The Advisors' Blog

– Steve Seelig, Towers Watson

For those who thought they’d need only consider how pending Financial Services Reform legislation would influence executive compensation, here’s something else you may need to worry about. Part of the House version of H.R. 4213, the American Jobs and Closing Tax Loopholes Act of 2010, includes provisions that would provide funding relief for certain companies with pension shortfalls, but would offset that relief to the extent the company paid “excess employee compensation” or made certain dividend payments in stock redemptions. While the universe of companies needing to worry about this legislation may be somewhat limited, this provision may signal that Congress is not yet done seeking to have companies recraft executive compensation designs.

For a company electing funding relief, the legislation would increase the required pension funding contribution by the amount of any excess employee compensation paid by the plan sponsor. “Excess employee compensation” is essentially any W-2 compensation for the year that exceeds $1 million (indexed after 2010 for inflation). It also includes any amounts set aside or reserved (directly or indirectly) for employees in a trust or similar arrangement under a nonqualified deferred compensation plan.

The latter definition appears to apply without regard to whether the employee’s compensation exceeds $1 million. A grandfather rule would exclude any nonqualified deferred compensation, restricted stock, stock options or stock appreciation rights payable or granted under a written binding contract that was in effect on March 1, 2010 and was not modified in any material way before the remuneration was paid. Commissions paid to those who would not be considered specified employees under 409A are also excluded as is compensation attributable to services rendered prior to 2010 (other than the funding of deferred compensation).

On its face, the legislation seeks to have companies craft pay programs to avoid the funding of nonqualified deferred compensation for higher paid employees during the years for which they are taking advantage of relief by funding less of their pension shortfall. Further, by defining “excess employee compensation” based on W-2 income, the rule will also tend to punish companies that grant equity compensation (after March 1, 2010) whose value is realized in a later year where stock values have increased. Given the choice of dealing with the vagaries of stock price volatility, companies that elect funding relief may be more inclined to craft cash-based programs where they can at least cap the amount of funding relief they would lose.

Of course, regardless of the form of the pay program, companies considering whether to elect funding relief will need to weigh the relative cost of the executive pay program in its current state versus the additional cash cost of having to contribute more to their pension plan.

Policy-wise, it seems Congress may also believe this structure also will help to drive down executive compensation levels for these companies. An interesting dynamic, thus, is created where the very executives in charge of choosing whether to elect funding relief may be doing so at the peril of their compensation committee granting them a scaled-down or non-equity based compensation program. And once the decision to use funding relief is made, the compensation committee will need to include the potential cash cost to the company of losing out on some funding relief, as it considers the other tax, accounting and cost implications of the pay program it approves.