Feature | Published in April 2005

Health Care & Compensation: Nonqualified Plans: More than COLI

Drawn by the big bucks involved, providers are offering lots of new investment options to nonqualified plans

By Judy Ward | April 2005

Drawn by the big bucks involved, providers are offering lots of new investment options to nonqualified plans

» Mirroring 401(k) Options

» Doing Something Exotic

It really is the DC-ification of the deferred comp industry," says Tom Johnson, chief marketing officer at Springfield, Massachusetts-based MassMutual Financial Group, about what is happening with nonqualified plans these days. Many now have investment options a lot like those available in 401(k) plans.

Nonqualified plans have seen a boom in recent years. Ninety-three percent of the Fortune 1000 had one of these plans in 2003, according to Jennifer Sanders, a Los Angeles-based senior vice president and managing director at Clark Consulting. "The prevalence of these plans has increased dramatically over the past 10 years, as other tax-savings opportunities are no longer allowed," she says.

Providers have noticed, and started offering a wide array of investments to these plans. "Traditionally, most of your large retirement-services players did not look at nonqualified plans and get all excited," Johnson says, because the cash flow into the plans seemed modest in comparison to 401(k)s, "but, now, all of the companies are saying, 'We have to get on the bandwagon.' They have woken up to this in the past couple of years. It has been more of a cottage industry that is coming together."


Mirroring 401(k) Options

Five or more years ago, most nonqualified plans just credited a simple declared interest rate, and had no choice of investments. Many plans tied the rate to the Moody's corporate bond index, the prime rate, or Treasury rates.

However, as interest rates fell and suppliers got more savvy about the big dollars involved in these plans, investment options started to be introduced. Insurance products with embedded mutual funds dominated the choices for some time, says David Sugar, a senior consultant at Hewitt Associates LLC in Lincolnshire, Illinois.

"Most were put in by insurance brokers, and were funded by COLIs [corporate-owned life insurance policies]," says Ken Kirk, Atlanta-based managing director of retirement strategy at Mellon Financial Corp. "They were able to sell the concept that these insurance policies would subsidize the very high interest rates. Some plans had a 15% to 20% crediting rate." Many sponsors bought COLIs to fund deferred compensation benefits; when a policy paid out, the money helped fund the deferred comp plan on an aggregate basis.

However, in the past several years, the momentum has swung toward nixing the fixed rate and offering investment choices similar to those in companies' 401(k) plans. "Some companies have chosen to replicate what the 401(k) offers, and others offer similar asset classes but different funds," Sanders says, referring to investment options. "Maybe as much as a third mimic the 401(k). The other two-thirds offer something different."

Several things led plans to start introducing investment options. "Number one, sponsors empirically saw that insurance products were not performing in the way they expected them to perform," Kirk says, "and Congress began chipping away at the tax benefits of insurance contracts, which subsidized the yields." Congress took away the interest deduction employers got from leveraging the policies, he says.

The stock market's run-up in the 1990s brought pressure from participants to get those impressive returns. In addition, sponsors increasingly wanted similar investment setups in both plans, since it means simpler plan administration and greater leverage with a single service provider.

Yet, COLIs still have a place in the market. Today, about 70% of plans are funded, Johnson says, half via COLIs and half via mutual funds. Sugar thinks that the majority of funded plans still invest in COLIs as opposed to Wall Street funds that parallel 401(k) offerings, primarily because it helps lower corporate taxes.

Some major suppliers like Fidelity Investments have created cloned funds used in insurance products, Sanders says. "There has been a lot of movement from the big investment houses to create cloned funds that can be used with these insurance products," she says. However, the insurance products retain some tax advantages.


Doing Something Exotic

Going forward, sources say, participants want alternative investments uncorrelated to the stock market. "One of the hot issues is volatility, particularly with senior management who are maybe within three, or five, or seven years of retiring. CEOs and other higher-level managers often take lump-sum payments, and they either have already elected that or are forced to by their companies," Kirk says. They remain wary of the kind of big dip the market had earlier in the decade, he adds: "Had they gone out in 2000 or 2001, they would have gotten killed on the nonqualified plan." The current mutual fund options do not address the volatility concerns of many executives enough, he adds, since they often have to make a distribution election far in advance.

Expect interest in private-equity deals, Johnson says. "The high-net-worth investor wants to buy the same thing as a billion-dollar pension fund."

New derivative instruments are popping up, Kirk says, typically funds created with a derivative overlay to protect principal. "They are crediting a rate based on the S&P 500 index, with no chance of principal loss," he says. "That is paid for by the dividends: The dividends finance the derivative structure that guarantees the principal. That has allowed a lot of senior executives to maintain their asset allocation in equity, rather than go to fixed income."

Some senior executives also want hedge funds in nonqualified plans. "A lot of plan sponsors and participants feel there is not going to be a great deal of growth within the fixed-income or equity markets over the next several years," Kirk says. "A lot of alpha is going to come from hedge funds."

However, many executives also want daily net asset value and daily liquidity in the plans, says Mendel Melzer, chief investment officer and president of Newport Group Securities, Inc. That seems likely to slow the embrace of some alternative assets in these plans. "The number of firms that will accept that low level of liquidity and transparency is small," he says, "but there certainly will be expansion of liquid alternative assets. There are 100 different mutual funds out there that pursue alternative investment strategies."

Plan sponsors also may want to go with milder options among alternatives. "There will be a lot of resistance to being the first one out with cutting-edge ideas," Sugar believes. "In this era of corporate governance and everything related to executive pay being under a microscope, I do not know that senior management wants to publicize the fact that they are off doing something exotic."