The Advisors' Blog

– Ira Kay and Steve Seelig, Watson Wyatt Worldwide

As we begin to mine the lode of compensation rules begetting unintended consequences, we’ve begun to keep track of those we are seeing. Hopefully, Congress will take note before enacting additional attempts to restrict executive pay and spend some quiet reflective time to think through all the potential results.

1. Changes in 162(m) Might Cause Less Performance-Based Pay, Not More – In an attempt to reduce executive pay (or raise taxes, or both) the TARP rules now limit to $500,000 the deduction allowed for compensation earned each year by SEOs. What if Congress expands new 162(m) to the rest of corporate America? Remember, this rule eliminates the “performance-based” exception, which is blamed for the proliferation of stock options.

Putting aside whether companies will respond by continuing to reduce their option grant level under new 162(m) – a notion we question since FAS 123R has already reduced those levels significantly – we think this change could cause some companies to move toward using more discretionary bonus and performance plans. The merit of current 162(m) is that it forces compensation committees to pre-establish performance goals at the start of the 1-year annual, or 3-year LTI cycle. The SEC and shareholders certainly want to see those up-front goals disclosed; witness the controversy over companies that do not disclose their performance goals.

If 162(m) eliminates the need to have performance-based compensation, we are concerned some companies simply will decide to move to purely discretionary plans since they are likely to continue to pay executives over $500,000. Our experience is that compensation committees like having pre-set formulas in place, so we’re not sure how this change will play out.

But it is possible companies will continue to have pre-set goals in mind, but could decide they won’t need to communicate them outside of the company itself. This approach would help solve the problem for companies who don’t wish to disclose their up-front performance targets in their CD&A. Ironically, the discretionary annual plan is a feature well known at Wall Street firms. So a new 162(m) could drive companies to adopt the very plans often blamed for the financial mess we are in.

Regarding 162(m) for TARP participants, there is another unintended consequence. While the rules may tend to lower total compensation paid if there is no deduction available, it certainly would have little effect on existing compensation promised. So the immediate result will be for companies to reduce the deferred tax asset (depicting the anticipated tax deduction) listed on this year’s balance sheet, which would cause them to have even more losses for the year. This might cause them to ask Treasury for even more money to prop up their balance sheet. In effect, this rule could be causing the taxpayers to loan money to companies in the TARP to help pay for the now non-deductible compensation.

2. 409A Hastens Distributions from Troubled Firms – At least two high-profile, troubled companies are taking advantage of 409A to hasten distributions of deferred compensation. “Wait,” you say, “wasn’t this rule designed to prevent distributions of deferred compensation from troubled firms?” Well, because of a combination of a very liberal regulatory transition rule and a lengthy delay in finalizing the regulations, any company can decide to trigger deferred compensation distributions as soon as 1/1/2009 for the entire balance in an employee’s account.

While it is arguable these accelerated distributions were permissible under old law, it is clear that under 409A, these distributions are permitted now. The companies using this exception argue, using logic Congress would find perverse, they need to make distributions of large account balances to retain their executives. The notion being executives with large deferrals might decide to terminate early to get their money (the only current distribution triggering event), thereby creating a talent drain from which the company could not recover.

The desire to take the money now would be far greater in a company where bailouts are needed and bankruptcy looms. Yet we really don’t know how many employees would decide to quit to get their deferrals. Perhaps this is a valid argument, but one certainly antithetical to that which created 409A.

We’ll post again soon as we hear of more of these. Feel free to share those you see.