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How Tax Reform Changed the Hedging of NQDC Plans

David J. Marshall, Benjamin R. Eisler

Historically, when determining how to hedge Nonqualified Deferred Compensation (NQDC)


plans, companies have considered three main factors: elimination of P&L volatility, use of balance sheet,
and tax efficiency. Not much has changed in terms of balance sheet or eliminating volatility. A lot has
changed with regards to tax efficiency. For multiple reasons, the efficiency of tax-sheltered products like
Corporate-Owned Life Insurance (COLI) has significantly declined.

Below, we detail how COLI has been affected, how companies can continue to get the most out
of their COLI, and innovative alternatives to COLI that many companies are now utilizing.

Key Takeaway: COLI’s Relative Value Has Been Reduced


COLI is often described as a portfolio of investments with a life insurance wrapper. In exchange
for paying insurance-related fees, it allows companies to generate earnings tax-free. COLI was often sold
on the basis that the tax benefit of the product exceeded the costs of the product. This may no longer
be the case.

• The large drop in tax rates caused an equally large drop in the tax savings that COLI provides.
• BlackRock now predicts equity and fixed income returns to be lower than in the past. Lower
earnings mean lower taxes on those earnings – and an even lower tax savings from COLI.

The question now is, given that COLI-related fees range from 50-150 bps, does COLI still make
economic sense? The table below reveals the answer. It shows the earnings required, at different
expense levels, for the tax savings that COLI provides to exceed its fees (fees include premium taxes,
cost of insurance, M&E charges, administrative charges, and broker commissions). Considering these
fees often total 125 bps and that much of COLI is in money market and shorter duration fixed income, it
is clear that much of COLI is not earning the 5.06% in the table below, and thus is not economic.

COLI Earnings Now Required for COLI to Be Economic

Earnings
Required
50 bps 2.02%
COLI 75 bps 3.04%
Expense 100 bps 4.05%
Level 125 bps 5.06%
150 bps 6.07%
*Uses the average combined state and federal corporate tax rate of 24.7%.
Even prior to these recent developments, COLI had shortcomings:

• Ties up significant capital that could earn higher returns in company’s core business
• Typically does not eliminate volatility in Compensation Expense or Operating Income caused by
the NQDC plan (COLI earnings are generally recorded in Other Income)
• Over-hedges the NQDC plan if used to fund 100% of the liability: increases in the liability flow
through the income statement after-tax (pre-tax expense less a deferred tax asset) while COLI
earnings are tax-free (no deferred tax liability is required under GAAP)

All of this said, there are actions companies can take to get the most out of their COLI in this
new tax environment, and there are alternative strategies that may offer substantially more value.

Key Takeaway: COLI’s NPV, Accounting Treatment, and Hedge Can Be Improved
As described above, a sizeable portion of COLI is allocated to money market and shorter
duration fixed income. This is because COLI investments typically map to NQDC plan allocations, and
those allocations are made by participants saving for retirement. This creates a challenge for COLI
because these investments generate lower returns for which COLI may not be financially beneficial.

One solution is for the company to continue to hedge the volatile portion of its NQDC plan with
COLI, and allocate the remainder of the COLI to a stable value or guaranteed return fund. Alternatively,
the company can allocate its entire COLI cash value to a stable value or guaranteed return fund, and
then hedge the volatile portion of NQDC plan with a dynamically re-weighted Total Return Swap (TRS).

The benefits of these strategies are as follows:

• Economic for all liabilities


• Spread income is generated by the stable value (if available)
• Carrier may agree to lower fees, since the COLI is less complex
• If TRS is used, the strategy yields superior accounting treatment; TRS gains are recorded in
compensation expense, directly offsetting increases in NQDC plan
• If TRS is used, the strategy eliminates any over-hedging of the plan

Key Takeaway: Alternatives to COLI Offer Significant NPV, Accounting, Hedge Benefits
There may be some cases where companies want to partially or completely get out of their
COLI. This can generate significant value. A 2017 Columbia Business School study found that switching to
a Total Return Swap can generate an NPV so large that it could pay for as much as two-thirds of the
compensation owed to executives under the NQDC plan. It can yield improved accounting treatment as
well. Unwinding COLI may also, however, trigger a tax expense.

One solution is for the company to withdraw its tax basis in the COLI. The company then hedges
part of the volatile portion of the NQDC liability with COLI and part with a TRS, or allocates the
remaining COLI to a stable value fixed income alternative and uses a TRS to hedge the entire volatile
portion of the liability.

An alternative strategy is to unwind all of the company’s COLI and hedge the volatile portion of
its NQDC plan with a TRS. If company desires to fund its liability, it substitutes a low-cost letter of credit
(LoC) for the COLI funding. While this is rarely done because of significant inside buildup that would be
subject to tax, such an unwind could be executed over several years so that the tax impact is offset by
deductions related to plan distributions.

The benefits of these strategies are as follows:

• Frees up substantial capital that can now earn higher returns in the company’s core business
• Superior accounting treatment (TRS gains are recorded in compensation expense, directly
offsetting increases in the NQDC plan)
• Eliminates any over-hedging
• Economic for all liabilities; only volatile components of the plan are hedged
• If only the tax basis is withdrawn and the policy is Non-MEC, no additional taxes are due

Conclusion
Tax reform and other factors have greatly reduced the value of COLI, but various readily
available strategies can help mitigate this. The optimal strategy can offer substantial value, improved
accounting treatment, and a more accurate hedge. Atlas Financial Partners can provide a customized
model at no cost to assist companies in identifying the best strategy for their needs.