THE SWAP OVERLAY STRATEGY: A Tax and Accounting Efficient Way to Fund Nonqualified Deferred Compensation Plan Liabilities

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1 THE SWAP OVERLAY STRATEGY: A Tax and Accounting Efficient Way to Fund Nonqualified Deferred Compensation Plan Liabilities PREPARED BY: JOHN E. COLEMAN CLIFFORD R. EISLER DAVID J. MARSHALL MATTHEW J. MARSHALL NOVEMBER 2013

2 DISCLAIMER This White Paper on The Swap Overlay Strategy: A Tax and Accounting Efficient Way to Fund Nonqualified Deferred Compensation Plan Liabilities (the White Paper ) has been prepared by Analect Benefit Finance LLC ( ABF ). This White Paper does not purport to be all-inclusive or to contain all the information that an interested party may desire in pursuing the business opportunities described herein. While the information herein is believed to be accurate, ABF makes no representations or warranties, expressed or implied, concerning this White Paper or any other written or oral communication transmitted or made available to any party. No part of this material may be i) copied, photocopied or duplicated in any form, by any means, or ii) redistributed without ABF s prior written consent. ABF does not provide accounting or tax advice to its clients. All prospects and clients are strongly urged to consult with their accounting or tax advisors regarding any potential investment. Any trademarks used herein are the sole property of their respective owners. ABF expressly disclaims any and all liability which may be based on such information, errors therein or omissions therefrom. Any recipient shall be entitled to rely solely on any such representations and warranties as may be made to it in any definitive agreement. Certain financial projections contained herein are based on ABF's estimates of future events. Although ABF believes such projections to be reasonable and realistic, all estimates, projections and other forward looking material involves significant elements of subjective judgment and analysis and ABF does not assume any responsibility for the validity, reasonableness, accuracy or completeness of such estimates. The recipient is encouraged to conduct its own independent analysis of any estimates or projections contained in this White Paper. All non-tax related information contained in this White Paper is to be kept strictly confidential and is proprietary to ABF. By receipt of this White Paper, the recipient agrees to preserve the confidentiality of the contents in this White Paper and not acknowledge or disclose to any third party confidential information concerning ABF including its business strategies and objectives. Upon receipt of notice from ABF, the recipient will promptly return all material received in connection with its review (including this White Paper) without retaining any copies or reproductions thereof. All inquiries or requests for additional information should be submitted or directed to ABF. In furnishing this White Paper, ABF undertakes no obligation to provide the recipient with access to any additional information. The methods and products disclosed in this White Paper are covered by one or more of the following: United States Patent No. 6,766,303 issued July 20, 2004, United States Patent No. 8,290,849, issued October 16, 2012, and/or pending U.S. patent applications.

3 TABLE OF CONTENTS I. THE PURPOSE OF THIS WHITE PAPER 4 II. WHY FUND NQDC PLANS? 4 III. FUNDED NQDC PLAN ADVANTAGES BENEFIT SECURITY 5 IV. FUNDED NQDC PLAN ADVANTAGES FUNDING & HEDGING 6 V. LIMITATIONS OF TRADITIONAL FUNDING & HEDGING METHODS 7 VI. OVERVIEW OF TOTAL RETURN SWAPS 9 VII. THE TRS OVERLAY STRATEGY 10 VIII. CONCLUSION 13 IX. APPENDIX A ADDITIONAL INFORMATION ON TOTAL RETURN SWAPS 14 X. APPENDIX B DEFINITIONS OF KEY TERMS 17 XI. APPENDIX C ACKNOWLEDGEMENTS 19 3 P a g e

4 I. THE PURPOSE OF THIS WHITE PAPER This White Paper describes a method by which plan sponsors can use total return swaps to hedge their market-based nonqualified deferred compensation plans while setting aside assets to fund these obligations. Our conclusion is the combination of funding and the total return swap (TRS) strategy provides plan sponsors with improved accounting while sharply reducing costs relative to plans that use traditional funded strategies (i.e., corporate-owned life insurance, taxable investments, managed separate accounts, etc.). The strategy is simple to implement with minimal administrative burden. II. WHY FUND NQDC PLANS? TYPES OF NQDC PLANS UNFUNDED VS. FUNDED Nonqualified deferred compensation (NQDC) plans fall into two broad categories: unfunded and funded plans. For purposes of this white paper, we define an unfunded NQDC plan as one in which assets have not been set aside for plan participants (also called a "pay as you go" plan.) We define a funded NQDC plan as one in which assets have been set aside, since these assets remain subject to the claims of the plan sponsor s general creditors (this is sometimes referred to as an "informally funded" plan.) FIGURE 1: UNFUNDED VS. FUNDED MATRIX BENEFIT SECURITY FUNDING HEDGING Unfunded NQDC plan None (plan sponsor s unsecured promise to pay) None ( Pay as You Go ) TRS is a strategy for hedging plans that remain unfunded. Funded NQDC plan Implementing a funded Rabbi Trust can protect against a change of heart or change in control Funding also provides the security that the plan sponsor will have the assets available when benefits are due. Taxable investments, Corporate-Owned Life Insurance (COLI) or other corporate assets can be set aside to fund the benefit liability. Traditionally, investment strategies for funding match reference funds of plan liabilities. However, the TRS strategy can be combined with funding to provide improved results. 4 P a g e

5 In general, a plan sponsor has the ability to provide greater benefit security to plan participants, fund the plan sponsor s future benefit liabilities and hedge the market volatility of those liabilities by setting aside assets in a rabbi trust with investments matching the reference funds of the NQDC plan. III. FUNDED NQDC PLAN ADVANTAGES BENEFIT SECURITY For NQDC plans to provide the benefits of income tax deferral and avoid ERISA regulations, plan assets cannot be accessible and cannot provide any benefit to the plan participant at any time prior to distribution. If either occurs, the plan participant is considered to have constructive receipt of those assets and must pay income tax on those assets immediately. Therefore, assets in an NQDC plan must remain part of the general assets of the plan sponsor, limiting the plan participant s benefit security. The plan participant must remain unsecured creditors of the plan sponsor. Although the rules regarding NQDC plans prevent a plan participant from completely avoiding the risk of losing their deferrals, the risk of repudiation can be tempered through the use of Rabbi Trusts and through proper funding. RABBI TRUSTS A Rabbi Trust provides the maximum benefit security that the law permits for plan participants in NQDC plans. The Rabbi Trust protects assets in the plan from the plan sponsor s change of heart and/or change in control but does not protect the assets from creditors of the plan sponsor in the event of insolvency or bankruptcy. The name Rabbi Trust comes from a ruling by the Internal Revenue Service involving a rabbi whose congregation had made contributions to such a trust for his benefit. The synagogue asked the IRS to rule that the rabbi would not be taxed on an amount of money set aside in a grantor trust until the money was paid to the rabbi. To the extent the trust earned income that was taxable, the synagogue would pay taxes on the income and it would not be entitled to a deduction until the money was paid to the rabbi, at which point the rabbi would be subject to income taxes on the payment. The IRS s favorable stance on this rabbi trust led its use for holding assets of NQDC plans at taxable companies. Characteristics of Rabbi Trusts: Assets in the trust are typically irrevocably set aside to pay benefits to plan participants and their beneficiaries Assets are owned by (and income derived from such assets is taxed to) the plan sponsor Assets are subject to the claims of plan sponsor s creditors in the event of their insolvency or bankruptcy. This is generally the only time assets may be used for the plan sponsor s purpose other than paying benefits (trusts may, 5 P a g e

6 however, have a provision permitting reversion of excess assets to the employer when the trust is overfunded by a predetermined percentage) FUNDING A plan sponsor is not required to use a Rabbi Trust when funding its NQDC plan liabilities, nor is it required to fund the Rabbi Trust once it is established. Funding the NQDC liability using a Rabbi Trust or other instrument adds another layer of benefit security to the plan participant. Appropriate funding is evidence that the plan sponsor is setting funds aside to pay its liabilities when they come due. IV. FUNDED NQDC PLAN ADVANTAGES FUNDING & HEDGING Plan sponsors can choose either to leave their NQDC plan unfunded or to fund and hedge the plan. Funding and hedging the NQDC liability allows the plan sponsor to match plan assets with its future benefit liabilities and is traditionally accomplished by either investing in taxable investments (mutual funds, separate accounts, etc.) or corporate-owned life insurance (COLI). UNFUNDED ( PAY AS YOU GO ) Unfunded plans result in NQDC plan liabilities paid out of plan sponsor general assets or cash flow as plan participant distributions occur. Accounting Treatment: Since no funding/hedging is occurring, accounting treatment will be that of a NQDC plan. Liabilities are recorded by plan sponsors on a mark-to-market basis with expenses flowing through the income statement. NQDC plan accruals are offset by deferred tax assets to accrue for the tax deductions a plan sponsor receives when plan participants receive distributions. Tax Treatment: Since no funding/hedging is occurring, the tax treatment will be that of a NQDC plan. TAXABLE INVESTMENTS Funding and hedging the NQDC plan liability using taxable investments (mutual funds, separate accounts, etc.) funds the deferral distribution at the outset. The assets set aside are typically invested by the plan sponsor in the investment strategies offered to plan participants under the NQDC plan. Accounting Treatment: If taxable investments are used to fund the NQDC plan, the plan sponsor may elect SFAS 159 entitled The Fair Value Option for Financial Assets and Financial Liabilities to account for these assets. Under SFAS 159, all realized and unrealized earnings are recognized currently on the income statement. Alternatively, plan sponsors may adopt SFAS 115, Accounting for Certain Investments in Debts and Equity Securities, which may require that all unrealized gains (losses) be accounted for as comprehensive income (a separate component of the stockholders equity). 6 P a g e

7 Tax Treatment: When the plan sponsor buys taxable investments, any realized investment earnings are taxable to the plan sponsor. These taxable investments earn dividends and interest and the plan sponsor will be taxed on those amounts as they are received. Moreover, when the plan sponsor sells the taxable investments, whether to improve earnings or to pay benefits when an executive terminates employment (or is otherwise entitled to benefits under the NQDC plan), the sale can trigger capital gains tax. CORPORATE-OWNED LIFE INSURANCE (COLI) To avoid the tax costs incurred by taxable investments, many plan sponsors utilize COLI to fund and hedge NQDC plan liabilities. COLI is life insurance on employees' lives that is owned by the plan sponsor, with cash values and death benefits payable to the corporation. The earnings of the contracts are tax-free as long as the plan sponsor holds the contracts until the deaths of the insureds. Accounting Treatment: Earnings from COLI are reported on a plan sponsor's balance sheet under the "cash surrender value" method. FASB Technical Bulletin 85-4 states that "the amount that could be realized under the insurance contract as of the date of the statement of financial position should be reported as an asset." This "cash surrender value" method will allow the value of the life insurance policy to grow on the balance sheet of the plan sponsor. This is in contrast to most other assets which are recorded at historical cost on the balance sheet (until the funds are reinvested in a different asset which can then be recorded at its historical cost until it is eventually transferred). Once the cash surrender value of a life insurance policy exceeds the premiums paid by the plan sponsor, the company will be entitled to record the annual increase as a revenue item in Other Income on its income statement each year. No deferred tax liability for COLI earnings need be recorded as long as the plan sponsor expects to hold the contracts until the deaths of the insureds. Note: COLI therefore does not generate a deferred tax liability to offset the deferred tax assets of the NQDC plan (see above). Tax Treatment: The three major income tax advantages of COLI are the tax-free "inside build-up" in the cash surrender value of the policy, the ability to withdraw funds tax-free to the extent of the plan sponsor's basis in the policy (and the ability to make tax-free loans), and the tax-free receipt of the death benefit. V. LIMITATIONS OF TRADITIONAL FUNDING & HEDGING METHODS UNFUNDED ( PAY AS YOU GO ) Funding Impact: The NQDC liability will be unfunded and distributions will be paid out as they occur using the general assets or cash flow of the plan sponsor. The plan sponsor (and the plan participant), therefore, is relying on the assumption that there will be adequate funds available to the plan sponsor in the future to pay the benefit liabilities when they come due. 7 P a g e

8 P&L Impact: The plan sponsor s P&L will be exposed to the mark-to-market volatility of the unhedged NQDC liabilities with the earnings impact flowing directly through compensation expense in Selling, General and Administrative Expenses (SG&A). If the NQDC plan offers market-based investment options, this volatility will become increasingly significant as plan balances accumulate over time. Economic Impact: If long-term earnings on participant balances exceed a plan sponsor s weightedaverage cost of capital (WACC), there will be a negative net present value (NPV) for the plan. TAXABLE INVESTMENTS Funding Impact: Under this strategy, taxable investments are typically held in a rabbi trust to fund the NQDC plan liability. Plan sponsors most often invest the underlying assets in strategies that match or are highly correlated to the reference fund allocations elected by NQDC plan participants. Under the terms of a rabbi trust, the plan sponsor typically will from time to time true up any difference between the pre-tax NQDC plan liability and the underlying assets of the rabbi trust. P&L Impact: As long as the plan sponsor invests in strategies that match or are highly correlated to the reference funds elected by NQDC plan participants, the overall P&L impact of the plan should be limited. However, GAAP typically requires that the earnings for these assets flow through Other Comprehensive Income (OCI). This creates an accounting geography mismatch as expenses for the NQDC plan flow through SG&A (note above). Economic Impact: This funding and hedging approach can be expensive (negative NPV) if the after-tax earnings for the assets are (as is typically the case) less than a plan sponsor s WACC. CORPORATE-OWNED LIFE INSURANCE (COLI) Funding Impact: Under this strategy, COLI is typically held by a plan sponsor in a rabbi trust to fund the NQDC plan liability. If separate account variable COLI is used, underlying cash values are invested by plan sponsors in strategies that closely match the investment elections of NQDC plan participants. The inside buildup of the COLI generates tax free returns as long as the plan sponsor holds the contracts until the deaths of insured individuals. The COLI returns are reduced by any applicable insurance-related expenses. Similar to taxable investments, the plan sponsor will from time to time true up any difference between the pre-tax NQDC plan liability and the underlying assets. P&L Impact: As long as the COLI investments are in strategies that match or are highly-correlated to the reference funds elected by NQDC plan participants, the overall P&L impact of the plan should be limited. However, as is the case for taxable investments, GAAP typically requires that the earnings for COLI flow through OCI creating an accounting geography mismatch. COLI may "over-hedge" P&L volatility related to the NQDC plan because of the difference in the way deferred taxes are handled for COLI relative to deferred compensation liabilities. As noted above, owners of COLI need not establish a deferred tax liability for COLI investment earnings as 8 P a g e

9 long as the contracts are expected to be held until the deaths of insured. Deferred compensation liabilities are offset with a deferred tax asset - recognizing that the company will receive a tax deduction when benefits are paid to plan participants. Therefore, for example, if a plan sponsor is in a 40% tax bracket, a 10% return loss for the deferred compensation plan will cause a net 6% reduction in deferred compensation liabilities while attracting a full 10% (less applicable COLI expenses) loss for the COLI. Economic Impact: Like funding with taxable investment, COLI can be expensive (negative NPV) if related earnings are less than a plan sponsor s WACC. VI. OVERVIEW OF TOTAL RETURN SWAPS A Total Return Swap (TRS) is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets in exchange for periodic cash flows, typically a floating rate such as LIBOR plus a basis point spread, usually depending on the credit quality of the company. A TRS is similar to a plain vanilla swap except the deal is structured such that the total return (cash flows plus capital appreciation/depreciation) is exchanged, rather than just the cash flows. FIGURE 2: TRS BASIC MECHANICS LIBOR + Spread Company Asset Total Return Swap Provider In effect, the plan sponsor (Company) is simply renting the Swap Provider s (also called Swap Counterparty) balance sheet at a rate equal to LIBOR plus a spread. In return, over the term of contract, the plan sponsor will receive gains from or pay losses to the Swap Provider depending on whether markets increase or decrease. These payments will be equal to the difference between the original notional investment value and the current composite value of the investments, and will offset the change in the value of the NQDC liability (as long as the swap mirrors the liabilities investments). As new deferrals occur, amounts are distributed, or employees make NQDC plan reallocation decisions, the swap notional is adjusted up or down accordingly, to mirror the NQDC plan liability. A deferral distribution triggers a tax deduction for the plan sponsor and creates a taxable event attributable to the amount distributed on the swap gains, net of the LIBOR based costs. 9 P a g e

10 VII. THE TRS OVERLAY STRATEGY To implement the TRS Overlay strategy, a plan sponsor would enter into a total return swap with a Swap Provider, while keeping its taxable investment or COLI assets as a funding tool. FIGURE 3: TRS OVERLAY BENEFIT COMPARISON TRS OVERLAY (TRS WITH TAXABLE INVESTMENTS OR COLI) UNFUNDED ( PAY AS YOU GO ) TAXABLE INVESTMENTS (STAND-ALONE) COLI (STAND-ALONE) Creates Upfront Liquidity Economic Value Optimizes Capital Structure Potential Tax Benefits Minimize Income Statement Volatility Minimize Compensation Expense Volatility Ease of Administration BENEFITS OF USING A TRS WITH TAXABLE INVESTMENTS OR COLI The TRS Overlay strategy would provide the following benefits beyond funding and hedging with taxable investments or COLI alone. Optimal Accounting Geography Using taxable investments or COLI can result in suboptimal accounting geography. As noted above, plan sponsors record expenses, gains and losses on taxable investments and COLI belowthe-line in OCI, thereby eliminating the product's ability to generate a direct hedge against a highly visibility operating expense (executive compensation) in SG&A. The TRS typically allows a plan sponsor to report expenses, gains and losses in the deferred compensation expense line item of the income statement. Eliminates Excessive Volatility Since the TRS is marked-to-market for accounting purposes (similar to the accounting treatment for NQDC obligations) it is possible to match increases and decreases of the plan liability. Additionally, 10 P a g e

11 since the TRS is settled regularly (i.e. monthly) the plan sponsor receives cash equal to the appreciation in the NQDC plan liability. Unlike the COLI-only strategy, the TRS Overlay strategy does not create deferred tax-related overhedging as expenses, gains and losses for the swap attract deferred tax treatment. Significant Tax Benefits from Swap Based on Private Letter Ruling # , the NQDC Swap Solution may be designated as a hedge for tax purposes and the tax treatment of gains, losses and costs of the NQDC Swap Solution will match the tax characteristics of the NQDC plan liability. Specifically, the plan sponsor can utilize the hedging rules under Treasury Reg (b)(2) to defer the taxable event for gains/losses and dividends attributable to the swap until distributions are made under the NQDC plan to participants. In other words, taxable swap gains are allocated to each distribution and taxed in the year of each distribution when the company also receives a tax deduction for the amount distributed. Full Tax Benefits from COLI Retained Using the TRS Overlay strategy, the plan sponsor can continue to generate tax-free gains on its COLI and will also benefit from tax deferred treatment for the expenses, gains and losses for the swap overlay. Ease of Implementation The TRS Overlay strategy requires no changes to: a) the underlying nonqualified plan, b) the recordkeeper, c) plan communications, d) participant benefits or e) the existing workload for HR resources. All activity is outsourced and all tax, accounting, tracking error and attribution reporting is provided. Compelling Economics FIGURE 4: ECONOMIC COMPARISON ASSUMPTIONS Plan Sponsor COLI Corporate Tax Rate 40.00% Average Age 45 Taxable Investment Tax Rate 40.00% COLI % Funding % Insurance Expenses Other Than Investment Expenses % of AV 1.00% NQDC Plan % 2001 CSO Experience 60.00% Initial Deferral $1,000 COLI Earnings Net of Expenses (Stand-alone) 8.00% Equities % Funding 70.00% COLI Earnings Net of Expenses (TRS Overlay) 3.10% Equity Investment Earnings After Investment Expenses 8.00% Blended Fixed Income % Funding 30.00% Taxable Investments Blended Fixed Income Earnings After Expenses 2.00% Taxable Investment % Funding % Taxable Investment Earnings Net of Expenses (Stand-alone) 8.00% TRS Overlay Taxable Investment Earnings Net of Expenses (TRS Overlay) 2.00% TRS Hedge Cost % The following analysis shows the net present values of discounted cash flows (DCF) for multiple funding and/or hedging strategies for a sample NQDC plan. All amounts are after-tax and include the cost for benefit distributions. The amounts are for $1,000 of deferral and assume that 11 P a g e

12 participants invest 70% of their deferrals in equities and 30% in blended fixed income strategies. For funded strategies, an assumption is made that amounts are funded at 100% of the pre-tax obligation. We can customize the analysis to reflect a plan sponsor s existing plan specifics. FIGURE 5: ECONOMIC COMPARISON NPV RESULTS AT DIFFERENT WACC RATES Unfunded: NPV (Including NQDC Plan) Assuming WACC Rate of: Description 3.0% 5.0% 8.0% 10.0% NQDC Plan Unfunded and unhedged stragegy (NPV of the NQDC Plan only) ($1,440) ($345) $294 $453 TRS Unfunded and hedged with the TRS $1,255 $1,550 $1,478 $1,355 Taxable Investments: NPV (Including NQDC Plan) Assuming WACC Rate of: Description 3.0% 5.0% 8.0% 10.0% Taxable Investments Funded and hedged with taxable investments ($900) ($959) ($870) ($795) TRS Overlay w/ Taxable Investments Funded with taxable investments and hedged with the TRS ($95) ($273) ($371) ($394) COLI: NPV (Including NQDC Plan) Assuming WACC Rate of: Description 3.0% 5.0% 8.0% 10.0% COLI Funded and hedged with COLI $520 ($55) ($360) ($423) TRS Overlay w/ COLI Funded with COLI and hedged with the TRS $711 $220 ($107) ($205) 12 P a g e

13 VIII. CONCLUSION Total return swaps have become an increasingly important tool for hedging nonqualified deferred compensation plans because of their ability to reduce income statement volatility, provide good accounting geography and generate economic value. Additionally, a total return swap can be very flexible it does not need to be used in place of taxable investments or COLI. By using the TRS Overlay strategy, a total return swap can be combined with these other funding strategies and tailored to a plan sponsor s specific circumstances and needs. The TRS Overlay has the ability to retain the benefits of a plan sponsor s current funding and hedging strategy while adding the significant benefits of using a swap. Plan sponsors would be well-served to consider the TRS Overlay strategy to optimize its current NQDC plan funding and hedging strategy. 13 P a g e

14 IX. APPENDIX A ADDITIONAL INFORMATION ON TOTAL RETURN SWAPS MARKET PARTICIPANTS The Total Return Swap (TRS) market is strictly institutional and over the counter (OTC). Market participants include investment banks, commercial banks, mutual funds, hedge funds, funds of funds, private equity funds, pension funds, university endowments, credit card lenders, insurance companies, governments, non-governmental (NGO) organizations, home loan banks, and the Treasury departments of large multinational corporations. A variety of special purpose vehicles (SPVs) such as CDOs and real estate investment trusts (REITs) also participate in the TRS market. The TRS market was traditionally between commercial banks where one party (Bank A) had exceeded its balance sheet limits, and the other (Bank B) had balance sheet capacity available. Bank A could shift assets off its balance sheet synthetically and gain additional income with less risk. Bank B could "lease" the assets of Bank A by paying some regular cash flows and offering a guarantee against any capital losses. A TRS can be structured on any type of reference asset, including single equities, indexes, leases, oilbacked credit obligations, baskets of corporate bonds, mortgages, municipal bonds, other swaps or derivatives, real property, credit card ABS, residential MBS, CDO notes, investment grade convertible bonds, etc. This makes the range of potential market participants extremely broad. TRS TRANSACTION STRUCTURE A TRS is made up of two legs, the Return Leg (or Total Return Leg) and the Funding Leg. The performance of the reference asset or basket of assets determines the Return Leg. The cash flow payment stream exists on the Funding Leg. The Return Leg is generally made up of two components: cash flows and capital appreciation of the reference asset(s). The Funding Leg also has two components: floating coupons based on LIBOR plus a spread and payments to offset any capital depreciation of the reference asset(s). Additional legs may be structured to account for reinvestment of returns, interest payments on collateral / haircuts, multi-currency flows, or differing payment schedules. Fees, spreads, principal payments, etc. may be added in a customized structure. SWAP COUNTERPARTY The Return Leg counterparty is called the Swap Counterparty. Swap Counterparties are usually large institutions with big balance sheets such as commercial banks, investment banks, mutual funds, securities dealers, and insurance companies. Swap Counterparties have lower cost of funding than plan sponsors, but their returns are often limited by regulatory capital requirements or conservative 14 P a g e

15 strategies. By "leasing" a portion of the Swap Counterparty's balance sheet through a TRS, a plan sponsor can achieve higher returns while ensuring against capital losses. The Swap Counterparty has a long position in the reference asset or basket of assets, holding them on its balance sheet. The Swap Counterparty agrees to pay all of the future returns of the reference asset(s) in exchange for a floating stream of payments, usually LIBOR plus a spread. Thus, the plan sponsor receives one set of expected future returns (capital appreciation, coupons, fees, dividends, etc.) in exchange for another set of future returns - LIBOR coupons plus a spread. PLAN SPONSOR Cash Flows and Risks for the Swap Counterparty: Owns reference asset(s) Has lower cost financing Pays total return of asset(s) Receives LIBOR plus spread Receives payments to offset any capital losses Takes on interest rate risk Transfers away asset return risk The Funding Leg counterparty is the plan sponsor. The plan sponsor seeks exposure to the returns of the reference asset or basket of assets, but does not want to purchase and hold them on its balance sheet. This party takes a synthetic long position in the asset(s) and makes regular floating cash flow payments and capital loss payments to the Swap Counterparty. Cash Flows and Risks for the plan sponsor: Does not own reference assets Has higher cost financing Receives total return of assets (pays losses) Pays LIBOR plus spread Takes on asset return risk TRS transactions are typically structured with a notional amount, start date, end date, and periodic dates where asset returns are swapped for cash flows. The notional amount is defined at the start as the market value of asset(s) on the Return Leg. The parties establish a regular payment calendar for transfer of net returns. For example, the parties may set a monthly or quarterly payment calendar defined by LIBOR coupon dates. On those dates, the Swap Counterparty will mark-to-market the capital appreciation/depreciation and accumulated cash flows of the Return Leg asset(s). The plan sponsor will calculate the required coupon consisting of LIBOR plus a spread. Value of the reference asset(s) is determined on a periodic basis by mark-to-market using dealer quotations, independent pricing data, or independent valuation. The parties will then exchange the net difference between the value of the two legs. At expiration date of the TRS, the parties will exchange the remainder of net returns. 15 P a g e

16 FIGURE 6: DETAILED TRS MECHANICS Plan Participant 1 4 Swap Spread and Related Fees Tax Deferral for Swap IRS 5 Deduction for Benefits when Paid Company Benefit Information 2 Accounting Entries, Distribution Information Benchmark Return Benefit Recordkeeper 3 Allocation and Information Payment Return Information and Confirms Swap Provider Confirms Trade Instructions Swap Facilitation Provider (ABF) 1 Employee defers compensation Record-keeper collects benefits-related information and provides Company with statements, accounting and distribution information Swap facilitation provider receives investment allocation information and generates trade instructions for balance sheet providers. Also provides Company with net exposure statements, accounting and distribution/tax information Company periodically pays swap fee in exchange for a benchmark return 1 on NQDC plan At plan maturity date or termination of employment, benefits (deferral + return) paid by Company to employee. Upon payment, company realizes cumulative gains/losses on the Swap, net of interest paid to balance sheet provider, and realizes tax deduction for compensation amount 1 Benchmarks must be based on publicly-available investment alternatives. FIGURE 6 above illustrates the structure of an NQDC swap hedge, which is an exchange of returns between a plan sponsor and a Swap Counterparty (referred to as the Swap Provider in the Figure). In effect, the plan sponsor (Company) is simply renting the Swap Provider s balance sheet at a rate equal to LIBOR plus a spread. In return, over the term of agreement, the plan sponsor will receive gains from the Swap Provider. These payments will be equal to the difference between the original notional investment value and the current composite value of the investments, and will offset the change in the value of the NQDC liability (as long as the swap mirrors the liabilities investments). As new deferrals occur, amounts are distributed, or employees make NQDC plan reallocation decisions, the swap notional is adjusted up or down accordingly, to mirror the NQDC plan liability. A deferral distribution triggers a tax deduction for the plan sponsor and creates a taxable event attributable to the amount distributed on the swap gains, net of the LIBOR based costs. The NQDC plan administrator (Benefit Recordkeeper) will continue to manage and track the liability information and required transactions needed to administer the NQDC plan, communicate portfolio status to the participant, support implementation of participant deferral decisions, and track the tax, accounting, and other information needed to effectively manage all aspects of the plan. The Swap Facilitation Provider will manage and track the required transactions needed to administer the swap, communicate this information to the swap provider, communicate net exposure and P&L to the plan sponsor, and track the tax, accounting, and other information needed to effectively manage all aspects of the NQDC plan and NQDC Swap Solution. 16 P a g e

17 X. APPENDIX B DEFINITIONS OF KEY TERMS Constructive Receipt Doctrine: Under the doctrine of constructive receipt, the IRS can tax a plan participant before they receive funds from the plan if the funds are credited to the plan participant s account, set aside, or otherwise made available to the plan participant without substantial restrictions or limitations. The doctrine of constructive receipt is most relevant to NQDC plans that permit the plan participant to elect to defer receipt of compensation or would allow the plan participant to elect to receive previously deferred compensation. Under IRS guidelines, a plan participant can avoid constructive receipt by making their election to defer compensation before the year they perform the services that earn the compensation. Also, to avoid constructive receipt, the plan participant generally cannot have any right to elect to receive payment of their deferred compensation before payment is due under the terms of the NQDC plan. Discounted Cash Flow (DCF): DCF is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the company s weighted average cost of capital, or WACC) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity will most likely increase shareholder value. Employee Retirement Income Security Act of 1974 (ERISA): Federal legislation that protects workers' retirement benefits. ERISA contains complex rules governing participation, vesting, funding, reporting, disclosure, administration, and fiduciary activities. While ERISA governs most qualified retirement plans, NQDC plans can be structured to avoid almost all of ERISA's requirements. Net Present Value (NPV): NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. NPV is associated with the concept of the time value of money, a core principal of finance, which states that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. Typically, if the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will be negative. NPV is a central tool in discounted cash flow analysis, and is a standard method for using the time value of money to appraise long-term projects. Section 409A of the Internal Revenue Code: IRC Section 409A provides specific rules relating to deferral elections, distributions, and funding that apply to most NQDC plans, and in part codifies constructive receipt rules. If an NQDC plan fails to follow the 409A rules, the plan benefits of affected participants, for that year and all prior years, may become immediately taxable and subject to penalties and interest charges. 17 P a g e

18 Weighted Average Cost of Capital (WACC): WACC is the overall return that a corporation must earn on its existing assets and business operations in order to increase or maintain the current value of its stock. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, etc. Different securities, which represent different sources of finance, are expected to generate different returns. A firm s WACC is the overall required return on the firm as a whole and is the appropriate discount rate to use for cash flows with risk similar to that of the overall firm, often defined as the blended rate for cost of debt and return on equity. 18 P a g e

19 XI. APPENDIX C ACKNOWLEDGEMENTS ABOUT THE AUTHORS John E. Coleman is a Principal of Analect Benefit Finance in Boston. Clifford R. Eisler is a Principal of Analect Benefit Finance in New York. David J. Marshall is a Principal of Analect Benefit Finance in New York. Matthew J. Marshall is a Managing Director of Analect Benefit Finance in Los Angeles. ABOUT ANALECT BENEFIT FINANCE Analect Benefit Finance LLC (ABF) specializes in the design, implementation, funding, hedging and ongoing administration of nonqualified deferred compensation (NQDC) plans. ABF pioneered the development of the NQDC Total Return Swap solution, a proprietary, low-cost solution that dynamically hedges income statement volatility created by NQDC plans, as well as the TRS Overlay strategy. ABF established a joint venture in 2013 with the Newport Group to deliver the NQDC Total Return Swap solution and the TRS Overlay strategy to some of the world s largest companies. 19 P a g e