Long-term Compensation Choices: Real Equity or Phantom Stock?

Shareholders, business owners, and Boards have two primary options when considering key employee long-term compensation linked to shareholder value. Long-term compensation is typically structured to:

  • Motivate, reward and retain key employees
  • Promote long term thinking
  • Grow the business
  • Build shareholder value

At the same time, talented and entrepreneurial employees are looking for opportunities to become owners, to share in the success and create wealth for themselves and their families. So what’s the right way to deliver the long-term compensation aligned with shareholder value? Sharing real equity or using phantom stock?

Like many other business decisions, the choice of real or phantom equity can be a challenging one. The answer depends on your philosophy, corporate governance and culture, objectives, corporate structure, and the desires of your key employees. 

I believe that if using real equity is practicable, it serves as the best way to deliver long-term compensation. Key employees become shareholders and enjoy the same benefits as other shareholders. This may include voting rights, dividend rights and the opportunity for capital gains once the shares are earned and vested. This is the case for virtually all public companies which use their shares as the “currency” to deliver at least part, if not all, of the long-term compensation.

Real equity works for certain privately held businesses which hold a philosophy of key employee ownership and can manage the issues of having minority shareholders. Real equity is also used as part of a shareholder succession plan – replacing one generation of owners with the next.

However, in many cases, particularly with closely held businesses and not-for-profit organizations, the use of real equity is not possible or practicable. Examples include a family business that desires to keep stock ownership in the family or with a single business owner who doesn’t want to deal with minority shareholders.

Real equity or phantom stock comparison for long-term compensation elements

Issues with Having Minority Shareholders

Many corporate attorneys will advise their clients against having minority owners because of the issues it presents. These issues include:

  • Governance issues including minority shareholder rights to dissent against mergers and other significant corporate transactions.
  • Minority shareholders of private companies may have unrealistic expectations regarding their role in corporate decision-making.
  • Minority shareholders may have voting rights (if common shares carry voting privileges).
  • Minority shareholders owning enough stock individually or collectively may create obstacles to corporate action and have the right to petition a court for the involuntary dissolution of the corporation. During times of great opportunity or immense hardship, minority shareholders can cause trouble.
  • Minority shareholders may exercise inspection rights and force privately owned businesses to produce their accounting records.
  • It may be difficult to terminate the employment of a minority shareholder.
  • Minority shareholders may make claims of excessive compensation of majority owners or question expense reimbursements.

Phantom Stock

This is a form of compensation where a company promises to pay cash at some future date, in an amount equal to the market or formula value of a number of shares of its stock. Thus, the payout will increase if the stock price rises, and decrease if the stock falls, but without the recipient actually receiving any stock. Like other forms of stock-based compensation plans, phantom stock broadly serves to encourage employee retention, and to align the interests of recipients and shareholders. Recipients are typically employees, but may also be directors, third-party vendors, or others.

In general terms, phantom stock is a compensation plan that confers the right to receive cash at a future point in time, typically tied to a valuation formula. Design of a phantom stock plan can replicate the value of real stock. The value of the company’s stock or the appreciation in the value of the stock after the date of the phantom stock award determines the amount of compensation. 

The award is usually contingent upon the phantom stockholder’s continued employment with the company, i.e. retention of key management.

When a business is sold, the phantom stockholder might receive an amount equal to the cash the recipient would receive if he or she owned the same percentage of the corporation’s stock (or the appreciation in value of an equivalent amount of stock). Some plans also include participation in dividends paid to shareholders.

Designed and administered properly, phantom stock should be non-taxable until the cash is paid, generating ordinary income for the employee and a deduction for the company.

Plans that are limited to only key employees should be free from the burdens of ERISA rules governing participation, vesting, funding and fiduciary responsibilities.

Implementing a phantom stock plan should cost less in legal and accounting fees than a formal stock program with buy-sell agreements.

Phantom stock provides a way to share a stake in a business while avoiding the need for the new “owner” to invest cash or suffer taxable income. Most importantly, phantom stock avoids the risks inherent in having additional shareholders.

Questions? Contact the Findley consultant you normally work with, or contact Marc Stockwell at marc.stockwell@findley.com, 419.327.4122.

Published August 14, 2019

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Two of a Kind? Not All 457(b) Plans Are the Same

You may already know there are significant differences between a 457(b) plan sponsored by a governmental entity and a 457(b) plan sponsored by a tax-exempt organization. But do you know what they are? It can be confusing for plan sponsors because the plans are so similar and articles on the subject of 457(b) plans do not always point out the distinctions.

How All 457(b) Plans Are Alike

A 457(b) plan is a deferred compensation plan that permits certain employers or employees to contribute money for retirement on a tax-deferred basis. Internal Revenue Code (Code) Section 402(g) provides the contribution limit (402(g) Limit) which for 2019 is $19,000. Earnings on these contributions are also tax-deferred. A 457(b) plan is not subject to coverage or nondiscrimination testing.

If you are familiar with 401(k) plans, you’ll recognize many of the other common requirements or provisions described below that apply to both tax-exempt and governmental 457(b) plans.

  • Documentation: the plan must be in writing.
  • Catch-up contributions: a participant may be permitted to elect to increase salary reductions for the final three years before reaching normal retirement age up to the lesser of
    1. two times the applicable dollar limit ($38,000 for 2019), or
    2. the applicable dollar limit plus the sum of unused deferrals in prior years provided the prior deferrals were less than the applicable deferral limits (not counting any age 50 catch-up contributions (permitted only in governmental plans)).
  • Deferral election timing: the election to make contributions through salary reduction must be made before the first day of the month in which the compensation is paid or available.
  • 402(g) Limit: employer and employee contributions in the aggregate are measured against the 402(g) Limit.
  • Hardship distributions: these are permitted if the distribution is required as the result of an unforeseeable emergency beyond the participant’s or beneficiary’s control, all other sources of financing have been exhausted and the amount distributed is necessary to satisfy the need (and the tax liability arising from the distribution).
  • Required minimum distributions: Code Section 401(a)(9) rules apply.
  • Distributable events: these include attainment of age 70½, severance from employment, hardships, plan termination, qualified domestic relations orders, and small account distributions (with a minor difference).

How Governmental and Tax-Exempt 457(b) Plans Differ

The differences between a tax-exempt 457(b) plan and a governmental 457(b) plan include:

  • Eligible employees: governmental plans can include any employee or independent contractor who performs services for the employer while tax-exempt plans can only make select management or highly compensated employees eligible.
  • Automatic enrollment: governmental plans may provide for automatic enrollment while tax-exempt plans may not.
  • Roth contributions: governmental plans may provide for the designation of Roth contributions for all or a portion of salary reductions while tax-exempt plans may not permit Roth contributions.
  • Catch-up contributions: governmental plans may permit age 50 catch-up contributions ($6,000 in 2019) while tax-exempt plans may not.
  • Correction of excess deferrals: governmental plans must distribute any excess contribution (plus income) as soon as practicable after the plan determines that an amount is in excess while tax-exempt plans must distribute the excess by April 15 following the close of the taxable year in which the excess deferral was made.
  • Loans: governmental plans may permit loans while tax-exempt plans may not.
  • Contributions to a trust: governmental plans are permitted to contribute to a trust while tax-exempt plans are not.
  • Rollovers: governmental plans may provide for rollovers to other eligible retirement plans (401(k), 403(b), governmental 457(b), and IRAs) while tax-exempt plans may not.
  • Taxation: for governmental plans, taxation is at the time of distribution, while for tax-exempt plans, taxation is at the earlier of when amounts are made available or distributed.
  • Statutory period for correction of plan failures: governmental plans have until the first day of the plan year beginning more than 180 days after notice from the Internal Revenue Service regarding failure to meet applicable requirements while such correction period is not available to tax-exempt plans.
  • Correction programs: a governmental plan can apply for a closing agreement with a proposal to correct failures that will be evaluated under EPCRS standards while such corrections are generally not available to tax-exempt plans.

If you sponsor a 457(b) plan, you may want to review your plan design to make sure it provides the available optional features you want for your employees. In addition, you’ll want to make sure that the plan is compliant as written and in operation.

Questions? Please contact the Findley consultant you regularly work with or Sheila Ninneman at Sheila.Ninneman@findley.com, 216.875.1927.

Posted January 15, 2019

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Mapping Your Route to Pension Plan Termination Readiness

Trying to nail down the financial aspect of being ready to terminate a pension plan is like trying to hit a moving target. And, unfortunately, it is not the only consideration to determine if your pension plan is ready to terminate. A qualified plan termination is a multi-step, government-regulated process. It involves multiple parties, requires accurate participant data and benefit information, and includes managing the resources and messaging for several required communications with plan participants. It also requires leadership involvement and effective change management to determine a successful implementation strategy. Assessing the status of all these aspects will lead to the successful execution of a termination strategy that is predictable and efficient.

Terminating a plan is not something most organizations do more than once. So it is unlikely that you have a prior project plan saved on your company network. Typical project management approaches will require months to coordinate all the people involved and all the decisions that need to be made.

Using Findley’s approach, as an alternative to typical project planning, can dramatically accelerate the process.

Determine Your Destination:

Gather Background Data and Assess Current Status

The first phase of your process should focus on developing some financial projection analyses and assessing the current status of the plan. This will give stakeholders a baseline understanding of your time horizon, the biggest areas you will need to focus on to get ready, and the capacity of your team to take on tasks related to the termination.

A fully funded plan, measured on a termination basis, is a moving target with several factors that influence the funded level over time (asset returns, cash contributions, interest rates, etc.). Actuarial analytics, projections, and interactive scenarios, that can be modeled with a tool like Findley’s PlanTermTM Financial Modeler, show how possible future economic conditions could affect your plan and will provide critical data for stakeholders to understand which variables have the most impact, and how they all interact.

Outside of the financial aspect, a review of the plan document provisions and compliance and an assessment of historical data will uncover any additional work needed.

Plan Your Itinerary:

Define Your Objectives by Leveraging a Collaborative Session

Defining your multi-year strategy requires key leadership engagement and effective change management. C-suite leaders understand the importance of this preparation but are often challenged to find the time required for the typical strategic planning approach. To overcome this, a compressed planning session, like Findley’s Rapid MapTM session, can be used to form the basis of the strategic plan and build consensus around the priorities and action items.

A trained facilitator addresses important issues connected to the plan termination process in a systematic and focused manner. The Rapid MapTM approach is a proven technique used to:

  • Reach decisions on strategic objectives in a compressed timeframe. In the course of one afternoon, the process can be used to develop and prioritize objectives related to the plan’s readiness to terminate.
  • Build consensus among the many stakeholders. Internally, this group of stakeholders is likely to include key members of your executive, finance, and HR teams. Externally, it also may involve your investment advisors, annuity consultants, actuaries, third party benefit administrators, and ERISA legal counsel.
  • Outline key communications priorities. There are many required communications that must be sent over the course of the plan termination. It is important to discuss a communication strategy that includes the timing, target audiences, key messages to be delivered, who will deliver those messages, and the communication channels you will use.

The trained facilitator will lead a prioritizing activity to define and map out the top goals and objectives that become part of your strategic plan. Action steps are then refined in the last phase.

Start Your Trip:

Create, Implement, and Monitor Your Multi-Year Strategic Plan

In this final phase, project leaders manage the multi-year milestones and implement the change management strategy developed in the planning session. Once the strategic plan is set, a detailed change management project plan defines each year’s implementation steps and timing. Monitoring actual vs. forecast experience begins immediately and continues throughout the course of the multi-year strategic plan. The interactive forecast modeling tool established in the first phase becomes a key tool for ongoing monitoring of financial readiness to terminate, and will also indicate if economic conditions are causing time horizon changes.

While waiting for the plan to be financially ready to terminate, use the time to tackle other objectives identified during the planning session. This might include research into historical data sources, finalization of any benefits that are not already certified, and locating lost participants. You may also need to engage an annuity consultant or identify a partner to outsource some or all of the administrative functions to handle the expected increase in volume.

Plan termination communications can also be tackled during this time. Effective communications will make sure participants are well-informed about their decisions while helping to anticipate and alleviate concerns. Be sure to leverage the opportunity to tailor the messaging and layout of the required notices to be consistent with your company or benefit program branding.

In Perspective

Once the plan termination has begun, the steps in the process are defined by several governmental agencies, and each step has specific timing requirements that make all of the steps interrelated. So, once you start, you need to be ready to progress through the steps at a regular pace.

To make the plan termination process run predictably, smoothly, and most efficiently, the best approach is to assess your readiness well ahead of time and have a strategic plan and process in place.

Questions? For additional information about developing or enhancing your strategic plan, contact the Findley consultant you normally work with, or Colleen Lowmiller at Colleen.Lowmiller@findley.com, 216.875.1913.

Posted January 15, 2019