In this post, we cover three ways you can reduce the risk you have in your deferred compensation plan (DCP) for those that have a substantial portion of their net worth tied up in deferred compensation.
409(a) Nonqualified Deferred Compensation plans present a fantastic way to defer taxes and build net worth. But, after many years contributing to the program coupled with investment gains, these plans can become a substantial portion of your net worth.
And because these plans are an unsecured liability of your employer they come with more risk than other forms of tax-deferred savings, like your 401(k).
So, in this post we’ll outline three ways you can hedge or offset this risk. For assessing how much risk you have in your DCP, see our Tech Employees Guide to Deferred Compensation Plans.
Strategy #1: 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 by 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). For this example, we’re assuming a $0 basis for the company stock, but if you have higher basis this 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 directly hedge the risk in your employer.
Strategy #2: 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.
We’ll use Intel as an example. Using puts to hedge Intel’s Deferred Compensation plan (SERPLUS) could be structured as follows:
- Let’s assume you have deferred $1 million into the Intel SERPLUS.
- You buy 50,000 January 2023 put options at a $25 strike for $1.27 (price as of November 11, 2020)
- If Intel’s share price declined to $5 between now and January 2024—which it would do if it is in (or on the verge) of bankruptcy—your profit equals $1 million ($20 per option x 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.
Strategy #3: 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. Here’s 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 five years). The pooled cash is invested in US 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.
A Free Deferred Compensation Election Assessment
Obviously, there is a lot to assessing the risk of your DCP and to balance the risk and rewards of the plans.
That’s why we created a Free Deferred Compensation Assessment. In the assessment, we’ll answer the key questions outlined in this guide specific to your situation. We’ll analyze:
- Your risk level in your employer’s plan
- Your tax benefit of participating
- Potential contribution amounts
- Your current and future distribution schedule
For a sample of the assessment and to sign up, go here.