Despite their limitations, the executive pension tables in the proxy are better than nothing. In the S&P 500, 160 companies don’t have the kinds of retirement benefits that they are required to disclose in the proxies’ pension tables. This doesn’t mean that those executives receive no retirement benefits, just that the companies characterize the benefits as something other than a pension, so the benefits don’t fall under the enhanced SEC disclosure rules that companies were required to adopt in 2007. These require companies to place an overall value on their executives’ pension benefits.
Omnicom, for example, established a Senior Executive Restricted Covenant & Retention Plan in 2006 to provide top executives at the global advertising giant with an annual payment, based on salary and years of service, for fifteen years after they depart. John Wren, the company’s chief executive, will receive $1.3 million a year for fifteen years. The retirement payments will grow with a cost-of-living adjustment, a feature that most companies have discontinued in the pensions for regular employees. The liability for this? Anyone’s guess.
Some companies even give the impression that they’ve cut executive retirement benefits. Companies that freeze their regular pension plans sometimes freeze their executive pensions, too, especially when the plan is a so-called makeup, or excess, plan that mirrors the regular 401(k) but allows greater deferrals. But companies may take steps to soften or eliminate the impact. State Street Corp. froze its executive pensions effective January 1, 2008, but awarded executives “transition” benefits that postponed the freeze for two years. Thanks to this feature, and a drop in interest rates and other factors, their pensions rose 47 percent in 2008, and CEO Ronald Logue’s pensions (like most top executives, he has more than one) rose by $7.8 million to $25.3 million. The company also added a retirement savings component to the plan and will contribute $400,000 a year in cash and stock to each executive’s account.
Lincoln National Corp. also froze both its regular and executive pensions in 2008. When it did, it converted the executive pensions to lump sums, enhanced their value by $6.3 million, and added the benefits to a new deferred-compensation plan, to which the company will contribute a minimum of 15 percent of the executives’ total compensation each year. That year, it contributed $12.3 million to the new account for CEO Dennis Glass. The company didn’t enhance the 401(k) plans of regular employees whose pensions it froze.
One thing people can count on: Unlike the pensions of regular employees, executive liabilities aren’t going away. They’re protected by contracts. Though lower-level executives can lose their deferred comp in bankruptcy, the pensions and savings of top officers are usually protected by bankruptcy-proof trusts. Chesapeake Energy, the secondlargest natural gas producer in the United States, doesn’t disclose the total amount it owes executives, but it’s no doubt a hefty sum. Aubrey K. McClendon, the chief executive, had compensation that totaled $156 million in the last three years. He’s also owed $120 million in pension and deferred-compensation benefits. In its annual report, Chesapeake needs thirty-four pages to describe its executives’ retirement benefits. The benefits for 8,200 employees require only half a page to describe—they don’t have pensions.
DEFERRED GRATIFICATION
Pensions aren’t the only executive liability. So is much of their pay. Unlike salary paid out to factory workers or the CFO, deferred compensation creates huge, and largely hidden, obligations. The plans can cover thousands of lower-level executives and other highly compensated employees, who participate in so-called excess plans. These enable employees to defer some of their salary that they can’t put into the 401(k) because of tax laws that limit total employee contributions to $15,000. So if a 401(k) allows employees to contribute 15 percent of pay, someone making $200,000 will be allowed to contribute only a total of $15,000 to the 401(k), and can defer the rest in the excess plan.
These are also called mirror plans, because they “mirror” the 401(k). The only difference is that the amount deferred into the excess plan isn’t actual cash, as it is with a 401(k), but an IOU from the company for the pay. Nonetheless, the employee allocates it among virtual mutual funds—usually the ones available in the 401(k)—and may also receive virtual employer contributions.
Upper-level executives often have more elite deferred-compensation plans that enable them to defer upward of 100 percent of their salary and bonuses each year, and sometimes restricted stock or the gains from exercising stock options.
The deferred pay can grow quickly. Companies might contribute a percentage of what the executive defers or make an outright contribution, no strings attached. The savings grow with returns pegged to investment, or with guaranteed returns—as high as 14 percent at GE. The accounts also grow with company contributions, such as the 20 percent match that drug giant Wyeth provides its top executives. John Stafford, the former chairman, one year collected $3.8 million in interest alone on his deferred-compensation account, valued at nearly $38 million. Together, the value of the company contributions and tax-deferred returns can boost the value of the pay by 40 percent.
Companies are required to report only guaranteed above-market interest paid annually into the accounts of the five highest-paid executives, and include the size of each individual’s accounts in a separate table. But the total amount of all the deferred compensation of hundreds of executives is typically hidden.
Totting up the total amount a company owes its executives can take some creativity. One way to get a sense of their size is to look at a reporting item called a “deferred tax asset.” Companies can deduct compensation they pay, but only when they actually fork over the money (or put money into the pension or 401(k) plan).
When compensation is deferred, companies record a deferred tax asset for the compensation, which is essentially an estimate of how much the company will be able to deduct in the future—when it actually pays executives what it owes them. JPMorgan Chase, for instance, reported a $3.4 billion deferred tax asset for employee benefits in 2007. Assuming a 40 percent combined federal and state tax rate—and backing out obligations for retiree health and other items—this indicates that the financial giant owed its executives $8.2 billion just before the market crisis. Applying the same technique to Citigroup yields roughly a $5 billion IOU, primarily for restricted stock shares of executives and eligible employees. Fannie Mae had a liability of roughly $500 million for executive pensions and deferred compensation at the end of 2007, judging by the size of its deferred tax assets. The liability remained even as the troubled company was placed into conservatorship.
PAY DIRT
By many means, including the relentless cuts to pensions and retiree health benefits, executive pay tied to stock performance and earnings continues to climb. But how much are executives really taking home? For all the hand-wringing by compensation critics, the magnitude of executive pay has remained an elusive figure. But given that so much of it creates an ongoing liability for both the supplemental pensions and deferred compensation, knowing how large the total is can help investors, at least, gauge the pension headwinds ahead.
An indirect way to calculate the percentage of pay executives collectively receive at U.S. companies is to look at payroll tax data compiled by the Social Security Administration, which most people know as FICA. The key: Only earnings up to a certain ceiling are subject to a U.S. payroll tax of 12.4 percent, split between employer and employee, which finances Social Security retirement benefits. The ceiling, which is indexed to the average growth in wages, was $106,800 in 2010. (Employers and employees also each pay 1.45 percent on an individual’s total income, with no salary ceiling, to fund Medicare.)
The Social Security data shows that 6 percent of wage earners have pay that exceeds the taxable earnings base, and that their “covered earnings” above the taxable maximum totaled $1.1 trillion in 2007. Adding the portion of their pay below the taxable wage base, $991 billion, produces a total of $2.1 trillion. In other words, by 2008, executives were receiving more than one-third
of all pay at U.S. companies—more than $2.1 trillion of the $6.4 trillion total compensation.
The 6 percent of those taking home one-third of all pay includes everyone earning more than the wage base. But the top 2 percent of earners account for the lion’s share of the $2.1 trillion. And that’s just the pay top earners receive or defer. The figure understates executive pay because it includes just salary and vested deferred compensation, including bonuses.
It doesn’t include unvested employer contributions and unvested interest credited to deferred-compensation accounts. Nor does it include unexercised stock options (options aren’t subject to payroll tax until exercised) and unvested restricted stock (which isn’t subject to payroll tax until vested; the subsequent appreciation is taxed as a capital gain).[11]
Also not included in the total compensation figures are types of executive pay that are never subject to payroll tax at all. This category includes incentive stock options (which are generally taxed as capital gains) and compensation characterized as a benefit (certain benefits, including pensions, aren’t subject to any Social Security taxes). The compensation data also leave out compensation paid to hedge fund and private equity managers. The billions they receive isn’t considered pay; it’s treated as “carried interest,” which is taxed as a capital gain.
And what about the other half of the compensation equation—benefits? In addition to $6.4 trillion in wages and salaries, private companies pay $1 trillion in benefits, which include contributions to retirement plans—both pensions and 401(k)s—health care, and life insurance contracts. It isn’t possible to tell what portion represents benefits—and liabilities—for executives.
At the giddy height of the mortgage bubble in 2006, economists at Goldman Sachs analyzed what had been the biggest contributors to record corporate profits. The lead items on their list weren’t productivity, innovation, or the quality of management. “The most important contributor to higher profit margins over the past five years has been a decline in labor’s share of national income,” they wrote. They weren’t talking about pensions and benefits, but the patterns are parallel.
SHADOW PLAN
Even if the public doesn’t know or care how big the executive liabilities are, finance officers certainly do, and they have come up with various ways to deal with it.
The life cycle of pension plans at drug wholesaler McKesson Corp. may provide a hint about how this trend will play out at the many companies with frozen pensions and growing executive liabilities.
McKesson froze its employees’ pensions in 1997, and the next year established a SERP for top management. The frozen pension plan soon had a surplus because workers were no longer building pensions and the liability was falling with every dollar paid out to retirees. Thanks to gains from curtailing the pension, plus asset returns, the frozen plan began to generate income. This offset the annual expense of the unfunded executive pensions.
Essentially, frozen employee pensions, like the one at McKesson, provide shadow funding for executive pensions. This isn’t necessarily a cash resource (see Chapter 8, “Unfair Shares”). Rather, the pension income offsets the drag the unfunded executive pensions create on income. This is one reason why companies freeze pension plans rather than terminate them: They can be worth more alive than dead. Why kill the fatted calf when you can continue to milk the cow for years?
In 2007, McKesson acquired Per-Se Technologies and merged that company’s underfunded frozen pension with McKesson’s overfunded frozen pension. This relieved McKesson of the need to contribute to the Per-Se plan. Indirectly, McKesson had monetized the surplus assets in its frozen pension plan. Over time, assuming McKesson doesn’t extract the assets, the plan will have a surplus that will continue to build, especially when interest rates begin to rise from their historically low levels. Once again, the frozen plan will be a shadow fund for the executive pensions, including the more than $90 million owed to chief executive John Hammergren.
Chapter 7
DEATH BENEFITS
How Dead Peasants Help Finance Executive Pay
JUST BEFORE CHRISTMAS 2008, Irma Johnson, a widow in Houston with two young children, got a check in the mail for $1,579,399. It was the death benefit proceeds from the life insurance policy on her husband, Daniel, who’d died of a brain tumor at age forty-one the summer before. But the check wasn’t payable to the Johnson family. It was made out to Amegy Bank, the company that had fired her husband six years before he died.
The check was accompanied by a note from the U.S. Postal Service, saying that the original envelope had become damaged in processing. But there was no other explanation. Mystified, Johnson called the insurer that had issued the check, Security Life of Denver Insurance Co. The person she spoke to told her that Amegy Bank of Houston was the beneficiary of a life insurance policy on her husband’s life. The insurer had already sent the bank a check to replace the one lost in the mail.
This was the first time Johnson had ever heard of the policy, and she was appalled. The bank had taken out a life insurance policy on her husband and now was going to keep the money. But she would have been even more outraged if she had known where the money would go.
In recent years, as the costs of salaries and benefits for executives have put huge IOUs on corporate books, companies have begun stuffing billions of dollars into new and existing life insurance contracts taken out on the lives of their employees. The insurance policies serve as pseudo pension funds for executives: companies deposit money into the contracts, which act like giant IRAs. Like an IRA, the money in the policies is allocated among investments and grows tax-free. When the employees die—no matter how long it’s been since they’ve left the company—the death benefit goes to the company tax-free. The primary goal, though, isn’t to harvest the death benefit but to reap tax benefits and to use the investment income to offset the cost of the executive obligations.
Technically, it’s illegal for companies to buy life insurance on workers as a tax dodge, but companies can buy it to finance “employee benefits.” This loophole was created in the 1990s when companies and life insurance lobbyists convinced lawmakers that they could use the insurance to pay for “retiree benefits.” What they didn’t tell Congress was that the retiree benefit they were referring to was executive deferred compensation.
This corporate-owned life insurance, or COLI for short, was initially nicknamed “janitors insurance,” because when companies first started taking out the coverage in the 1980s and early 1990s, the policies could cover almost anyone at a company, even the janitors. More recently, it has become known as “dead peasants insurance,” which is how an insurance consultant for Winn-Dixie Stores, who had apparently watched too many Monty Python movies, referred to it in some memos in the mid-1990s.
Although the companies receive the death benefits, it isn’t really the cash that the companies are looking for. The big money, and the big benefit they get, comes from keeping the money in the contracts. This is thanks to a cascade of tax breaks and accounting rules that enable these pseudo pension funds to generate income that boosts profits. It works like this. Let’s say a company owes its executives $1 billion in deferred compensation. Since the obligation is unfunded, the interest on the debt hurts the company’s earnings. Essentially, the executives, by deferring their pay, are making a loan to the company; the company owes them interest on the loan. The interest cost on the debt reduces the company’s income. Unlike regular pensions, executive pensions aren’t funded, so there are no investment returns to offset the cost of carrying the debt. And whereas other debt burdens, like retiree health benefits, can be—and often are—cut, companies rarely cut executive benefits.
Enter life insurance policies. The kind companies buy aren’t the simple ones that pay a death benefit, but “cash value” policies, like “whole life” and “universal life” contracts, which are investment accounts with a death benefit attached. Because the account is wrapped in an insurance policy, the investments within it accumulate u
ntaxed. In other words, the life insurance contract is a stand-in for a tax-favored pension fund.
The life insurance contracts not only provide some of the same tax benefits as pension funds; they also provide the same accounting benefits. Investments in insurance policies not only grow tax-free, but their returns pump up company income. If the investments had a return of $100 million, the company could add the $100 million to its income that year, which would offset the interest cost on the executive obligations. This tax-free flow of investment income—like the income from investments in pension funds—offsets the interest cost of the executive obligations.
If the investments weren’t wrapped in an insurance policy, the company would have to sell the investments, then pay taxes on the gains, if it wanted to be able to report the income. Bottom line: Even though companies aren’t supposed to get tax breaks for funding executive deferred comp and pensions, they get essentially the same tax breaks—and accounting benefits—by taking out life insurance on workers.
TO DIE FOR
Though the investments are essentially locked up in the insurance policies, companies receive tax-free cash when employees and former employees die whether in car accidents, in plane crashes, or from illness. Even people who are murdered or accidentally killed at work produce death benefits for their employers.
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