Managing Expenses Related to Nonqualified Deferred Compensation Plans May 2016
Topics to be Covered Page I. Scope of Our Discussion 2 II. The Cost of Nonqualified Plans 5 III. Tools for Evaluating Costs 17 IV. Comparing Results 19 V. Summary 22 1
I. Scope of Our Discussion 2
Scope of Our Discussion Non-Qualified Deferred Compensation (NQDC) Plans Our discussion is limited to the portion of the Plan liability that is market-based: 401k Mirror Plans Broad Menu of Mutual Fund Investments Menu of ETFs and/or Market Indices P&L Impact Nonqualified plan liabilities are marked-to-market with the change expensed through the income statement as Compensation Expense Cost Management - Plan Sponsors manage these liabilities in one of three ways: Leave liability exposure unhedged - accept income statement ( Compensation Expense ) volatility Buy matching physicals (mutual funds or ETFs) or corporate-owned life insurance (COLI) Utilize an off-balance sheet Total Return Swap (TRS) to dynamically hedge expense 3
Alternatives to Managing the Risks of NQDC Plans Unfunded / Unhedged Corporate Owned Life Insurance Taxable Investments Futures TRS Hedge Program Description No Funding or Hedging of the Liability Purchase Life Insurance Policies on Employees Purchase Underlying Investments Purchase Financial Futures Enter into a Total Return Swap to Receive Benchmark Returns in Exchange for LIBOR-based Payments Desired Benefits Minimized Cost of Hedge Yes No No Yes Yes Avoids Tying Up Capital Yes No No Yes Yes Cash Savings Yes No No Yes Yes Earnings Volatility Minimized No Yes Yes Yes Yes Hedging Tracking Error Minimized No No Yes No Yes Hedging Gains Booked with Plan Expense N/A No No No Yes Tax Efficiency of Hedge Gains N/A Yes No No Yes Liquidity Match / Ease of Unwind No No Yes Yes Yes HR/Treasury Administration Ease Yes No No No Yes Other NQDC Plan Issues Possible Indirect Funding of Rabbi Trust No Yes Yes No Yes (with LOC) Ease of Employee Relations Yes No Yes Yes Yes Avoids Headline Risk Yes No Yes Yes Yes 4
II. The Cost of Nonqualified Plans 5
Cost From Multiple Perspectives Many Moving Parts Multiple Stakeholders Bottom Line Impact Cash Flow NPV Cost - Time Value of Money P&L Impact on Earnings Accounting Geography Compensation Expense Management Participant Relations Employee Retention Managing Scarce Internal Resources 6
Elements of NQDC Plan Cost NQDC Plans create significant economic and income statement volatility Returns: Linked to performance of a menu of investment options P&L: Mark-to-market accounting generates significant and visible unbudgeted executive compensation expense Traditional hedging strategies such as mutual funds or corporate-owned life insurance (COLI) require companies to hold assets on their balance sheets Balance Sheet: Ties up in costly balance sheet in a non-operating asset Accounting Geography: Returns for non-operating assets are below-theline (NQDC Plan expense accruals are booked to Compensation Expense) Tax: Investment return of hedging assets subject to current tax (unless wrapped in COLI, which incurs other costs) Participant Relations: COLI requires purchasing insurance on the lives of employees from whom the plan sponsor must receive consent 7
Off Balance Sheet TRS Hedging Strategy Increasingly, companies in the Fortune 500 are using dynamically-managed total return swaps to hedge their nonqualified plans: Balance Sheet: The plan sponsor utilizes a bank s inexpensive balance sheet to hedge its program rather than its own balance sheet Accounting Geography: Expenses, gains and losses for the swap are recorded as a direct offset to the compensation expenses generated by the NQDC Plan (same geography) Tax: Expenses, gains and losses for the swap may be deferred for tax purposes utilizing a well-establish tax hedging election strategy Participant Relations: The use of this strategy does not require consents from participants and does not require any changes in the NQDC Plan or the plan recordkeeper 8
Dynamically-Managed Total Return Swaps The Mechanics: The Plan Sponsor enters into a Swap Agreement with a Bank where: The Bank pays the positive return on an underlying instrument, e.g. a mutual fund, specified index or ETF, equivalent or very similar to what the Plan Sponsor owes its plan participants In return, the Plan Sponsor pays a floating interest rate such as LIBOR plus a spread in addition to any negative return on the mutual fund, specified index or ETF Analect Benefit Finance interfaces with both the Bank and the Plan Sponsor s recordkeeper to provide all administrative support, recordkeeping and reporting related to the TRS Hedge Plan Participants Plan Return Offering Plan Sponsor Pays LIBOR-based rate plus loss on benchmarks Pays positive return on benchmark investments Bank 9
Dynamically-Managed Total Return Swaps (cont.) Frees Up Capital and Creates Economic Gains Cash proceeds from executive deferrals can be reinvested into the business Cost of program converted to a LIBOR-based rate Accounting Geography The NQDC Plan appears as an operating expense in a Company s income statement (typically in Compensation Expense) Gains, losses and expenses of mutual funds and COLI are typically recorded in Other or Investment Income (bad accounting geography) However, the TRS offsets the NQDC Plan liability in the expense category where it occurs, thus reducing compensation expense volatility (good accounting geography) Operating income and efficiency goals and projections are therefore not affected by the volatility of the NQDC Plan 10
Dynamically-Managed Total Return Swaps (cont.) Enhances Tax Efficiency Taxation of TRS gains, losses and expenses occurs at the same time as the deduction for NQDC Plan withdrawal payments is realized Improves Plan Flexibility Maximum flexibility of investment options offered to participants Program allows for hedging of most publicly-available investments Eases Administration All TRS Hedge related activity is outsourced - does not disrupt current NQDC Plan administration Ease of communication with stakeholders 11
The Nonqualified Plan Liability and Risk Accounting Treatment NQDC Plan liabilities are marked-to-market and run through the Compensation Expense line of the income statement Embedded Volatility Quarter-to-quarter volatility of an unhedged NQDC Plan has been in excess of 20% 20.0% 15.0% 16.9% 19.7% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% Q1 10 2.7% 3.7% Q4 09 Q3 09 Q2 09 Q1 09 Q4 08-12.5% Q3 08 Q2-2.5% Q1 08 08-15.7% Q4-2.7% Q3 07 07-9.5% 1.9% Q2 07 5.8% Q1 07 2.1% Q4 06 8.0% Q3 06 4.0% -1.1% Q2 Q1 06 06 6.1% Q4 05 2.7% Q3 05 6.6% 0.0% Q2 05 S&P 500 MSCI World 3 Month LIBOR Barclays Agg -20.0% -25.0% -22.2% Minimizing Volatility The TRS Hedge reduces income statement volatility by exchanging these volatile returns for a LIBOR-based (1-Month LIBOR in red above) cost 12
12/1/2001 6/1/2002 12/1/2002 6/1/2003 12/1/2003 6/1/2004 12/1/2004 6/1/2005 12/1/2005 6/1/2006 12/1/2006 6/1/2007 12/1/2007 6/1/2008 12/1/2008 6/1/2009 12/1/2009 6/1/2010 12/1/2010 6/1/2011 12/1/2011 A TRS May Reduce Volatility Significantly Back testing shows how volatility may be dramatically reduced The standard deviation of a hypothetical $100 mil plan exposed entirely to the S&P 500 Index from Dec. 31, 2001 through Dec. 31, 2011 was reduced by over 90% Average Standard Deviation of Ratio of SD to Maximum Quarterly Expense Quarterly Expense Average (ABS value) Quarterly Expense Unhedged Plan (100% Invested in S&P 500): ($232,668.41) $8,555,137.43 36.77 ($11,999,163.82) Hedged Plan (Based on 3-Month LIBOR): ($869,692.21) $612,559.03 0.70 ($2,082,020.85) $25,000,000.00 $20,000,000.00 $15,000,000.00 $10,000,000.00 $5,000,000.00 S&P 500 Income (Expense) 3-Month LIBOR Expense $0.00 ($5,000,000.00) ($10,000,000.00) ($15,000,000.00) 13
Accounting Treatment and Geography Under FAS 133, the TRS Hedge is accounted for on a marked-to-market basis Subject to approval from the Plan Sponsor s auditors, the TRS Hedge typically enables good accounting geography directly offsets changes in the benefit liability in the income statement: The income or earnings on COLI and mutual funds is typically recorded in Other or Investment Income Unlike with COLI or mutual funds, the Company, in consultation with its accountants, will typically record the mark-to-market gains, losses and expenses of the of the TRS Hedge in Compensation Expense This accounting match enables the TRS Hedge to offset the benefit liability in the expense category where it occurs, thus reducing operating income volatility This can be of particular importance for executives whose compensation is based on the achievement of particular operating income or % goals/growth 14
Potential Tax Benefits of TRS Hedge Tax Neutral Results Under the TRS Hedge, the Company may defer taxes on the swap gains, losses and expenses until the underlying nonqualified plan obligations are paid to executives and an offsetting deduction is received Tax Hedge Election under Section 1221(b)(2) of the Internal Revenue Code Allows for deferred recognition of i) gains, ii) losses and iii) expenses (ie LIBOR based-payments) We believe there is no reasonably accurate way to track relevant information without the use of a mini-swap approach Swap Facilitation: Our firm has developed the TRS Hedge swap facilitation system that supports this approach Items tracked by our firm (changes in the following make it difficult to determine appropriate tax treatment using an aggregate liability approach): LIBOR + Spread, Equity leg gains and losses, Deferral-specific distribution events, and Investment-specific hedging 15
Potential Tax Benefits of NQDC TRS (Cont.) Analect Benefit Finance s TRS Hedge Program offers the most accurate form of taxefficient hedging available today, thereby limiting tracking error and tax exposure Tracking Error: Traditional NQDC Plan hedging instruments, such as corporateowned life insurance, often generate tracking error due to a mismatch in funds used or expense levels incurred Hedging with underlying physicals will not provide for similar tax benefit: Recently finalized Treasury regulations make COLI and mutual funds incompatible with the 1221(b) hedging election "[t]he purchase or sale of... an equity security... is not a hedging transaction even if the transaction limits or reduces the taxpayer's risk with respect to... ordinary obligations." 16
III. Tools for Evaluating Costs 17
Methods Used for Evaluating Costs Project Cash Flows for various elements of the NQDC Plan Participant Deferrals Benefit Distributions Investments in funding Cost of hedging All tax effects Discount Cash Flows (NPV) using Plan Sponsor s hurdle rate Weighted-Average Cost of Capital Long Term Cost of Debt Stress Test using a variety of assumptions 18
IV. Comparing Results 19
Economic Results Assumptions Company-Specific Assumptions (a) Swap Fee Assumptions (a) Corporate Tax Rate: 40.00% LIBOR Rate (b): 0.25% Return on Capital Hurdle Rate: 10.00% Spread: 0.90% All-in Swap Fee: 1.15% Program-Specific Assumptions (a) Size of Deferral (in US$): $100,000,000 Plan Benchmark Return (Net of Fees): 7.00% (a) Estimates for illustrative purposes. The above pricing includes the fee for ABF's swap facilitation services of 20 bpts pa. The swap spread will vary, depending on the underlying item being hedged, and will generally be 50-80 bpts pa. (b) Approximate market rate as of 3/31/2016. 20
Economic Results NPV Results for Corporate Alternatives Gain / Loss NQDC Plan Hedge Total 10 Year Deferral Period: Unfunded / Unhedged $14,494,680 $0 $14,494,680 Taxable Mutual Fund Investments $14,494,680 ($47,805,586) ($33,310,906) NQDC Total Return Swap Solution $14,494,680 $36,942,179 $51,436,859 40 Year Deferral Period: Unfunded / Unhedged $40,148,426 $0 $40,148,426 Taxable Mutual Fund Investments $40,148,426 ($132,415,414) ($92,266,988) NQDC Hedging Program $40,148,426 $102,325,155 $142,473,580 21
V. Summary 22
Summary NQDC Plans create unbudgeted mark-to-market volatility for Plan Sponsors A Total Return Swap Hedge is an efficient way to mitigate this exposure: Substantially eliminates the market-based risk and income statement volatility Specifically eliminates the highly visible swings in compensation expense Radically reduces the economic cost of the NQDC Plan The tax hedge election can create additional economic value Implementing the TRS Hedge creates no additional internal workload 23
Disclaimer This Presentation 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, Analect Benefit Finance makes no representations or warranties, expressed or implied, concerning this Presentation or any other written or oral communication transmitted or made available to any party. Any trademarks used herein are the sole property of their respective owners. Analect Benefit Finance 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 Analect Benefit Finance s estimates of future events. Although Analect Benefit Finance 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 Analect Benefit Finance 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 Presentation. All non-tax related information contained in this Presentation is to be kept strictly confidential and is proprietary to Analect Benefit Finance. By receipt of this Presentation, the recipient agrees to preserve the confidentiality of the contents in this Presentation and not acknowledge or disclose to any third party confidential information concerning Analect Benefit Finance including its business strategies and objectives. Upon receipt of notice from Analect Benefit Finance, the recipient will promptly return all material received in connection with its review (including this Presentation) without retaining any copies or reproductions thereof. All inquiries or requests for additional information should be submitted or directed to Analect Benefit Finance. In furnishing this Presentation, Analect Benefit Finance undertakes no obligation to provide the recipient with access to any additional information. The methods and products disclosed in this presentation 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. 24
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