This document discusses non-qualified deferred compensation programs (LTIPs) for private companies. LTIPs are used to reward and retain current employees, attract new employees by focusing on long-term results, and supplement tax-qualified retirement programs. LTIPs can take the form of equity shares, stock options, phantom shares or fixed/variable payments. Employers must consider who participates, what triggers payment, the payment form, amounts, and compliance with IRS rules. Benefits are unsecured and subject to employer credit risk, so some employers informally fund LTIPs using assets like corporate-owned life insurance, which provides tax advantages over mutual funds. The design process involves determining performance requirements, analyzing reward structures, and funding
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Today’s Topics
• Why should employers use long-
term incentive compensation
programs (LTIP)?
• What types of LTIPs are commonly
used by privately held companies?
• How do LTIPs operate?
• How does an employer pay for
an LTIP?
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Why Are LTIPs Used?
Current employees
• Reward for past performance
• Retain/golden handcuffs
• Supplement tax-qualified
retirement programs
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Why Are LTIPs Used?
Attract New Employees
• Both new and current—
Focus on long-term results
Motivate
• Employer—cash flow
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How Do LTIPs Operate?
Form: A written agreement between employer and employee
setting out
• What must be accomplished to earn the award
• Defining the award—form and amount
• Terms for payment
Administration: legal formalities; employee communication
• Financial statement/tax consequences depend on the form
of the award
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Award Forms Used By
Privately Held Companies
• Equity-related
Actual shares
(outright/restricted)
Stock options/incentive
stock options
Phantom shares/stock
appreciation rights
• Fixed/variable dollar payments
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How Do LTIPs Operate?
Design issues:
• Who participates?
• What must occur for the award to be paid?
• Form of the award
• How much should be awarded to each participant and to
the participants as a group?
• Employee choice and Internal Revenue Code Section
409A
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Benefit Security
• “Top Hat Plans” for select group of
highly-compensated key executives
• Nonqualified benefits are
contractual obligations of the
employer
• Plan Participants are unsecured
creditors
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Benefit Security
Unlike qualified plan benefits,
nonqualified plan benefits are
subject to risks arising from:
• Change of Heart
• Change in Control
• Change in Financial Condition
• Insolvency/Bankruptcy
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Why Secure
Nonqualified Benefits?
• As discussed, the primary
purpose of plan is to attract,
retain, reward and motivate
key employees
• Benefit may be a significant
element in participant’s
retirement resources
• Secure benefits increase the
value of the promise.
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Why Companies Choose
Not to Secure Benefits
• Corporate philosophy
• Many are rethinking
securitization because of:
Stock Market Performance
Business Cycle Risks
Growing nature of the liability
Cash flow management
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Informal Funding
• Plan is technically “unfunded”
54% of companies surveyed informally funded the plan*
• Employer sets up sinking fund to match future
benefit liability (Asset/Liability Matching)
• Asset subject to claims of creditor
• Asset held by the employer or a trust
* From responding employers of the Newport Corp 2-17 benefit survey
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Trust Held Assets
• Irrevocable Grantor Trust
(Rabbi Trust)
• Assets may only be used
to pay benefits
• Assets remain subject to
claims of creditors
• Assets and income reflected on
balance sheet and income statement
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Trust Held Assets
• No deduction for contribution
• Unused assets revert back to
employer
• Use is prevalent and
consistent with section 409A
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Types of Assets Used
Mutual Funds
30%
Corporate Owned Life
Insurance
60%
Other
* From responding employers of the Newport Corp 2-17 benefit survey
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Mutual Funds:
The Tax Problem
• Capital Gains created when employer sells share to:
Generate fund for benefit payments
Fund transfer for asset allocation purposes
• Pass-through income distributed by fund
Dividends
Interest Income
Capital Gains
• Employer has no control on timing
• Taxation can occur when fund has negative returns
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Corporate Owned
Life Insurance (COLI)
• Corporate Owned Life
Insurance (COLI) is the
primary funding asset largely
because of its tax benefits
Tax-free Cash Value Growth
Tax-free Distributions
Tax-free Death Benefit
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COLI- Pricing & Design
• Retail products
Available to broad segment of the market
Low face amount/premium requirements
Relatively higher policy expenses
• Institutional products
Not generally available to individual purchasers
High minimum face amount/premium/case size
Reduced expenses reflecting favorable mortality experience and
economy of scale
• Defined contribution funding
• Minimum death benefit design
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COLI Implementation
• Insure some or all participants
• Premium determined by funding objectives
• Employer/Trust is owner & beneficiary
• Individuals must consent to be insured
• Guaranteed and simplified issue underwriting may
be available
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COLI Advantages
• Institutional pricing and design minimize expenses and
maximize policy cash value
Cash value may equal or exceed premium in first year
Expenses generally less than taxes in mutual fund alternative
• Death benefit is a cost recovery mechanism
• Flexible options to determine cash value growth
Fixed
Variable
Equity Indexing
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COLI Disadvantages
• Investment losses are
not deductible
• Legislation risk that
favorable tax treatment
could be modified
• Participant may need
to qualify medically
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Summary
• Informal funding can increase the value of the promise as
well as help:
Manage the expense liability
Provide better overall cost management
Provide source of funds for future benefit payments
• COLI may be a better funding asset:
Expenses in the contract are less than taxes on taxable mutual
fund alternative
Death benefit provides cost recovery mechanism to reduce plan
costs
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The Design Process
• Determine what the employer
expects the participants to do to
earn the reward
• Analyze reward choices from
employer and employee viewpoint
• Model award amounts in total and
per employee for financial
statement/tax/cash flow impact
• Determine funding methodology