SERPs Up! Supplemental Executive Retirement Plans Look Better Than Ever in Light of FAS 123R

Growing the wealth of those who have grown the company recently got tougher for Sierra Health Services (SHS), a diversified healthcare provider in booming Las Vegas. SHS has grown from the one physician's private practice in the 1970s into Nevada's largest multi-specialty medical group - with 2004 revenues at $1.6 billion, (NYSE:SIE). Because of that growth, "We had a fairly large number of people who were able to accumulate wealth at a level they never dreamed possible," says Dan Kruger, vice president of human resources at SHS.

Kruger proudly shares the story of one woman in the Employee Records department who earned $15 per hour. She believed she could never own her own house. Thanks to the company's original stock option plan for all employees - and a stock price that soared from $8 to $75 over the course of fours years - she was able to buy her first home.

Commensurate benefits were felt throughout the organization. The stock option plan gave SHS a powerful tool for recruiting and retaining executive talent. "But now, we are losing this critical flexibility to create wealth through stocks," Kruger declares, "and that means some very good people are going to miss out on wealth potential - because of FAS 123R."

Kruger refers, of course, to the Financial Accounting Standards Board's (FASB) guidance that companies must now expense stock options on their books. For many companies, this requirement makes the use of stock options financially prohibitive. It severely weakens the once-prized stock option as a long-term incentive tool to attract and retain high performers.

In the case of SHS, the company saw the writing on the wall regarding stock options back in 2004. Management reluctantly abolished the company's broad-based stock option plan because of the potential impact to the bottom line. Now SHS - like many other companies - is evaluating alternative ways to retain and reward key executives.

A Solution that May Already Be in Place-the Supplemental Executive Retirement Plan (SERP)

The ideal remedy may be closer than they think. While companies are revisiting the use of such long-term incentive instruments as multi-year cash incentive plans, restricted stock plans, or other deferred compensation plans, a company's best friend may be an old friend - the SERP.

In Clark Consulting's 2005 Executive Benefits-A Survey of Current Trends, which reflects data compiled from nearly 20% of Fortune 1000 companies, the use of SERPs continues to be strong, with particularly high prevalence in certain sectors:

• Utilities:
  • 100 percent
• Diversified financial services:
  • 92 percent
• Energy:
  • 85 percent
• Healthcare:
  • 83 percent

If one of your goals is to retain your best talent, SERPs provide an excellent vehicle to create post-retirement income. If another goal is to offset restrictions on expensing stock options, SERPs again provide an excellent vehicle to deliver long-term and performance-based incentives. The characteristics of SERPs that mirror long-term incentives include:

• Performance-based criteria
• Long- or short-term horizon
• Vesting
• Tax deferral

In calculating SERP benefit formulas, employers may select a defined benefit or defined contribution formula. A defined benefit formula provides a stated monthly or annual amount at retirement - such as 70 percent of the executive's final average pay.

A defined contribution formula involves the employer making specified annual contributions to a fund or trust based on a percentage of salary or total compensation.

For example, under the defined benefit formula a SERP could specify that an executive is entitled to a $60,000 a year benefit at retirement, payable over ten years. Alternatively, an employer can offer a fixed percentage formula, rather than a fixed dollar amount at retirement.

Offset Plans

Another popular design feature used in SERPs is an offset provision. This design feature involves the employer's promise to provide the executive with a benefit amount, subject to an "offset" of pension benefits and/or Social Security payments due to the executive.

For instance, the SERP could provide an annual benefit equal to 60 percent of the executive's final three-year average salary less: 1) pension benefits provided under the company's qualified plan, 2) Social Security payments, and 3) the company match in the 401(k) plan.

Implementing a SERP Program

The first step in creating a SERP program is to clarify objectives, and then determine who will participate. Participation in the plan can be decided by either the CEO, board of directors, compensation committee or company retirement plan committee. The decision can also be based on specific salary levels, job grade level, title, and years of service.

The next step is to determine the level of benefits that will be provided to participants in the plan.

Conveniently, there is no need to hold an annual open enrollment for your SERP. Once participants are enrolled, further paperwork is minimal. Because a SERP is a nonqualified "top hat" plan and, therefore, is generally not subject to the burdensome requirements of ERISA, a company is not required to file a Form 5500 or submit other tedious reporting documents. A simple one page letter to the Department of Labor stating that a nonqualified "top hat" plan has been established is sufficient.

Defensive Measures at Sierra Health Services

Sierra Health Services is in the early stages of finding equitable ways to deal with FAS 123R.

Working with Clark Consulting, SHS put into place some years ago a deferred compensation plan and two SERPs. In order to offset the accrued liability in each plan, and to provide additional benefit security under the plans, SHS established an informally funded Rabbi Trust. Kruger emphasizes that the SHS benefits plan is still "very rich." Nonetheless, executive reaction to eliminating the broad-based stock option plan has been mixed. Executives were understandably concerned that a significant number of unvested options would be eliminated and the value of their compensation package would be reduced going forward.

SHS was reluctant to use restricted stock with senior managers because it does nothing to encourage personal involvement or higher performance. It could even have the unintended consequence of accelerated departures, according to Dan Kruger.

Another possibility under consideration is to expand the participation base in the Company's SERP. With a fixed benefit at retirement, executives would be compelled to stay longer and dive deeper into the success of the corporation. In effect, this SERP design limits executive attrition with a "golden handcuffs" arrangement.

There is a vesting schedule tied to the benefit that affects the level of payout the executive will receive at retirement.

"We are taking a very serious look at all our options so that we are not behind in any way," states Kruger.

Next Steps

With characteristics similar to long-term incentive plans, nonqualified benefit plans like SERPs are becoming increasingly utilized as an alternative to stock options. With clarity provided by the proposed regulations for Internal Revenue Code section 409A, there is now an opportunity to design nonqualified plans in a manner that satisfies the company's objectives while complying with the new legislation. It is recommended that any company considering these alternatives look to an outside source to advise them on the proper plan design and administrative requirements for these types of programs.

Now is the time to take advantage of properly designing or enhancing your company's benefit arrangements. The competition to cost-effectively attract and retain management talent is one no company can afford to lose.

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