Companies like to take care of their executives while they are active con- tributors. They also like to take care of them in their retirement—apparently concerned that their retired CEOs and other senior executives might have to lower their standard of living after they have left the company. Many therefore take steps to ensure that their retired top corporate officers are not constrained by the “decency” caps that govern “qualified” retirement plans.
They provide them with additional “nonqualified” pensions—in most cases taking advantage of the delayed taxation benefits of deferred compensation.
What does this mean? It means that in 2002, you and I could not con- tribute more than $11,000 to our 401(k) plans, which are considered qual- ified plans. The purpose of this limit was to ensure that a 401(k) was truly a retirement vehicle rather than a tax-dodging device.
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This is not the case with the kinds of nonqualified plans that are offered to top corporate officers and which take a variety of forms. However, one constant is that firms use these plans to minimize the payment of taxes—
on both the executive’s benefits and on their own contributions. And the best formula, from a company’s standpoint, is one that allows the company in the end to reclaim the entiretyof its contributions. Such plans do exist, mainly because there are tax loopholes to be taken advantage of.
On their deferred compensation, Enron executives were guaranteed a minimum annual return of 12 percent at a time when the 10-year Treasury Note yield was fluctuating in the 5 to 6 percent range. Even this extraordi- nary yield paled in comparison with the income obtained by so-called friends of Enron, mainly Houston-based cronies who routinely enjoyed a 15 percent return on very short-term loans. “Often,” as some friends of Enron told David Barboza of the New York Times, “the deals were done near the end of financial reporting periods to meet Wall Street’s expectations.”9 Is this outright fraud? No. Is it just another example of entrepreneurial creativity? Well, no, not exactly that either. These stunts lie somewhere in the gray area, shading toward the unethical. They certainly do not pass the sniff test.
What else do the members of America’s corporate elite have going for them? One special treat is the split-dollar deferred death-benefits plan, whereby the plain-vanilla life insurance contract is modified and put to very clever use. Here’s the formal definition of the plan: “Split-dollar is usually an arrangement between an employer and employee, in which the parties agree to share (or ‘split’) the obligation to make premium payments on a life insur- ance policy, and share (or ‘split’) the rights and benefit under the policy.”10 Several variations on this theme are in use today. The most common arrangement is the equity variation,under the terms of which, on the death of the employee, the company that contributed to the split-dollar plan recov- ers an amount equal to the premiums paid by it, whereas the employee’s beneficiary receives the cash surrender value that is in excess of the pre- miums paid. Taxwise, the plan is extremely favorable. As a book devoted to deferred compensation structures observes, “If the employee establishes an irrevocable life insurance trust (‘ILIT’) which acquires the policy on the employee’s life, and the trust is properly structured, the death benefit payable under the split-dollar arrangement can escape estate tax on the death of the employee, and then escape estate tax again on the death of the employee’s spouse.”11This is a very nice way to shelter assets and even skip a genera- tion of taxation!
At Enron, Kenneth L. Lay enjoyed his own $12 million split-dollar life insurance policy and also had the benefit of a second policy in a similar amount for his wife and himself. Jeffrey K. Skilling had an $8 million split- dollar life insurance policy. “The assets in those policies are protected from (Enron’s) creditors,” as the Wall Street Journalreported. “The policies aren’t assets of Enron, and the policies are secure from creditors who sue the exec- utives personally.”12Is it possible that this was one of the appeals of these policies in the first place? We investors need to ask these kinds of questions.
The magic of the split-dollar arrangement resides in the splitting of premium payments between employee and employer. Legal, yes, but does it pass the “in the intention of the Congress” standard? Probably not.
Advantage is clearly being taken of an unintended consequence of the logic of life insurance.
The same applies to the so-called janitor life insurance (also known as company-owned life insurance,or COLI). It had never occurred to law- makers that anybody but the bereaved would want to benefit from a deceased person’s life insurance. Gradually, though, firms realized that life insurance provides a useful corporate tax shelter. In some cases, employees are not even advised by their employer that they have had life insurance policies taken out on them. In such cases, presumably, executive peace of mind is not the main objective.
Eventually, most of the tax loopholes that lie behind these kinds of sweetheart deals get closed. One such loophole was eliminated in the early days of March 2002. It had allowed a company, for tax purposes, to treat the deferred compensation of an executive as a financial hedge to its own business—the business in question being that of paying an executive’s deferred compensation.
Confusing? Of course. To understand the scheme, you need to under- stand the concept of a hedge.The purpose of a hedge is to remove some financial risk by neutralizing it with risk of an opposite nature. You take a hedge on a financial product by taking a market position whose price is likely to move in the opposite direction from that of your original product.
Products whose prices move in synch are said to be correlated; if they move in opposite directions, they are said to be anticorrelated.The perfect hedge is obtained using the one product that is perfectly anticorrelated with the risky one. Since no two products are perfectly identical, their price changes are not likely to be identical; therefore, their mutually canceling out can only be realized if their difference in responsiveness is fully taken into consideration.
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Let’s look at an example of a hedging strategy: sale of an all-electric cars. We can agree that electric cars are increasingly popular when the price of fuel rises. However, what if you are making electric cars, and the price of fuel plummets?
In order to hedge the sale of its electric cars, Acme, Inc., will take a short position on the fuel markets—for instance, by buying a put on oil prices, which means that Acme will make a profit if oil prices drop. This will lessen its possible losses in sales of electric cars if fuel prices drop.
Matching the short position in oil in exact proportion to the amount by which sales of electric cars drop will be the perfect hedge. Should the match be perfect, Acme will be able to lock a profit at a particular level. If oil prices drop, Acme loses on the sales of its electric cars, but its put on oil prices gets in the money in the exact same amount. Conversely, if the price of oil rises, the put is out of the money, but the sales of electric cars com- pensate for unrealized gains on oil price.
The whole notion of hedging an executive’s deferred compensation seems ludicrous on the face of it because the burden is (1) self-inflected, (2) tax-advantaged, and (3) not exactly crucial to the running of the busi- ness. As it happened, the government was not amused. Assistant Secretary of the Treasury Mark Weinberger, who focuses on tax policy, observed that it was “improper to use the hedge rules to get full tax deferral on deferred executive compensation.” He called resorting to the hedge interpretation a
“back door to obtain a favorable treatment for deferred compensation that Congress never intended.”13
Such schemes offering extra compensation for executives create a two- tiered system in which rank-and-file employees take a hit in bad times and executives have relatively little to fear even from the company’s demise.
This kind of setup has become associated with Enron but appears to be far more widespread than anyone knew.