Mutual funds have the advantage of
providing the company with returns that can be closely matched
to the participants' investment allocation, although the
company must pay the income taxes incurred on realized gains
out of current income. Depositing the participants' deferrals
into mutual funds and paying the taxes incurred on gains in cash
can neutralize the P&L impact of providing the benefit. However, when the company retains
the executives' deferred compensation, they have no current expense, and therefore no
tax savings. Depositing the entire deferral means that the company's
after-tax cash outlay is greater than if there were
For example, executives in a plan defer $1 million of
current compensation. The corporation will allocate and invest
the deferrals in the same plan-designated mutual funds which
the participants have selected.
Although the company keeps the $1 million, it is not able
to deduct it as an expense until it is paid out, so it's net
increase in cash is only $600,000 (assuming that the company
is in the 40% tax bracket). If the company invests the $1
million that the participants deferred, it must come up with
an additional $400,000.
In addition, the company must pay taxes on realized gains
and dividends produced by the investments. For example, if
they earn $100,000 of realized gains, they incur current
taxation of $40,000. However, they have an asset that exactly
offsets what they owe the executives, as well as a deferred
tax asset. The company is out $440,000 in cash, and has a
deferred tax asset equal to $440,000 - neutralizing the
balance sheet impact of the plan by achieving earnings equal
to the liability created by the participants.
Establishing a funding mechanism utilizing mutual funds
permits current management to plan for distribution of
benefits by future management. By funding the plan now with a
matching asset that will grow over time to match the payment
obligation, future management is relieved of the burden of
supporting those future payments.
It is important to remember, when a
company makes real
investments, such as purchasing mutual funds, they must
not actually attribute ownership of these investments to the
participants as this would require ERISA compliance.