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© Copyright 2000 Rogers Media. The following article first appeared in the August 2000 edition of
BENEFITS CANADA magazine.
Executive Sweet
Supplemental Executive Retirement Plans are an important component of plan sponsors' compensation
strategies. More organizations are using this tool as an attraction and retention strategy.
BY KEVIN MORIARTY
It's a hot economy. Rising salaries are bumping up against frozen income tax limits on registered pensions
and employers are looking for incentives that will help attract and retain top-notch talent, particularly
at the executive level. Increasingly, executive salaries are being earned by a wider variety of individuals
in various professions, who are hitting the tax limit ceiling for the first time. These market forces are
resulting in a growing interest in Supplemental Executive Retirement Plans (SERPs).
The Mercer Executive Management and Professionals Compensation Survey reveals that pensions,
including registered pension plans and SERPs, make up about 15% of the average chief executive officer
(CEO) compensation package. Base salary, long-term incentives (primarily stock options) and annual
incentives comprise 40%, 25% and 20%, respectively, of average CEO compensation.
While pensions are not a primary source of compensation for executives, they are far from insignificant.
Indeed, The Mercer Executive Management and Professionals Compensation Survey (which surveyed 478
public and private sector organizations ranging in size from less than 500 employees to more than 5,000
employees) indicates that 46% of respondents offer SERPs. That finding is similar to results from the
Toronto Stock Exchange 300 composite index, which show that about half the companies listed on the index
have SERPs.
The Mercer survey also shows that 27% of organizations offering SERPs provide them to all employees
affected by the Income Tax Act limits on registered pension accruals. Almost all the plans mirror the same
pension formula as the underlying registered plan, pointing to a standardization in plan design.
SPECIAL PROVISIONS
SERPs tend to be more generous and customized at the higher end of the corporate ladder. Of the 62% of
SERPs that are reserved for a limited group of designated executives, some 16% provide special provisions
for mid-career hires. A typical provision provides two years of credited service for every year of
continuous service. Meanwhile, 11% of SERPs are given only to CEOs. Almost half of CEO SERPs have a pension
formula that is different from--and usually better than--the formula for other employees.
Traditionally used as a golden handcuff, with benefits frequently forfeited if a member terminated
employment before they were eligible to retire, SERPs are increasingly used as a valuable attraction and
retention tool.
About 70% of all SERPs provide vesting based on the same or more generous rules than the underlying base
plan. In other words, vesting usually occurs after two years or less of plan membership. Similarly, SERPs
used to have restrictive covenants such as non-compete clauses. But now, 68% place no conditions on the
payment of SERPs, and their main purpose is to provide retirement income. Again, this trend reflects the
fact that an increasing number of non-executives are now covered by SERPs.
Considering that the Income Tax Act limit on registered pension accruals has not changed significantly
since 1976 when it was five times the industrial wage, SERPs are more instrumental than ever in keeping
sought-after executives.
SERPs have traditionally been documented by a letter or a brief agreement between an employer and an
executive. But as coverage extends to a growing number of employees, more detailed documentation is
required. In particular, if a plan is secured, a proper description of how the SERP liabilities are
determined, and how the security mechanism works, must be included in plan documentation.
According to the Mercer survey, 31% of SERPs secure the benefits of active employees against the employer's
creditors. This is up from 24% just two years ago. In contrast, the Financial Executive's Institute 1998
survey (which focuses on a small group of large employers) reports that 45% of SERPs are funded.
The survey illustrates that two-thirds of SERPs are secured through a funded retirement compensation
arrangement (RCA) holding assets equal to the plan liabilities. The rest are secured through a letter of
credit held in an RCA trust. Other means of security include terminal funding, or for smaller companies,
insurance arrangements. The most common arrangements, however, remain funded RCAs and letters of credit.
There are a number of reasons driving the security trend. For one, high-profile corporate failures such as
Confederation Life have fuelled concerns over security. In addition, misunderstandings about the methods
and costs associated with securing executive pensions are now being clarified. In the process, many plan
sponsors are discovering that security is not as costly as they once thought.
Currently, the two most common methods of securing SERPs are a funded RCA and an RCA holding a letter of
credit. These instruments provide full security of an employee's retirement or termination benefit--if they
are properly set up.
Security can be provided during an employee's career or on a terminal basis at retirement. Terminal funding
is similar to purchasing a prescribed annuity when an employee retires. Once again, life insurance is a
third method of security, but it is rarely used in Canada by mid- to large-sized organizations.
An RCA is a trusted arrangement under which employers can make tax-deductible contributions to fund a
supplemental retirement plan. Employee contributions are tax deductible if they are required and do not
exceed the amount contributed by the employer.
Under a funded RCA, one-half of the book value of the plan assets is held by the RCA trust while the other
half is held in a refundable tax account with the Canada Customs and Revenue Agency (formerly Revenue
Canada). The net effect is that investment earnings in the RCA are taxed at the rate of 50%. No distinction
is made between interest income, dividends and realized capital gains. As is the case for all taxpayers,
unrealized gains do not trigger the 50% refundable tax.
As an alternative to funding, an RCA trust can also hold a letter of credit (see "Writing letters of
credit," page 64). The letter of credit provides the trustee with access to a bank's funds to pay benefits
in the event that the employer is unable, or even unwilling, to pay the executive pension.
A letter of credit is an agreement by a financial institution to pay the holder an agreed-upon amount if a
specified event occurs. For executive pensions, the face amount of the letter of credit is usually equal to
the accumulated pension liability.
Letters of credit have been successful in protecting executive retirement benefits in instances of
corporate bankruptcy. For example, Woodwards department store had a letter of credit for its executive
pensions. When the company became insolvent, the letter was challenged but, ultimately, it was successful
in protecting plan members.
WEIGHING THE COSTS
The downside to a fully funded RCA is that initial cash flow requirements are significantly higher than for
a letter of credit. However, the RCA contributions in the funded arrangement will be used to pay pension
benefits, and the cost of security must be separated from the cost of paying pension benefits.
The RCA is still regarded as costly because of its refundable tax. To the extent that the employer's
after-tax cost of making the RCA contribution is higher than the RCA's after-tax return (because the
employer tax rate is less than 50%), the cost of the RCA rises relative to an unfunded plan. While the
employer's after-tax cost is often difficult to determine, RCA contributions typically come from borrowed
assets or excess cash reserves.
For example, if an employer with a 40% tax rate has built up a cash reserve and is investing it at 7% with
the intent of using the assets to pay supplemental pensions, the organization earns an after-tax return of
4.2%. But the assets are not secured from creditors. If the company contributed the assets to an RCA
arrangement, its cost of making the RCA contribution is the 4.2% investment return forgone. However, the
RCA would earn an after-tax return of 3.5%. Overall, the net cost of securing the SERP arrangement is equal
to 0.7% of the SERP liability.
If the employer secures SERP liabilities using a letter of credit where the fee charged by the employer's
bank is equal to 0.5% of the face amount of the letter of credit, the expense is equal to the fee, plus the
opportunity cost on the matching contribution to the refundable tax account. Depending on the length of
time until the RCA tax account is refunded, the cost of the letter of credit will be between 0.5% and 1% of
the plan's liabilities. This annual cost is comparable to the funded RCA arrangement.
If the organization did not pay any tax, its after-tax return on the cash reserve would equal the pre-tax
investment return of 7%. However, the company will still earn 3.5% in the RCA. Therefore, the net cost of
funding through the RCA equals 3.5% of the plan's liabilities. If the letter of credit's cost remains at
the same 0.5% to 1%, the funded RCA is more expensive.
Ultimately, the cost of securing supplemental pensions depends on both the employers' corporate tax rate
and the fee for the letter of credit. Organizations that are tax-exempt, or have built up significant tax
losses, may find the letter of credit less expensive. It's worth noting that a few organizations have
recently adopted funding strategies that allow them the flexibility of moving between letters of credit and
RCA funding.
The overall trend in these developments stems from the focus on retirement security when providing SERPs.
Interestingly, the growth of stock options as a means of rewarding performance does not appear to have had
much effect on this trend.
It's also evident that unsecured SERPs will increasingly be viewed as having little value compared to the
growing number of secured SERPs. Prudent and progressive organizations offering secured SERPs will have a
far better retention and attraction tool than their counterparts.
Kevin Moriarty is a principal with the retirement consultant practice of William M. Mercer Limited in
Toronto.
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WRITING LETTERS OF CREDIT
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HOLD IN TRUST. The letter of credit must be held in trust because if the employer holds it directly,
the proceeds are available to all creditors--not just pensioners--in case of insolvency. The employer
pays the letter of credit fee to the trustee. The trustee then pays the bank to buy the letter. The
employer continues to pay pension benefits directly to the employee.
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RENEW ANNUALLY. The letter of credit is irrevocable and must be renewed annually. Payment is triggered
on the failure of the employer to pay the promised pension or to renew the letter of credit. The annual
letter of credit fee is usually 0.5% to 1.5% of the face amount. The cost is primarily determined by
interest rates, the employer's credit rating and the face amount of the letter of credit.
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MAKE CONTRIBUTIONS. Contributions to pay the fee are subject to the 50% refundable tax because letters
of credit are held in an RCA. Therefore, employers must contribute an amount equal to twice the letter
of credit fee--half goes to the bank and the other half to the government. The tax is refunded when the
RCA trust is wound up. In the meantime, the refundable tax is an asset of the plan and it can be used
to reduce the face amount of the letter of credit.
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