Pay-As-You-Go, as the name implies, means that no cash
is specifically set aside to meet the benefit obligation, and
when it becomes due it is paid from current
For rapid growth companies with good cash flow, significant
returns from invested capital, expanding operations, etc. this
may be an appropriate approach. In addition it effectively
transfers responsibility for the benefit program from current
management to future management. To satisfy benefit
obligations, the cash must be liquid at distribution. This
could be a problem for companies that invest in fixed assets
that don't generate cash.
For example, executives defer $1 million of current
compensation that will earn 10% annually. Although the company
keeps the $1 million, it is not able to deduct it as an
expense until it is paid out, so its net increase in cash is
$600,000 and it books $400,000 as a deferred tax asset. The
executives' deferrals grow 10% the first year to $1.1 million.
This additional $100,000 liability, when paid, will give the
company another $40,000 in tax savings, however it increases
the current net liability by $60,000. While the $1.1 million
dollar liability has now accrued a $440,000 deferred tax
asset, the company must still have adequate cash on hand to
make the payments.
Alternatively, the company may wish to
shield future management from significant liabilities by
planning to accumulate assets to satisfy the future obligation
and create a funding mechanism. While the company can invest
in anything it wishes, two of the more popular choices are
taxable securities summarized as Mutual Funds, or tax-sheltered Corporate Owned Life Insurance.