A clever person once said it’s “difficult to make predictions, especially about the future.” This is true with most things, and it’s undoubtedly true with investing. However, despite the unpredictability of the future, there comes a time when we must place our bets and choose a direction—Ideally, one that tips the odds in our favor.
409(a) Nonqualified Deferred Compensation Plans present one of these opportunities. You willingly forgo income today with the faith that your company will survive many years into the future to make good on this liability to you—all for a tax benefit that tips the odds in your favor.
As a participant in your company’s deferred compensation plan, you’ve become an unsecured creditor of your company. You should think about that opportunity as skeptically as a bank underwriter would when approving a loan. As Andy Grove once said, “only the paranoid survive.”
There are always unknowns when it comes to the future of any investment, but to make matters worse for Intel employees, at yet another inflection point in the company’s history, the uncertainty has taken center stage.
Competition closing in, manufacturing delays, and considering, for the first time ever, outsourcing the manufacture of some of its most advanced chips. The stock market has noticed these challenges, with Intel shares down 22% year to date compared to up 10% for the market overall and up 30% for the Technology sector.
All these “unknowns” and Intel’s recent stock market performance cause many participants in Intel’s Deferred Compensation program (SERPLUS) to wonder—should I not defer money this year or change my deferral strategy?
This article will provide a framework to think about this decision and offer potential options for those with money already in the plan to offset some of their risk. This framework is specific to the Intel SERPLUS fund but can be generalized to any deferred compensation decision.
We’ll start but covering the advantages of deferred compensation (why would you do it in the first place), talk about the risks and how to measure them, look at the individual factors to consider when making your decision, and finally look at potential strategies for offsetting your risk.
Let’s dive in.
The Benefits of Deferred Compensation Plans
Deferred compensation plans have been around for decades, promising two potential benefits. Initially, with top marginal tax rates as high as 90 percent in the 1960s and 70 percent in the 1970s, these plans’ primary benefit was to shift income into lower-tax, retirement years. Now, with lower tax rates (the top marginal income tax rate is 37 percent + 2.35% Medicare), tax brackets fairly compressed, and higher executive compensation (meaning potentially large payouts from deferred compensation and other assets in retirement), most tax analysis is done at the top marginal tax bracket both pre and post-retirement (except for state income tax planning which we will address in a bit).
Today, these plans’ main benefit is the tax deferral feature—the ability to invest your money pre-tax and have it grow untaxed until the money is paid out.
The longer the tax deferral is in place, the more valuable this is. Deferring taxes one year before retirement and then over a 10-year distribution schedule has value, but deferring taxes for 20 years (allowing your money to grow pre-tax) has a lot more value. Of course, this comes with the risk of your company not being around to make good on its deferred compensation obligations in 10 or 20 years.
Using the assumptions listed in Table 1 below, we can see that deferring income for ten years for an individual at the top marginal tax bracket (37% income tax + 1.45% Medicare + 0.9% Medicare on wages over $200k) and earning a pre-tax return versus an after-tax return results in $22,000 more of wealth even after paying income taxes on your distribution from the deferred compensation plan.
Behold the power of compounded tax-free gains!
Table 1: Tax Calculations – Tax Deferred vs. Taxable
Furthermore, as you can see in the next chart, the longer taxes are deferred, the larger the benefit.
Source: Cordant’s Calculations using assumptions listed in Table 1
Not to be overlooked, another benefit of these plans is any company matching benefit. In 2020, for example, the Intel plan offered to match SERPLUS deferrals up to 5% of “excess pay” (pay above $285k in 2020). So, if your salary and bonus totaled $385k ($100k excess pay), you would want to defer at least $5k to get the full match (5% of $100k).
[See our full article on Intel’s SERPLUS match and the changes put in place for 2020, here.]
Lastly, as we alluded to before, even with Federal taxes being low by historical standards, there remains an opportunity for some to defer and potentially avoid state income tax. Current residents of Washington state (or future in the case of those who move out of Oregon at retirement) pay Oregon income tax on earnings while employed in Oregon. However, if the SERPLUS ten-year payout option is selected, the state tax is based on your state of residence at distribution. So, for many the ability to defer income and avoid the 9% Oregon state income tax by living in Washington state is another big potential benefit of the Intel Deferred Compensation plan.
The Risks of Deferred Compensation Plans
The primary risk of nonqualified deferred compensation plans is that they are, by rule, unsecured liabilities of the company. Your deferred compensation becomes just another liability. You become a creditor of your employer—and lower in priority to any creditor whose loan is secured by the company’s assets.
In addition, when you elect to receive your compensation, that is how long you defer it, is set up front and can’t be changed in most circumstances. Again, this is by IRS rules. You must select your distribution schedule before deferring any income (during your election period), and, except under rare circumstances, you cannot change that. (And typically, if you can change it, you cannot accelerate it. You must elect to receive it even further down the road).
So, you have a situation where you might not see your money until as much as ten years after you retire. For someone younger in their career, this could mean deferring money now, working for another ten years, and then getting the money paid out over the next ten years. In other words, deferring money now and not getting paid back for another 20 years.
So, accessing the financial risk of your company is important, but how to do that?
One way to look at it is simply the average failure rate of publicly traded companies. On average, around 80 public companies file bankruptcy each year. During a recession, this number obviously goes up (136 and 210 filed for bankruptcy protection in 2008 and 2009, respectively) but drops in times of economic expansion (58 and 64 filed in 2018 and 2019, respectively). Taking that 80 companies per year into the 3,700 listed companies here in the U.S. tells us that roughly 2% of public companies file bankruptcy each year.
Of course, not all companies are created equal. Smaller companies should be at higher risk, and Apple isn’t the same risk as J.C. Penny. And of course, even in the case of bankruptcy, some creditors end up recouping a portion of their money.
A more robust way to assess firms’ bankruptcy risk was developed by NYU Professor Edward Altman in the late 1960s, which he called the Altman Z-score. His Z-score uses a blend of publicly available financial statement information (working capital, retained earnings, profit, market value, assets, and liabilities) to predict companies’ bankruptcy risk (at least in the near term).
The higher the score, the better:
- The “Safe Zone” is a score of 3 or higher.
- The “Grey Zone” is a score between 1.81 and 2.99
- The “Distress Zone” is a score of less than 1.81
Currently, Intel’s Altman z-score is 3.59, in the safe zone but has been trending down for the last decade and lower than competitors AMD and NVIDIA. (See chart below)
It appears Intel is safe in the short term, but obviously, with deferred compensation plans, we need to look out many years in the future. Here is where factors specific to you as an individual come into play.
Go/No Go: Three Factors to Consider When Making the Deferred Compensation Decision
In addition to your company’s credit risk and future prospects, several factors specific to your financial situation need to be considered.
- Your current exposure to the company: This includes your salary and any stock you own in your company. The more dependent you are on your current salary and the more stock in your employer, the more you will be negatively impacted by poor company performance in addition to your risk in your deferred compensation plan.
- How much of your existing net worth is already in the deferred compensation plan? If a large portion of your net worth is already tied up in deferred compensation, the more risk you have if something goes wrong.
- How long do you have until retirement? Again, the longer you have until retirement, and therefore the longer the money will be shielded from taxes, the more significant the potential benefit.
Now, you could certainly imagine a scenario where a company stock, due to slowing growth or other factors, goes nowhere for a decade (think IBM), but the company still remains a viable company. However, it’s less likely (although not impossible: hello, Hertz!) that your company is in financial distress, but the stock price holds steady. For this reason, if you’re worried about your company’s future prospects, selling your company stock may be the right place to start.
However, if you do decide to defer money, you’ll have another three decisions to make:
- How much to defer?
- When to distribute?
- How to invest?
These final three decisions we cover more in-depth here: The Four Factors to Consider When Making Your SERPLUS Elections
This is, without a doubt, a lot to factor in. The best way to do this (and what we do for clients) is to have a model that lets us do different scenario analysis to make an informed decision based on both individual factors and your company’s outlook.
Strategies to Offset the Risks in Deferred Compensation Plans
For the majority of those deferring compensation at the majority of public companies, things will work out fine. But for those wishing to take some risk off the table, here are a few options.
Shift Your Risk – Sell Equities
One way to reduce your risk in your employer is to sell the company stock you hold instead of making a change to your Deferred Compensation. Obviously, if the company is in trouble, the stock price will decline in addition to the credit risk increasing. But you could imagine a scenario where the stock price declines but the company remains solvent. By selling stock and deferring compensation, you transition your risk from equity risk to credit risk and (at least theoretically anyway) higher up in the capital structure.
Here’s how you might combine deferring compensation along with selling your existing shares to lower your risk in the future viability of your employer and still reduce taxes along the way.
- Assume you need $120k for living expenses
- After income tax (rounded to 40%), that requires a salary/bonus of $200,000 (200,000 * (1-.40) = $120k)
- For those holding company stock, another way to generate $120k for living expenses is from selling that company stock.
- This exploits the difference in tax rates between income and capital gains.
- To generate $120,000 in cash you could sell $157,480 of company stock ($157,480*(1-.238) = $120k). Furthermore, this assumes a $0 basis…any higher basis means less tax and, therefore, fewer shares sold.
- This technique does three things:
- Allows you to save $42,000 in taxes in the current year, and
- Allows you to trade equity risk in your company for, theoretically safer, credit risk
- Shifts a concentrated equity position to a more diversified portfolio
This first technique trades one type of company-specific risk for another (and saves taxes along the way). Now let’s look at a couple of options to actually hedge the risk in your employer.
Buying Deep Out-Of-The-Money Puts
Buying a put gives you the right to sell stock at a price set today and therefore profit if the price drops below the strike price. Using puts to hedge your Deferred Compensation plan could be structured as follows:
- Let’s assume you have deferred $1 million into Intel’s SERPLUS plan.
- You buy 50,000 January 2023 put options at a $25 strike for $1.27 (price as of 11.11.2020)
- If Intel’s share price declined to $5 between now and January 2023—which it’s assumed it would do if it is in (or on the verge) of bankruptcy—your profit equals $1 million $20 per option times 50k options.
- Your cost for this protection equals $63,500 ($1.27 x 50k)
- The total cost for this insurance is 6.35% of the amount hedged or a little more than 3% per year.
It’s common for listed options only to extend out a couple of years, so with this strategy, you would either need to roll it every other year, or you could potentially work with a trading desk to create a longer-dated, custom option.
This 3% cost per year is obviously not cheap, and many companies will prohibit executives from shorting their company stock (which buying a put is typically considered since you profit if the price of the company stock falls).
Due to these restrictions and the cost, let’s look at one more option.
Deferred Compensation Protection Trust
A more recent entrant into this space is the Deferred Compensation Protection Trust. Developed by a company called StockShield, this trust essentially pools your risk with others across various companies and industries. An example of how this works according to their website:
Twenty (20) participants, each with a certain minimum balance in an NQDC [Non-Qualified Deferred Compensation] plan sponsored by a different company in a different industry, deposit a small amount of cash (e.g., 1%) for each year of desired protection (minimum 5 years). The pooled cash is invested in U.S. Treasury Securities. At the end of the term of the trust, the assets pooled in the Trust are paid according to the number of bankruptcies.
Assuming your company files bankruptcy in the period covered, the pooled funds would be used to offset your loss. If no companies in the pool file bankruptcy, the funds are returned minus trust expenses.
1% per year for protection isn’t too bad of a deal, although you run the risk of your losses not being fully offset in the case of multiple bankruptcies.
There is certainly a lot to factor in when it comes to your deferred compensation decision each year. If you pass on participating, you’re potentially leaving a valuable tax benefit on the table, but if you do contribute, you increase the financial risk tied to your employer.
Hopefully, this article has been helpful, but if you’re still struggling to assess this trade-off and make a decision that tips the odds in your favor, get in touch. We’d be happy to talk about how we can build a financial decision-making model for you to run scenarios on these and any significant financial decisions you’re considering.