Hedge behind a shelter
European companies doing business in the US have a fresh incentive to fund the supplemental pensions and deferred compensation promised to key employees while they are still working.
Advance funding of these obligations has been unattractive to many corporate financial officers because the net investment returns, even if sheltered under the tax umbrella offered by life insurance contracts, could not match the after-tax hurdle rates on internal capital projects.
Now, thanks to innovative new contracts, advance funding will make economic sense. These specialised contracts, known as Private Placement Variable Universal Life (PP_VUL), are only available to qualified investors through private placement offerings. With minimum premiums of $1m–5m, they have two main features: they widen the range of available investment strategies to include hedge funds; and dramatically reduce commissions and administrative charges.
Lower expenses reflect economies of scale and the stability of the resulting business arrangement. Corporate buyers are attracted by the credentials and reputations of the investment managers retained by the insurer. They also understand the power of the tax arbitrage provided by the contract. Trading insurance charges for taxes on investment returns is most appealing, and the economic advantages of the transaction are easily seen.
A 15% return taxed at a 40% corporate rate will give up 600 basis points of that return. With PP_VUL the tax burden is 0% and the annual PP_VUL charges of the most competitive contracts are less than 100bps. The resulting leverage of 6:1 is a happy prospect. The 14% after-tax return will for many corporations be very competitive with their hurdle rates on capital projects, encouraging a decision to fund their supplemental pension arrangements. Likewise, the cost-efficient returns on PP_VUL investments can add significantly to the growth prospects of executive deferred compensation accounts.
Adding hedge funds, which a decade ago were perceived as a niche investment vehicle suited only to high-net-worth individuals and families, is the second incentive for the corporate buyer.
Participating executives will more fully appreciate a funded supplemental pension and deferred compensation programmes. Current funding of the employer’s future obligation to pay supplemental pension benefits gives an assurance that the promise will be delivered on time. Likewise, the opportunity to have their deferred compensation accounts growing at rates of return reflecting the long-term returns on equity portfolios, including hedge funds, enhances their appeal.
From the employer’s perspective, funding during active employment will better track its pension accounting practices. And, having on its books a financial asset that matches its deferred compensation account liability will avoid the unacceptable risks of balance sheet and income fluctuations associated with unfunded deferred compensation programmes that offer equity-type returns.
William Dreher runs Compensation Strategy in New York