THE VALUE OF EMULATED EQUITY

By R. Randal Seal, President, Director of Consulting Services, The Capitol Financial Group, Inc.

Emulated Equity can be a tool for automobile dealers to attract, retain and reward high- level employees in an efficient and effective manner.
The latter 20th century brought about one of the strongest economies in memory. Low interest rates, low inflation and low unemployment have benefited all market sectors, but prosperity has also created a tightening labor market for top - flight talent. Unfortunately, to succeed in this environment, businesses need the best and brightest executives more than ever.
Most automobile dealers approach this challenge as a privately- held business that is often family-owned. As such, they must answer these questions:
  • What can a privately-held business offer to compete with stock options and other incentives available at publicly-owned corporations?
  • Can a family-owned business compete for key executive talent without diluting family control?
The answer to both of these questions lies in the concept of “emulated equity”. Emulated Equity provides a company with an instrument which can simulate market returns and investment diversity while adhering to the goal of family management. Emulated equity comes in many forms – phantom stock, stock appreciation rights and non-qualified retirement programs such as Supplemental Executive Retirement Plans (SERP) and Voluntary Deferred Compensation arrangements. For the purpose of this article, we will focus on the non-qualified retirement program as an emulated equity option.
The popularity of non-qualified retirement programs expanded greatly with the passage of the Employee Retirement Income Security Act of 1974. Commonly known as ERISA, the Act set specific regulations that companies must follow when offering pension or welfare benefit plans. Under ERISA, plans such as 401(k)s and defined benefit pensions qualify for favorable tax treatment and security provisions but must meet strict testing rules prohibiting discrimination in favor of highly compensated key employees. As a result, many companies are turning to nonqualified plans to make up for the “reverse discrimination” caused by the limitations on highly compensated key employees. These non-qualified plans provide the favorable tax treatment without being subject to the qualified plan limits and reporting requirements.

SERP vs. Voluntary Deferred Compensation

In its simplest form, a SERP is an employer-funded plan that provides a specified benefit to an executive at a specified date in the future. Most often this will be payable only at full retirement, but it could also be payable at early retirement, termination, disability or death. The benefit is typically based on a percentage of the executive’s compensation. As an example, a typical plan for a family owned business might provide an executive 60 percent of final average compensation at full retirement, reduced to 40 percent for early retirement and further reduced for termination before age 55. With their employer-funding and specified benefit levels, SERPs can be very effective retention tools.
Voluntary Deferred Compensation plans give highly compensated key employees the ability to maximize tax-deferred investment opportunities. The plans are sometimes known as 401(K) mirrors because of their similarity to 401(k)s. The executive can defer taxes on any amount of income contributed to the plan, as well as on earnings on the income. As an additional incentive, the company may also match the executive’s contribution to the plan. Voluntary Deferred Compensation Plans are often done in conjunction with a SERP, but can be used independently as well. /

Prevalence of Non-Qualified Plans

The use of non-qualified retirement plans by private companies has steadily risen through the years. In 1998, M Financial commissioned the accounting firm of Arthur Andersen to conduct a nationwide study of small and medium-sized private company compensation, benefit and wealth transfer strategies. The study found that nearly half the companies were either considering or currently offering a non-qualified retirement program. The most popular reasons for plan implementation included the ability to exceed qualified plan contribution limits, the creation of “golden handcuffs” and the enhancement of recruitment.

Pay for Performance

An employee-compensation mantra of the past few years has been “pay for performance”. This trend has recently been incorporated into the design of non-qualified retirement programs. As an example, a company could design a SERP where a 45 year old executive would receive 60% of his final average salary at age 65. In order to earn the benefit, a schedule of average annual profitability would have to be met. Assuming the performance objective was achieved, the benefit would be phased in over a period of seven years. In addition to increasing the power of the incentive for the executive, the design would also help to phase in the liability the company would have to book for accounting purposes. We call this design a Performance Associated SERP or PA-SERP. The concept could be applied to the matching portion of the Voluntary Deferred Compensation plan as well.

Tax and Security Considerations

Any benefits received from a SERP or a voluntary Deferred Compensation plan are taxed as ordinary income at the time payments are made to the executive or to his designated beneficiary. In exchange for this tax-deferred treatment, the government requires that a non-qualified plan participant have unsecured benefits; he is a general creditor of the company. In the event of corporate insolvency, he would have to “stand in line” with other creditors trying to get paid. If the executive is willing to be a general creditor, the benefits of these arrangements can be very attractive. It should be noted that proper plan design can help to mitigate risk to the executive considerably. Features such as a Rabbi Trust (protection in the event of a change of control or change of mind) and a “haircut” (the benefit amount is lessened in exchange for release from the plan) are often used for this purpose.

Conclusions

In today’s competitive environment traditional cash compensation and group benefits are not enough to acquire, motivate and retain the right executive personnel. Standout employees are looking for innovative thinking that allows them to expand their financial opportunities while having a sense of a greater stake in the success of the company. Automobile dealers, like other privately held family businesses are concerned about having to offer equity to non-family members. Emulated equity can allow both parties to meet their needs.