A Framework for Responsible Executive Benefits
By Doug Frederick and Heidi O’Brien
Executive rewards are under greater scrutiny than ever, requiring companies to continuously assess the elements of their programs and ensure that they not only support the attraction, retention and motivation of executives, but also provide an appropriate balance that is responsible and does not create undue risk.
Indeed, the economic downturn and a volatile business environment have heightened sensitivity to the cost predictability and effectiveness of executive rewards programs, incentive compensation in particular.
Executive benefits, particularly nonqualified retirement programs, should be a core component of any review — but they are often overlooked. The following steps will validate the role of executive benefit programs within the total compensation package:
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Review external competitiveness and assess internal equity
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Understand the impact on total compensation levels and pay mix
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Identify and mitigate risk associated with benefit provisions, funding and compliance
Reviewing External Competitiveness
Rewards should be meaningful enough to be competitive but not so generous that the company incurs unreasonable costs or is exposed to criticism.
Companies should monitor their programs regularly — because the competitive landscape continues to evolve, and the market positioning of an employer’s program likely will shift over time even if the program itself has not changed. Mercer data shows that one-third of publicly traded companies have made changes to their executive retirement programs in the past two years. Key changes include:
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Shift from defined benefit (DB) to defined contribution (DC) plans – Market practices for both qualified and nonqualified plans continue to migrate away from final average pay DB plans to less generous DB plan formulas (for example, cash balance or career average) or to DC plans.
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Shift from Supplemental Executive Retirement Plans (SERPs) to restoration plans – Most nonqualified plans are now restoration plans, meaning they simply restore underlying qualified plan benefits that are limited by caps placed by the IRS. SERPs, which provide more generous benefit formulas or contribution rates than restoration plans, continue to decline in prevalence.
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Elimination of favorable provisions
– Enhanced SEC proxy disclosure requirements and increased pressure from stakeholders have caused companies to scale back on atypical plan designs (for example, above market interest, additional service credits), especially as companies are making cutbacks to the qualified plans provided to rank-and-file employees.
According to Mercer’s Executive Benefits Research Tool (EBeRT), the prevalence of plans is largely unchanged
— 84% of companies with more than $5 billion in revenue offered an employer-paid nonqualified plan in 2005 versus 82% in 2009. But there has been a noticeable shift in the objectives and structures of plans away from
SERPs and DB plans.
Since the competitive landscape is shifting, companies need to understand how their programs stack up in the market and whether changes are needed. Companies can pursue a range of approaches to evaluate their programs, depending on the degree of review that is warranted.
Each of these approaches addresses a critical question:
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Prevalence of benefits
– How do the structure and design of the company’s benefit programs compare to market?
This can be helpful in identifying outlying practices that may be priorities for further review.
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Cumulative benefits/income replacement
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What is the ultimate retirement value provided to executives, and how does that compare to market?
This enables a comparison of all company-paid benefits on an apples-to-apples basis.
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Annualized benefit
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What current compensation value should be assigned to retirement benefits?
This provides an annual value to add to salary and short- and long-term incentives so that total remuneration can be compared to market and peers.

Companies should also be mindful of other rewards, such as executive perquisites, that could draw increased attention. Employers that continue to provide generous perquisites should ensure that they can justify the business rationale for the practice, especially if they have undertaken cost-cutting actions in other areas.
Impact on Pay Mix
Executive retirement benefits should always be considered in light of total executive remuneration rather than viewed in isolation. For example, generous retirement benefits may be defensible at an organization whose other pay components are below market. However, these same benefits may be inappropriate at an organization whose other pay components are competitive or above market.
Aside from understanding the level of benefits and total remuneration, the relative mix of compensation components is critical in determining whether the pay strategy is appropriate and effective. For example, an organization might provide total executive remuneration that is close to the market median, but the positioning may be driven by above-market retirement benefits and below-market incentive pay. While the total remuneration level may look appropriate, the underlying components may not deliver the performance weighting that the company needs to properly drive its objectives. A reallocation of pay components — for example, reducing retirement benefits and increasing potential long-term incentive pay
— may improve the effectiveness of the pay package without changing the overall amount of the package.
Identify and Mitigate Benefit, Funding and Compliance Risk
The concept of risk mitigation and avoiding unintended outcomes is top of mind for company executives, the board and regulators. Even well-conceived competitive designs can generate risk in several areas:
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Benefit volatility
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Financing strategy inefficiency
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Compliance
Common executive retirement design features should be examined to ensure the employer is comfortable with the potential range of cost volatility and disclosure impact. Companies should examine their programs for the following provisions in order to understand the potential impact and determine if any changes might be appropriate to manage potentially volatile outcomes:
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Annual bonus fluctuations
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Lump sum interest rates
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Late retirement
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Payment triggers (such as early retirement, death or change in control)
Additionally, optimizing the plan’s funding/financing strategy can minimize long-term costs and reduce expense volatility. Unlike in qualified retirement plans, plan sponsors are not required to set assets aside to finance nonqualified plans for executives. Companies typically choose to finance in order to mitigate expense volatility and long-term plan costs. However, a poorly structured financing strategy can be just as detrimental (or more so) as not financing at all.
For many employers, the plan financing strategy was developed during different economic conditions. Strategies should be reexamined and adjusted based on changes in the employer’s tax position, liquidity needs and plan liabilities. Reassessing whether to finance the plan, the level of financing needed and the financing vehicle can be an important strategy in keeping long-term program costs and short-term volatility in check.
In the past few years, executive retirement plan sponsors made significant efforts to amend plans to comply with
IRS Code Section 409A, which governs nonqualified retirement plans and other deferred compensation arrangements. But operational compliance risks remain. The IRS has announced its intent to conduct audits of
6,000 companies in the next few years. Given the severe penalties associated with violations, companies should proactively audit the operation of their plans to mitigate the risk of 409A violations.
Key steps companies should address in an operational review include:
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Ensuring that the plan document is consistent with the Summary Plan Description and other communication/administration materials.
Addressing conflicts in documentation is not only helpful from a compliance risk standpoint, but can also ensure that the design features communicated to executives accurately reflect the plan’s design intent.

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Reviewing the operational process and interviewing stakeholders.
It is not uncommon for many parties to touch the plan’s operation, including the company’s HR function, outsourced functions and the plan recordkeeper/actuary. It’s important to review process documentation and interview all parties to ensure agreement on plan provisions, timelines and span of responsibility to help uncover potential areas of inconsistency.
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Auditing a sampling of transactions each year.
A representative group of transactions should be audited to uncover potential 409A violations. This is especially critical as the IRS provides 409A corrections relief for violations that are timely identified and addressed.
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Identifying design provisions or processes that are overly complex.
Certain design features may cause difficult or complex plan administration, increasing the risk of unintended 409A violation. For example, the plan may offer options for benefit payment form/timing that provide great flexibility to executives, but require excessive manual intervention by the employer or record keeper.
Aside from compliance with current 409A rules, employers should be mindful of other legislative changes on the horizon. It is possible that proposals to cap annual deferred compensation may resurface, and while FICA rates are already scheduled to increase in 2013, it is widely anticipated that federal and capital gain tax rates will increase in 2011. Employers should consider addressing the potential tax rate increases in plan communications to enable participants to understand how changing rates may impact plan outcomes, allowing them to make more informed elections.
Maintaining Focus
The shifting landscape underscores the need to ensure that programs stay current with market practices and do not expose the organization to unnecessary scrutiny or competitive imbalance. And as with all elements of executive pay, a careful review of potential risks in the program is a key step to ensuring that the employer will realize maximum return on its investment.
About the Authors
Doug Frederick is a partner with Mercer and leads Mercer's national Executive Benefits Group (EBG). EBG is a national resource supporting all of Mercer's global offices by providing consulting services for the benchmarking, design, compliance, and funding of executive nonqualified benefit plans.
Heidi O’Brien is a principal and senior consultant in Mercer's Executive Benefits Group, and is based in Mercer's
Los Angeles office. Heidi consults on a broad array of issues related to executive benefits, including design, financing and implementation of voluntary deferred compensation plans, SERPs and benefit restoration plans.
Read the October 2010 edition of Compensation Focus .
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