Methods for hedging NQDC liability gains to avoid the pain of being hit by financial statement surprises.
Nonqualified deferred compensation (NQDC) plans allow companies to offer executives the opportunity to defer taxes and earn market-based, notional returns on the deferred amounts while the company gets access to additional capital. That’s all good.
- The complication is that executives usually choose from a menu of market-based “notional” investments whose gains directly affect compensation expense and the P&L unless they are hedged. Depending on the plan size, volatile markets can result in those gains swinging back and forth by tens of millions of dollars.
- Acknowledging that challenge, a member of NeuGroup for Pensions and Benefits queried peers about their hedging strategies.
- There are different ways to hedge NQDC plans, with total return swaps (TRSs) standing out as an efficient approach.
TRSs and de minimis mismatches. One assistant treasurer said the $350 million liability of his company’s deferred compensation plan can swing by $20 million to $50 million, but using TRSs to offset those swings has resulted in quarterly mismatches of just $1 million to $2 million.
- “It’s so small that it doesn’t matter,” the AT said, adding, “We’ve been able to do it cheaply and effectively.”
- His team looks through to all the individual investment elections and aggregates them into large-cap, small-cap and international equities, as well as fixed-income, and hedges those positions using a TRS.
- The team rebalances the positions monthly based on data it gets from the benefits department.
Be wary of consultants. The AT noted that some consulting firms offer soup to nuts solutions to hedge deferred compensation liabilities.
- “They’ll tell you all the problems with doing it yourself and they’ll try to charge you a massively exorbitant fee,” he said. “We do it ourselves. We’ve had no tax problems and it’s worked perfectly.”
Hedge accounting? Another member asked the AT if his firm gets hedge accounting treatment for the TRS transactions.
- “No, we don’t want hedge accounting,” he responded, noting that the TRS offsets the fluctuations of the marked-to-market liabilities in the P&L, and his team makes sure that both positions appear geographically in the same financial statement line item.
COLI hedging. Another member said his company’s deferred compensation plan holds a corporate-owned life insurance policy (COLI), and his team matches monthly whatever participants choose as investments in the COLI.
- “There’s a line item mismatch, and it’s a little more complicated, but that also works,” he said.
- Another AT said his firm had taken a similar approach, investing in the underlying assets and then rebalancing regularly through a so-called rabbi trust. However, the financial statement mismatch could at times be significant, so it switched a few years ago to TRS hedges.
- “There are a lot of benefits to TRSs,” he said, including better financial statement alignment and tax benefits.
Collateralized? Roger Heine, senior executive advisor at NeuGroup, asked whether the mark-to-market value of the TRS must be collateralized.
- The AT said the swaps net against the company’s entire portfolio and barely register amidst the company’s several billion dollars of posted collateral. “We settle monthly, so the marks never get too big and they’re usually a nonfactor,” he said.