Page 111 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 3. Current versus Deferred Compensation 97

provided a tax savings, but when combined with other plans, the tax savings was either
greatly reduced or eliminated. Examples can be found of executives who retired at
higher incomes than earned in their last year of employment.
5. Not only are deferred bonus arrangements difficult to construct from the view point
of value to the recipient, but they are also complicated from the viewpoint of applica-
ble taxes. To determine when they should begin and how long they should last, a num-
ber of assumptions and calculations must be made. Specifically, an estimate must be
made of the recipient’s income (from all sources) for the years in question and the
applicable tax rates at those times (a very tenuous assumption when dealing 5, 10, or
even 20 years in the future). Due to this high degree of uncertainty in both income and
tax rates, deferred compensation payments are logical only if a considerable safety
margin exists.
6. The current tax rate is always a given, but the tax structure even several years from now
is an unknown. What is known is that we get a new tax law about every other year.
Who’s to say that the current tax on income will not be increased? Few, if any, recall
the 91 percent marginal rate in effect in the early 1960s and the 70 percent rate in the
late 1960s. Perhaps an additional tax on deferred compensation, either during the
period of deferral or upon receipt, will become law.
7. The longer the period of deferral, the greater the risk that one or more of the assump-
tions will incur significant deviation (e.g., need for current cash, tax structure, or
alternative investment opportunities).
8. The greatest drawback to deferred compensation lies in its motivational appeal, or
more properly stated, its lack of motivational appeal. Since the reward is separated in
time from the performance of the act, it is often difficult to relate the two. This is
especially true when the deferral is until retirement.
9. Just as important is that as deferrals build up, there is a natural reluctance to do any-
thing to jeopardize the receipt of such payments. For the truly outstanding performer,
this is no problem because he or she will either succeed with the current employer or
find another who is willing to “buy off” the deferrals. However, for the maturing exec-
utive whose performance has plateaued, there is a reluctance to accept risk ventures
outside the current employer that would cause the forfeiture of unpaid bonus monies.
10. Evaluate answers to the first nine, and you’ll have a more thoughtful answer to the
question “Should income be deferred?”
SUMMARY AND CONCLUSIONS

Table 3-4 summarizes the tax and accounting treatment for current and deferred income as
well as the principles involved.
As the list of advantages and disadvantages would suggest, deferred compensation is
not for everyone. From the individual’s point of view, it is a needs vs. investment decision.
What are my current cash needs? What is the after-tax value of the award today? What is
it likely to be at the time the deferral ends? What is the compound rate of return on
the investment? What is the projected inflation and value of the dollar at the end of the
deferral? The executive must attempt to place future as well as present values on the chart
in Figure 3-4 before determining the extent to which deferred compensation is appropri-
ate. The before- and after-tax positions will vary by individual, based on the person’s
assumptions.