Page 337 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 323

from determining the retirement income target less other sources of income. The latter
consists of social security benefits, other company programs (e.g., defined-benefit plan), and
individual investments.
The investment choices available to the employee typically permit the individual to
select funds to meet conservative, moderate, or aggressive investment philosophies. While
these vary by individual, they also typically vary by age. Younger employees are likely to be
more aggressive, whereas older employees are more conservative, looking to minimize risk
and protect funds accrued. The key factors to consider are (1) at what point in the future one
is likely to make withdrawals, (2) what is the minimum amount needed when withdrawals
begin, and (3) over what period of time the monies will be needed.
Given a retirement target and time frame, one needs to balance risk versus return. The
highest rate of return opportunity typically creates the greatest risk that the money will not
be available. The aggressive investor accepts the higher risk for the possibility of a greater
return; the conservative investor accepts a lower rate of return in exchange for assurance that
the investment is protected. Bonds can run the full gamut from very conservative to very risky
(e.g., high-interest “junk bonds”). Many investors will seek to balance their portfolio by asset
allocations that include aggressive as well as conservative investments. However, they may be
weighted more in one area than another. In addition to considering the rate of return in light
of investment risk, one should also consider how the likely inflation rate compares with the
rate of return. If inflation is higher, the investment value will erode over time.
The serious investor will look to performance of the available possible investment alter-
natives and select the one or combination that best meets needs. Employing standard devia-
tions can be useful in predicting variability around reported performance. For example, a
fund with average annual return of 10 percent and a standard deviation of 20 would be
expected to return between 10 percent and 30 percent two-thirds of the time. A standard
deviation of 2 would result in a range of 30 percent to 50 percent 95 percent of the time.
Contrast that with a fund averaging 5 percent and a standard deviation of 5. It would range
between 0 percent and 10 percent two-thirds of the time and between 5 percent and 15
percent 95 percent of the time. The first is more likely to be the choice of an aggressive
investor; the second would be a selection by the conservative investor. Comparing standard
deviations with a “risk-free” investment such as short-term treasury bills is helpful in this
review as it establishes a benchmark for comparison. Assume that rate is 5 percent and a
comparison of one standard deviation. On the upside, the second choice has a 5 percent
advantage, whereas the first is 25 percent. On the downside, the second is 5 percent and
the first is 15 percent.
Table 6-32 shows the impact of a 5 percent employee contribution with a 50 percent
company match for an individual currently earning $50,000. Assume the individual received
10 percent annual pay increases for 20 years and the contributions set aside grew at the
annual rate of 10 percent. At the end of that time, the individual would have a fund value of
$504,563, but his or her compensation would be $336,375 (i.e., $50,000 increased annually
at 10 percent for 20 years). One can easily project other values based on multiples of $50,000.
For example, using the same assumptions, a person currently earning $500,000 would have
$5,045,630 in the plan. Part would be in the statutory plan and the balance in a nonqualified,
deferred plan.
The breakdown of contributions and growth of the $504,563 is not shown in Table 6-32,
but in this situation it is as follows: