The Danger of Deferred Compensation
In the 1990s, many companies adopted programs that allowed top executives to defer pay until they needed the money--and to delay paying the taxes that went along with it. Now many of those execs are paying a steep price for that perk. As more companies go belly-up, managers are learning about the danger of "deferred compensation"--namely, that it could be deferred forever.
It's one of the lessons from the collapse of Enron. As the company teetered on the verge of bankruptcy last year, select execs were allowed to bail out of its deferred-compensation plan, while former employees were not. The latter became, in bankruptcy terms, "unsecured creditors," likely to lose most of their money. "The idea that you can lose it all doesn't dawn on you," says Stephen Pearlman, a former Enron executive who lost $260,000 when the company ignored his requests to withdraw the cash in November.
Deferred compensation now ranks as one of the most common of executive perks. Indeed, 86% of the largest U.S. companies offer deferred-comp plans, up from 75% just five years ago, according to Clark/Bardes Consulting in North Barrington, Ill. In most, the pay, bonus, and even equity-based compensation are held in trust until the executive retires, reducing pretax income while accumulating sizeable returns. The company, meanwhile, gets a recruiting incentive for executive talent, a richer balance sheet, and a giant tax deduction when the employee cashes out.
As Enron made clear, executives who put their faith in a questionable company can put their money at significant risk. If the company declares bankruptcy, the assets of the deferred-comp plan become company assets, subject to the claims of banks and other secured creditors. This is not something executives should shrug off: Of the 15 biggest business bankruptcies since 1980, seven came in the last year, including Enron, Global Crossing, Kmart, and Reliance Group Holdings, according to BankruptcyData.com. Bankruptcies among publicly traded companies hit a record 257 in 2001, up from 176 a year earlier.
A plan participant can do little to mitigate the risk posed by bankruptcy--short of doing a thorough risk assessment. "If I didn't believe in the [company's] financial stability, I wouldn't be participating in its deferred-comp plan," says Solange Charas, a New York pay consultant. "I'd say give me my money now."
Change of control or management can also put the money at risk. Participants will want to learn how the deferred compensation plan is structured, how it's funded, and what other features it has. For example, cash held in an irrevocable "rabbi trust" is fairly immune to change-of-control risks. But if the trust is not fully funded, there may not be enough cash to make payouts. Cash held in a company account can be tapped for other purposes, leaving the plan's participants high and dry.
Even without a corporate meltdown, participants in deferred-comp plans can run into trouble. Early withdrawals often trigger substantial penalties, and a company's failure to meet financial targets in performance-based plans can leave nest eggs depleted. Plans designed as retention incentives have provisions for what may be the unkindest cut of all: Leave before you're vested, and you leave the deferred pay behind.
Still, thousands of executives have staked billions of dollars on their employer's ability to pay up when the time comes. For those whose companies aren't in peril, it could be one of the smartest moves they ever made. For everyone else, it's just a roll of the dice.
By Louis Lavelle