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Mutual Funds

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 no deferral.

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.

 

 

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