Supplemental Executive Retirement Plan (SERP)
and Performance-Based SERP
APRIL 2004
About this Report
With constant pressure from the FASB, SEC and investor groups to expense stock options, many companies have decided to look at alternatives to stock option compensation. This report discusses the Supplemental Executive Retirement Plan (SERP) as an alternative to attract, retain and reward key people. This report also compares the economics of restricted stock, stock options and Performance-Based SERPs.
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Table of Contents
I. II. III. IV. V. VI.
Prevalence of SERPs Plan Design Performance-Based SERP The Funding Decision Benefit Security Issue About Retirement Capital Group, Inc. (RCG)
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Section I. Prevalence of SERPs
Prevalence of SERPs
Overview Many companies utilize a SERP as a way of rewarding and attracting key executives and talent. SERPs are specifically designed to overcome basic pension plan limitations. For example, they can provide extra benefits for areas the qualified pension plan doesn’t cover including:
Income over IRS maximum Ineligible income (bonuses and deferred compensation) Short service that is not vested Early retirement
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Prevalence of SERPs
Among the Fortune 1000 According to the 2003 Survey, most Fortune 1000 responding companies have implemented SERPs.
1% 1% 1% 0% 5%
71%
76%
75%
75%
74%
28% 2003
Source: Clark Consulting
23% 2002
24% 2001
25% 2000
21% 1999
Not Currently Considering
Have a SERP
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Currently Considering
Prevalence of SERPs
Reasons for Popularity Over the last twenty years, two predominant themes have surfaced to cause corporations to implement supplemental benefit plans for their executives:
Government’s retreat from supporting company-sponsored pension plans The continued legislative limitations on how much executives can contribute and can receive in qualified benefit plans
Nonqualified plans are retirement vehicles that are a vital part of an executive’s overall financial portfolio. With the expensing of stock options, many companies are considering “Performance-Based SERPs.” This concept is covered in more detail in Section III.
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Section II. Plan Design
Plan Design
Traditional SERP A SERP provides additional retirement benefits according to a formula that supplements an executive’s other retirement benefits. A common formula targets a defined benefit, such as seventy percent (70%) of final average pay, for an executive who completes a particular number of years of service. Seventy-five percent (75%) of Fortune 1000 companies surveyed provide a SERP benefit to senior executives.
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Plan Design
Eligibility Design Feature
Position
Issues/Options
CEO Senior Officers
Comments
Prevalence
SERP Eligibility by Position Level
Highly Compensated Sales Personnel Division or Unit Managers Vice Presidents Senior Vice Presidents Executive Vice Presidents Board of Directors President and Chief Executive Officer
14% 13% 54% 70% 71% 5% 77%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
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Plan Design
Benefit Formula Design Feature
Target Benefit Average Compensation Retirement Age Supplemental Benefit Benefit Accrual Vesting
Issues/Options
60% - 70% of average compensation at retirement Three year average of salary plus bonus Age 65 or 10 years of plan participation, early retirement age 55 with 10 years of service 4% per year after retirement age, to a maximum of 70% Benefit accrues over years of service to retirement on a prorated basis using current average compensation Fully vested after 5 years of plan participation Accelerated vesting upon change of control
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Comments
Plan Design
Retirement Distribution
Design Feature Retirement Distribution Issues/Options Single life annuity Actuarially-equivalent forms optional Elected at least twelve months prior to retirement Comments
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Plan Design
Offsets Many plan designs reduce SERP benefits based on amounts received from other programs. The following is a list of common offsets:
Qualified Plan Social Security Company Match to 401(k) Other Nonqualified Plans Former Employer Qualified Plan Disability Payments
Each of these offsets reduces the company cost for the plan.
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Section III. Performance-Based SERP
Performance-Based SERP
The Performance-Based SERP is designed as a defined contribution method similar to a 401(k) plan. Basically, the employer tracks each executive’s SERP benefits as an account balance payable after the executive terminates employment. Until that time, the executive’s deferred compensation grows in two ways:
Employer Contributions Earnings on Past Credits
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Performance-Based SERP
Employer Contributions The central component to a defined contribution SERP is a formula by which the employer commits to make regular credits to the executive’s account.
Credits made as a percentage of the executive’s pay, with the percentage fluctuating based on previously defined measures of corporate performance.
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Performance-Based SERP
Employer Contributions (continued) Example:
2% of pay is targeted as annual credit for satisfactory performance, based on ROE,
which is targeted to be 16%. The SERP formula could provide for annual credits equal to one-eighth (1/8) of ROE times the executive’s base pay. A minimum percentage could be established, such as 1% of pay if the employer wants to ensure some minimal accrual toward supplemental retirement benefits.
Note: Vesting – The employers’ contributions would be subject to vesting.
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Performance-Based SERP
Employer Contributions (continued)
$350,000 $300,000 A ccumulation $250,000 $200,000 $150,000 $100,000 $50,000 $1 3 5 7
Years
Cumulative Employer Contributions
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13
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Executive age 50 Formula 2% of base pay earning 7% annual Salary $150,000
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Performance-Based SERP
Earnings on Past Credits The employer may secure significant accounting benefits by tracking each executive’s benefits in the form of deferred shares of employer stock. If this is done, no expense arises from appreciation in their value. An employer may instead opt to pay SERP benefits in cash, or to measure the earnings on SERP accounts by a measure other than stock price.
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Performance-Based SERP
Earnings on Past Credits (continued) There are many choices for crediting interest or earnings to the executive’s account. Some of the most common are:
A fixed or market interest rate, such as prime; A corporate performance measure such as a percentage of ROE; or Mutual fund investment selected by the employer (often to mirror 401(k) plan choices).*
*Could allow executives to self-direct.
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Performance-Based SERP
Conclusion The traditional SERP is difficult to justify in today’s pay-for-performance world. The alternative described in this section should appeal to shareholders and executives who expect to perform well. This win-win dynamic is enhanced when the SERP uses deferred shares, in part because favorable accounting rules make them less expensive than traditional SERPs. This provision could help meet stock ownership guidelines.
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Section IV. The Funding Decision
The Funding Decision
Formal vs. “Informal” Funding SERPs must technically remain “unfunded” to escape ERISA regulations regarding participation, vesting, benefit accrual and payment rules. However, SERP benefits can be “informally” funded by setting aside assets in a trust in amounts equal to the plan liabilities. There is also a positive correlation between the extent to which assets are set aside to meet benefit obligations and the level of plan participation.
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The Funding Decision
Rationale for Funding
In addition to economic and financial considerations, there are qualitative reasons for informal funding or financing nonqualified benefits: Current Fiduciary Responsibility. A current allocation of dollars removes the financial burden from successor management.
o Benefit costs for which the liability is currently accruing will not impact successor management’s profits, bonus and benefits. Some call this avoiding the “Social Security syndrome”.
Consistent with Funding of Qualified Retirement Plans. Dollars can be contributed today to a benefit Trust just as they would otherwise be contributed to a qualified pension plan trust if IRS guidelines allowed. Tax-Advantaged Funding Available. Similar to the qualified plan, the trust and its funding can be designed to allow for a non-taxable accumulation of assets.
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The Funding Decision
Funding Asset Alternatives
Corporate-Owned Life Insurance (COLI) Mutual Funds Tax-exempt Bonds Hedge Fund Strategy Company Stock COLI in PBT Trust COLI with Stable Value
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The Funding Decision
Funding SERP Benefits Fifty-three percent (53%) of Fortune 1000 companies fund their current benefit liabilities, with COLI being the most prevalent.
COLI 61% Bond or Bond Fund 3% Managed Portfolio 6%
Type of Asset Bond or Bond Fund Company Stock Mutual Funds Corporate Annuities Managed Portfolio COLI
2003 3% 8% 14% 8% 6% 61%
2002 6% 6% 13% 0% 7% 68%
Corporate Annuities 8% Company Stock 8% Mutual Funds 14%
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The Funding Decision
Design Alternatives The Stable Value (SV) feature removes account balance and accounting volatility of an actively-managed separate account investment division. Illustration of stable value portfolio:
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Stabilized Investment Value
Company can fund their DCP along with SV inside of COLI*. Policy’s cash value investment is accounted for at cash surrender value. Income will accrue steadily and is guaranteed not to be negative, absent default of securities. Upon a surrender election, the company will receive the stabilized portfolio value, regardless of market conditions.
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1.5
1
Stabilized Series1 separate account value Unstabilized account Series2
0.5
0
TIME
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*Corporate-Owned Life Insurance
The Funding Decision
Restricted Stock vs. Funded SERP Many organizations are using Performance-Based SERPs as an alternative to issuing restricted stock. The following chart compares the P&L Impact. After-Tax P&L Impact Restricted Stock vs. Funded SERP
$400,000 $300,000 $200,000 $100,000 $0 ($100,000) ($200,000) ($300,000)
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Funded SERP Restricted Stock 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31
Section V. Benefit Security Issue
Benefit Security Issue
Why Secure Nonqualified Benefits?
Unlike qualified plans, nonqualified benefits are subject to additional risk:
o o o o Change of Heart. Change in Control. Change in Financial Condition. Insolvency/Bankruptcy.
Nonqualified Deferred Compensation plans can be a significant investment of the participant’s own retirement resources. Most employers wish to provide highest possible quality of benefit promises possible, qualified or nonqualified. 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.
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Benefit Security Issue
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 equally.
Insured Security Option Plan
Control Heart Bankruptcy Proxy Design Cost
Retain Adminis tration Tax Des ign Cos t
S ecular COL I
Control Retain Adminis tration Tax Des ign Cos t Heart Bankruptcy Proxy
Retain Administration Tax
F unded Rabbi Trus t
Control Heart Bankruptcy Proxy
Effective Partially Effective Ineffective
Ideal S olution
S ecular Annuity
Control Retain Adminis tration Tax Des ign Cos t Heart Bankruptcy Proxy
Chang e in Chang e of He art Control Re te ntion & Attraction Bank ruptcy Prote ction Eas e of Adm inis tration Ce rtain of Tax Is s ue s Plan De s ig n Fle xibility Favorable Proxy Dis clos ure Econom ic Cos t
S pring ing Rabbi Trus t
Control Retain Adminis tration Tax Des ign Cos t Heart Bankruptcy Proxy
Mutual F und Option*
Control Retain Adminis tration Tax Des ign Cos t Heart Bankruptcy Proxy
Retain Adminis tration
S ecular Trus t
Control Heart Bankruptcy Proxy Des ign Cost
Tax
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*This feature could be added to an existing deferred compensation plan, allowing the Executive to “convert” account balance to an option with the same investment. That option could be transferred to a third party to provide post-retirement protection.
Benefit Security Issue
Seventy-four percent (74%) of companies are using Rabbi Trusts, however the trend is going toward more secure vehicles. 2003 2002
Funded Rabbi Trust Split Dollar Springing Rabbi Trust Other* Rabbicular Trust Secular Trust Executive Indemnity Insurance Letter of Credit 67% 7% 8% 10% 4% 2% 1% 1% 86% 4% 7% 2% 0% 1% 0% 0%
8% 7%
10%
4% 2% 1% 1%
67%
Funded Rabbi Trust Other* Executive Indemnity Insurance
*Others include ISOP®, Corporate Annuities, etc.
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Split Dollar Rabbicular Trust Letter of Credit
Springing Rabbi Trust Secular Trust
Section VI. About Retirement Capital Group, Inc. (RCG)
About Retirement Capital Group, Inc. (RCG)
RCG is a national executive benefits consulting organization that provides sound advice for Supplemental Executive Retirement Programs to a wide range of companies. We focus on developing cost-effective benefit solutions designed to attract, reward and retain key employees. Headquartered in San Diego, RCG has Regional Resource Centers in Cleveland and Atlanta, and Affiliate Offices in 35 cities throughout the U.S. Our services are designed to assist clients through a six-step process of consulting at all stages in the adoption and operation of executive benefit programs. RCG provides a “Best-In Class” third-party administration (TPA) selection process.
Initial Assessment
Plan Design
Funding
Security of Benefits
Plan Implementation
Ongoing Plan Administration
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About Retirement Capital Group, Inc. (RCG)
RCG professional staff and resources include the following professional disciplines, all dedicated to support our clients’ programs, systems and services:
Accounting Actuaries Attorneys Benefit Specialists Investment Advisors
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About Retirement Capital Group, Inc. (RCG)
RCG’s approach is to assist in the design, funding and securing of a nonqualified benefit plan.
Step 1:
Discuss corporate objectives Solicit input from study group and selected executives Analyze and understand current programs and agreements
Step 4:
Design final plan based on modifications made to Steps 2 & 3 Analyze funding vehicle (product bid process)
Step 5: Step 2:
Design preliminary plan based on input from Step 1 Implement:
o Communication o Enrollment
Step 3:
Design funding and security devices Evaluate funding vehicles based on:
o o o o o IRR Cash flow P&L impact Product risk Security design
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Step 6:
Administrate:
o System o Record keeping o Cash flow and P&L projections
About Retirement Capital Group, Inc. (RCG)
What is RCG’s process?
We use a process-based consulting approach to:
o o o Identify benefit issues Develop creative and innovative solutions for such issues Design programs that:
Are fair and appropriate for both shareholders and management Improve executive performance Enhance executive recruiting and retention
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About Retirement Capital Group, Inc. (RCG)
Unbundled Approach to Optimize Solutions
Plan Design
Plan Funding
Plan Administration and Monitoring
Plan Implementation and Communication
By unbundling, we believe our clients receive higher-quality service at a lower cost to the corporation.
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William L. MacDonald
Chairman, President and Chief Executive Officer Retirement Capital Group, Inc.
3636 Nobel Drive, Suite 250 San Diego, CA 92122 Phone: 858.677.5900 Fax: 858.677.5915 www.retirementcapital.com