United States: In Defense of Deferred Compensation – The Last Win-Win in Corporate America

A July 2003 issue of The Economist magazine contained an article that referred to the deferring of one’s pay as being part of a "lavish pension scheme confined to top executives." The implication of these carefully chosen words has two components: there’s "lavish pension", meaning that the amounts being discussed smack of royal excess. And then there’s "scheme confined to top executives" – read "ENRON".

Deferred compensation plans are only one in the line-up of nonqualified financial savings and reward vehicles used by large companies to attract and retain their key executives. Other nonqualified plans include SERPs, stock options, restricted stock and several others in countless variety. Deferred compensation plans most certainly do provide significant advantages to the companies that offer them and to plan participants, but they could not reasonably be considered "lavish", even on their best day ever. And as to being confined to top executives, deferred compensation plans are often made available to individuals earning in excess of $100,000 annually – not exactly the crowd you’d expect to see hanging around with Ken Lay or Dennis Kozlowski.

They provide participants with the only meaningful way of saving money on a tax-deferred basis. They cause no dilution in ownership that can negatively impact shareholders. As a tax-deferred vehicle, they are virtually revenue neutral from the U.S. Treasury perspective. And, when properly structured, they succeed in aligning the interests of management with those of the company, its shareholders and its stakeholders.

The backlash against anything even remotely connected to executive compensation is far from being driven by rational thought. We as a nation are irate about not being able to retire early on our E*Trade balances. We’re beside ourselves that "the Dennis" has a $15,000 umbrella stand courtesy of Tyco shareholders. And we’re not at all certain that our government is going to wreak adequate vengeance on those who wronged us.

Were our current circumstances happening in the Old West’s’ Dodge City, we’d be formin’ a posse ‘cause they’re gittin’ away.

Of course, all of this is predictable from an historical viewpoint. Our country has seen several bubbles burst and the fall-out always includes a smattering of irrational and misplaced aggression. But the bubble that burst in 2000 had been blown so big that more than three years later, we’re still trying to get the gum out of our national hair.

American business is under fire from all sides. The media, which helped executives attain super-star status just a few years back, now report any compensation received by executives as yet another blue dress – proof that our capitalistic system is rotten to the core. Trial lawyers, fat from attacks against Big Tobacco, are lining up like minor league baseball players at major league try-outs, hoping to hit one out of the park.

Shareholder groups which, by the way, should not be confused with groups of shareholders, are popping champagne purchased with union dues. And politicians, bored with promising to fix the health care system, have found their issue for 2004.

Yes, it’s anything but rational, but it sure does sell newspapers.

The recent proposals to restrict the use of nonqualified deferred compensation are an example of such a shotgun approach to getting the "bad guys".

In a typical deferred compensation plan, participants defer their own compensation, a percentage of the money they were due to receive anyway. We can argue until the three bears return to the estate whether that amount is too much, too little, or just right, but that issue has nothing to do with the appropriateness of deferred compensation plans. The amounts deferred by participants are amounts that the company would have paid out regardless of whether deferred or not.

While it is true that plan participants do not pay tax on their deferrals until they actually receive these monies, it is also true that the company doesn’t take the salary expense tax deduction until then either, so the impact on U.S. tax revenue is virtually nil.

Most importantly, traditional deferred compensation plans offer no assurance that when the time comes to pay out monies from the plan, those monies will be available for that purpose. Amounts deferred go into the company’s coffers making plan participants unsecured creditors of their companies. Should the company become insolvent, participants in a deferred compensation plan stand in the same line as the general creditors. Some companies place deferrals into a trust, known as a Rabbi Trust, which protects the participant from the company or new management changing its mind about keeping its promise to pay, but that trust does not protect those funds from the claims of creditors should the company become insolvent.

If this doesn’t sound good to those crying for the alignment of management’s interests with those of shareholders, it’s only because their chanting has grown so loud as to make it impossible for them to hear anything at all. This disgruntled segment of the population wants nothing but to see Yahoo! trading at $200 again. Executives, they argue, should only be paid if the stock is up at any given moment. Which moment? The moment of their choosing, of course.

It might be of some interest that the S&P 500, as of July 1, 2003, was trading at a P/E of 33, based on past profits. That’s higher than it was at the market’s peak in March of 2000. Is that relevant to the country’s opinion of the market? Apparently not. When unemployment is up, incomes are down and things seem generally yucky, we all start to worry that the only bull that will return to the Street won’t have horns.

Then the cycle cycles and it’s hard to remember why we were all so upset. (Remember the S&L crisis? Neither can we.)

Perhaps the best thing about deferred compensation plans is that they help to strengthen the company while at the same time benefiting those eligible to participate.

Deferred compensation plans are the only viable method for a highly compensated individual to save on a tax-deferred basis. Oh, there’s the 401(k) too, but the limits on contributions imposed under IRS and ERISA regulations make them only moderately attractive to those earning over $100,000 a year. Qualified plans, such as the 401(k), cost the government a lot of money. Not only are participant contributions tax-deferred, but the company takes the salary expense deduction for those contributions in addition to any matching amounts contributed. As a result, there are limits on how much retirement saving the government will subsidize.

The rule of thumb is that you should have a retirement fund sufficient to produce annual income at least equal to 60% of the final working year’s income. So, if you make $50,000 a year, you should plan on needing $30,000 a year in retirement. And at that level, the 401(k) plan works just fine.

Highly compensated individuals, however, have a much different road to hoe when saving for retirement. If a given executive earns $300,000 in his or her last working year, the rule of thumb dictates that annual retirement income needs to be $180,000. And that is where the 401(k) plan fails miserably.

At the risk of sounding elitist, $300,000 a year, while nothing to sneeze at, is not a huge amount of money these days. If you’ve worked hard enough in life to earn that amount of money each year, why should you be penalized when saving for retirement?

Deferred compensation plans are used by their participants to do just that. They do offer an element of risk to be sure, but they reward their participants without significant cost to the company, its stakeholders or our nation as a whole.

The abuses of the late 1990s are to be abhorred. Those who broke the law should be punished. The stock market will ride the bull again and future bubbles will again go "pop".

While we’re all waiting, some more patiently than others, let’s not strip legitimate American businesses of the tools that have served us so well for so long. The tolerance for risk, free market economics, capitalism and democracy must not be allowed to be weakened by our need for vengeance. There is only one way back and that’s through the growth of American business. Hang the bad guys if you will, but reward those who are guilty of nothing but pursuing the American dream.