D&A/Executive Deferred Comp Plans 01.12.04 i Table of Contents I. The Need for Additional Deferral Opportunities II. Design Alternatives III. Additional Design Features IV. Benefit Security Issue V. The Funding Decision VI. Plan Administration Section I. The Need for Additional Deferral Opportunities The Need for Additional Deferral Opportunities Why Executives need supplemental savings: ¾ 401(k) contributions limited to $13,000. ¾ Income eligible for qualified plans limited to $205,000. ¾ Reduction of Net income available for investment due to taxes (federal and state income tax, social security, property etc.). ¾ Procrastination created by lack of income tax shelters available for personal investment. 1 The Need for Additional Deferral Opportunities Why Employers offer deferral plans: ¾ Provide retirement savings opportunities above qualified plan limits for highly- compensated employees. ¾ Provide parity between highly paid and other employees. ¾ Enhance ability to attract, retain, and reward top management talent. ¾ Reduce pressure on existing qualified plan vehicles. ¾ Encourage and reward long-term employment. 2 Retirement Income – How much is sufficient? A 2002 Georgia State University study found that expenditures do not decrease significantly after retirement, and suggests the following replacement ratios: If a replacement ratio is to be met, one’s typical sources of retirement income other than social security are personal savings and private plans, primarily employer pension plans (qualified and nonqualified). The Need for Additional Deferral Opportunities 76% 48% 28% $90,000 75% 40% 35% $70,000 85% 68% 17% $150,000 74% 30% 44% $50,000 87% 77% 10% $250,000 86% 73% 13% $200,000 78% 25% 53% $30,000 Replacement Ratio Other Sources Social Security Income Level 3 The Need for Additional Deferral Opportunities Participant Deferred Compensation Retirement Benefit Deferred Compensation Agreement Corporation Deferred Compensation Book Account Deferred Compensation Book Account Participant’s Deferred Compensation Investment Allocation Compensation Received Compensation Earned Pre-tax Compensation Deferral (not limited by 401(k) contribution limits) Ma tch ing C on trib uti on (o pti on al) Investment “A” Investment “B” Investment “C” Investment “D” 4 Section II. Design Alternatives Design Alternatives Crediting Rate The single most important design decision of a deferred compensation plan is the crediting/investment rate feature. This feature dictates the volatility and level of return to the participant, balanced with the objectives of the corporation. Able to modify behavior of executives (retention or performance goals). Higher crediting rate can be triggered by individual, team or company performance. Easy to communicate, due to 401(k) plan prevalence. The trend for new or revised plans is toward the mirror plan concept. Not worth implementing. General Comments Taxes on funds or loads on COLI, offset by difference between rate earned and rate credited. Taxes on fund or loads on Corporate Owned Life Insurance (COLI). None. Cost 70% - 80%. 70% - 80%. Less than 10%. Typical Participation Fixed rate (e.g., Moody’s seasoned bond rate) or stated rate plus 2%. Mirror rate – i.e., credit the gross rate of the investment selected by each executive, less asset management fees. Company’s after-tax cost of money. Crediting Rate Fixed Rate Mirror Rate Corporate Cost of Money 3 2 1 The table at right provides an overview of three basic categories of deferral plan crediting rate structures. The remainder of this report focuses on Columns 2. Mirror Rate and 3. Fixed Rate. 5 Design Alternatives Crediting Rate continued The rate at which interest is credited to the accounts of DCP participants widely varies. 6 60% Stock/ Stock Index 35% Fixed 37% 23% 5% 7% 7% 9% 12% Moody's/Corporate Bond Index Prime Rate Fixed Rate Treasury Note/T-Bill Company Borrowing Rate Other Company Stock 401(k) Stock Interest Design Alternatives Crediting Rate continued Although the plan is linked to an underlying index (mutual fund, Moody’s, etc.) the actual crediting rate can be greater than the index; e.g.: 1) fixed rate plus a spread of one to three percentage points, or 2) gross investment rate before asset management fees. Either of these above-market rates can be structured in a variety of ways. ¾ Retirement/Termination Rates: Š Defined “above-market” rate credited if the participant retires or completes a certain amount of service (i.e. 10-year Treasury plus 3%) Š Market rate credited if the participant leaves without meeting given criteria (10- year Treasury) ¾ With performance: Š Above market rate based on company performance. 7 Design Alternatives Crediting Rate continued Examples of Crediting rates – Non-Equity ¾ Enhanced Index Approach: Š 130% of Moody’s. Š Moody’s + 3%. ¾ Enhanced Rate plus Retirement/Termination Rate: Š 130% of Moody’s for retirement (age 55 with 10 years of service). Š 100% of Moody’s for termination. 8 Design Alternatives Crediting Rate continued ¾ 401(k) Mirror Option: Š Participant given range of investment options. Š Allocates deferrals among various funds. Š Company stock often included as investment choice. ¾ Performance-Linked Rates: Š Participant is always credited with a floor-market rate. Š If certain performance goals are met, participant is credited with an above-market rate. Š Performance (which can be determined annually by management), can be linked to short-term goals, long-term goals, team goals, company goals, individual goals, or any combination thereof. 9 Design Alternatives Comparative Investment Returns +/- 5.21% +/- 12.25% +/- 20.75% Risk (Standard Deviation) 9.86% 14.43% 9.32% Average Compounded Return 9.84% 15.02% 11.17% Average Annual Return 130% of Moody’s 90% of S&P w/3% Floor S&P 500 10 Year Investment Results* +/- 2.47% +/- 11.03% +/- 16.92% Risk (Standard Deviation) 11.68% 14.86% 12.68% Average Compounded Return 11.71% 15.36% 13.98% Average Annual Return 130% of Moody’s 90% of S&P w/3% Floor S&P 500 20 Year Investment Results** * 1993 – 2003 ** 1983 - 2003 10 Design Alternatives Crediting Rate continued Examples of Crediting Rates – Equity ¾ 401(k) Mirror Option: Š Returns equal underlying fund returns. Š Returns equal underlying fund returns, less administrative charge. ¾ Performance Rate: Š Return credited with rate based on Company’s performance. Š Floor guarantee may be incorporated to limit downside risk. ¾ Enhance Index: Š 90% of S&P 500 Index, with floor of 3%. Š Stable value. 11 Design Alternatives Crediting Rate continued The SV (Stable Value) feature removes account balance and accounting volatility of an actively managed separate account investment division. Illustration of stable value portfolio: ¾ This feature can be added to those using COLI1 as funding vehicle. ¾ Policy’s cash value investment is accounted for at cash surrender value. ¾ Income will accrue steadily and is guaranteed not to be negative, absent default of securities. ¾ Upon a surrender election, the company will receive the stabilized portfolio value, regardless of market conditions. 0 0.5 1 1.5 2 2.5 Series1 Series2 tabalized separate account value Stabilized Investment Value Unstabalized account TIME 12 *COLI – Corporate Owned Life Insurance 7% 1% 21% 31% 15% 8% 8% 9% 2% 20% 37% 14% 13% 4% 10% 2% 2% 15% 34% 27% 10% 10% 1% 20% 33% 17% 8% 11% 10% 2% 16% 29% 15% 9% 14% 15% 8% 9% 27% 14% 11% 16% 15% 2002 2001 2000 1999 1998/1997 1997/1996 Interest Crediting Rates Other Corporate Borrowing Company Stock 401(k)/Stock Index Moody's Corporate Bond Index Rate Fixed Rate Prime Rate Treasury Note/T-Bill Design Alternatives Crediting Rate continued Investment Diversity with Unlimited Ability to Reallocate The rate at which interest is credited to the accounts of DCP participants varies widely. Thirty-one percent (31%) mirror the returns of a particular stock index or the investment options in the 401(k)/savings plan, down from 37% in 2001. Of respondents using 401(k)/stock index crediting rates, 62% allow plan participants to change their investment alternative elections on a daily basis. 13 Section III. Additional Design Features Additional Design Features Eligibility: ¾ Limited to select group of management or highly compensated employees. Š Typical earnings over $100,000 per year total compensation. Š Eligible group not greater than 5% of employee population. Š Can customize participation by criteria including job position and pay. Deferral Limits: ¾ Base pay: Š Most common is 50% limit. ¾ Bonus and LTIP: Š Commonly no limit. ¾ Ability to defer stock option gains. 14 Additional Design Features Events Triggering Payout: ¾ Death. ¾ Disability. Š Some plans give executive a choice of postponing until retirement. ¾ Termination. Š Commonly immediate lump sum payout. Š Most employers do not want to subsidize or administer plan for terminated executives. ¾ Retirement. ¾ Hardship. 15 Additional Design Features Form of Payment: ¾ More plans include flexible distribution options. Š Lump sum. Š Installment payments. Š Source tax protection. ¾ In-Service Distribution. Š Elected at time of deferral. Š Created a “lifestyle” deferral plan. Š Useful for creating liquidity pool for exercising stock options, funding college education, etc. 16 Additional Design Features Source Tax: One of the most overlooked benefits in deferred compensation is the Source Tax benefit. ¾ Source Tax law prohibits states from imposing income tax on the retirement income of nonresidents, regardless of when the retirement income was earned, as long as it is paid after termination of employment and for at least 10 years. Example: 0%* N/A Retirement in Florida N/A 0% Deferral of income in California Tax at retirement Tax at time of deferral 17 *Savings of 9.8% California Tax Additional Design Features Call Provision1: ¾ Allows participant to “demand” payment of vested account balance. ¾ Taxable upon receipt. ¾ Subject to “haircut” to avoid constructive receipt issue. Š 10% for actives is common. Š 5% for non-actives sometimes incorporated. Š Plan participation suspended for period of time after exercising call (i.e. next calendar year). ¾ Payout subject to recall by bankruptcy court in the event of a subsequent bankruptcy. Š One year for insiders. Š 90 days for non-insiders. 1. If the Thomas Bill passes, this provision will not be allowed. 18 Section IV. Benefit Security Issue Benefit Security Issue Why Secure Nonqualified Benefits? ¾ Unlike qualified plans, nonqualified benefits are subject to additional risk: Š Change of Heart. Š Change in Control. Š Change in Financial Condition. Š Insolvency/Bankruptcy. ¾ Nonqualified deferred compensation plans can be a significant investment of the participant’s own retirement resources. ¾ Most employers wish to provide benefit promises, qualified or nonqualified, of the highest possible quality. ¾ The primary purpose of nonqualified benefit plans is to attract, retain, and motivate key executives. Secure benefits will be more effective in accomplishing this purpose. 19 Benefit Security Issue Ideal Solution Change in Control Change in Heart Favorable Proxy Disclosure Bankruptcy Protection Economic Cost Plan Design Flexibility Certain of Tax Issues Ease of Administration Retention & Attraction Springing Rabbi Trust Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Insured Security Option Plan Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Secular Annuity Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Secular COLI Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Secular Trust Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Mutual Fund Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Funded Rabbi Trust Control Heart Bankruptcy Proxy Cost Design Tax Administration Retain Comparison of Security Alternatives No ideal benefit security vehicle exists. Each alternative involves trade-offs between risk, tax, and financial issues that must be weighed. Effective Partially Effective Ineffective Factors have been equally weighed. 20 Benefit Security Issue Criteria for Selecting a Security Device ¾ As illustrated by the graph on the previous page, there is currently no one security vehicle that meets the ideal criteria, although each device is effective to various degrees. ¾ Described below are the characteristics desired and their effectiveness in an unfunded, unsecured environment where participants are general, unsecured creditors of their employer regarding their non-qualified benefits. Ideally, the security device should not alter the underlying benefit plan and should be clear to avoid surprise adverse consequences. Maximum plan design flexibility: The cost of the benefits and security device should not be a burden to shareholders. Minimum economic cost: Unfunded benefits may require little to no disclosure. Ideally, the security device should not change current requirements. Minimum proxy disclosure: Management can refuse to pay promised benefits. The security device should prevent against this risk. Protection against Change of Heart: 21 Benefit Security Issue Criteria for Selecting a Security Device continued Administrative time and company costs are expended in providing benefit programs to employees. Nonqualified programs should benefit the company by providing a tool to attract and retain quality executives. If benefits under these programs appear to be at risk, this effectiveness may be lost. Attraction/Retention of Key Executives: In the event of a Change in Control, new management could refuse to pay promised benefits. The security device should protect against lost benefits due to this risk. Protection against Change in Control: A security device that requires a great deal of administrative time and cost is undesirable. Minimum administrative effort and cost: Participants are unsecured, general creditors of the employer. Ideally, the security should protect against lost benefit payments due to bankruptcy or insolvency. Protection against bankruptcy: 22 Section V. The Funding Decision The Funding Decision Unfunded Plan Issues: ¾ Emerging liabilities created. ¾ Obligation of funding benefits falls on future management – Social Security Syndrome. ¾ Unfunded obligation with no offsetting assets can cause concern for shareholders. ¾ Benefit funding requirements are not the same for nonqualified benefits as for qualified benefits, causing concern for participants. 23 Why fund Executive Benefits? ¾ To create an asset to offset emerging liabilities. ¾ To shift burden of funding to current management. ¾ To neutralize shareholders to the financial impact of emerging liabilities. Š Matching assets and liabilities will minimize P&L impact. ¾ To provide a level of securitization to participants that is as close as possible to the security level available to qualified plan participants. The Funding Decision 24 The Funding Decision Funding asset alternatives: ¾ Equity (“mirror”) plans: Š Mutual funds. Š Variable life insurance with multiple and stable value feature. ¾ Indexed rate plans: Š Tax-exempt securities. Š Portfolio life insurance. 25 The Funding Decision Asset selection: ¾ Taxpayers generally benefit from a tax-deferred investment strategy (i.e. life insurance or tax-exempt bonds). Š Policy loads are generally less than the impact of income taxes on taxable investments, resulting in a higher after-tax IRR. ¾ Non-taxpayers generally benefit from a taxable strategy (mutual funds, taxable bonds, etc.). Š Investment results are tax-free. 26 Section VI. Plan Administration Plan Administration When considering Plan Administration: ¾ Be aware and informed. ¾ Consider plan administration as you design the plan. ¾ “Unbundle” plan administration from design and funding. Š The new trend is to unbundle administration from funding and design. Š Many 401(k) providers offer single benefit statement for qualified and nonqualified. Š RCG’s “Best-of-Breed” evaluation process of TPA firms, services, etc. 27 Plan Administration & Monitoring Plan Design Plan Funding Plan Implementation & Communication Unbundled Elements of DCP By unbundling, a company could save 25% - 40% of plan cost and not be held hostage to bundled provider. Plan Administration 28 Plan Administration Summary ¾ Consider stable value protection or fixed rate of interest. ¾ Consider adding performance element to plan design. ¾ To save company money, unbundle funding and plan administration. 29 3636 Nobel Drive, Suite 250 San Diego, CA 92122 Toll Free: 866.RCG.4TRS (866.724.4877) Fax: 858.677.5915 Email: info@retirementcapital.com www.retirementcapital.com William L. MacDonald Chairman, President & CEO