October 13, 1996
Tax Breaks for Executives Who Earn Now, Pay Later
Rushing Away from Taxes: First of two articles
Why Delay Pays: A Business Response to Government Limits An Irresistible Deal: Tax Advantages and Secrecy, Too Trickle Down: Expanding Ranks of the Chosen Few Washington's Loss: Use of Insurance Costs the Treasury Related Articles
Putting Aside $1 Billion While Making a Company Thrive Spreading Way Beyond the Giants of Corporate America
By CHRISTOPHER DREW and DAVID CAY JOHNSTON
ven as the Presidential candidates debate sweeping tax breaks, American businesses have beaten them to the punch. Companies large and small have been signing up executives and other top employees for a generous tax break not available to other Americans. Hundreds of thousands of people have become eligible, most in the last few years, at more than 24,000 businesses.
The deal is simple: Rather than take all their pay, and pay taxes on it, executives let the company hold on to some. The company invests the money, and the executives do not pay taxes on any of it until they take the money years later.
It sounds like the I.R.A. or 401(k) savings plans used by tens of millions of Americans. Except this deal excludes the rank and file and has special benefits: there are no Government limits on how much can be put away, and many top executives have put away millions. A lot of companies guarantee them high interest rates on the money and throw in a matching contribution.
Just like that, the executive is able to build a much bigger nest egg than people who have to pay taxes immediately, taking greater advantage of the magical compounding power that makes all these plans so attractive.
Take John F. Welch Jr., chief executive at the General Electric Company. By deferring taxes on $1 million last year, he stands to have $263,000 more within five years than he otherwise would have had.
This executive privilege is known as deferred compensation. Once rarely used, it has soared in popularity in recent years -- an unintended consequence of Government moves to raise tax rates for high-income Americans, clamp down on executive pay and limit the benefits that executives can receive from regular company pensions. And it is spreading quickly, even as half the private work force has no retirement benefits and many companies have been trimming pension benefits for rank-and-file workers. Indeed, its growth represents a threat to a prime tenet of the nation's retirement policies: that companies offer benefits as fairly and to as many workers as possible.
Consider these facts:
--The amount of deferred compensation can be staggering. In 1994-95 alone, the chairman of the McDonnell Douglas Corporation, J. F. McDonnell, deferred $2.5 million in pay, and Michael H. Jordan of the Westinghouse Electric Corporation deferred $1.8 million. John L. Clendenin of the BellSouth Corporation has close to $10 million in his deferral accounts.
--There is no ceiling on how much money can be sheltered. One executive alone, Roberto C. Goizueta, the chief executive of the Coca-Cola Company, has accumulated $1 billion, most of it in company stock that will not be taxed until after he retires.
--No longer are just a chosen few capitalizing on this tax break. A growing number of large companies, including Merrill Lynch, I.B.M. and Tenneco, have recently expanded their plans to include hundreds or thousands of prized employees. Other companies have included middle managers and salespeople making as little as $55,000. Even nonprofit organizations as diverse as Mount Sinai Hospital in Manhattan and the Boy Scouts of America Greater New York Councils are signing up.
--Owners of small businesses like Ollies Station restaurant in Tulsa, Okla., are now setting up deferral plans, allowing them to save for retirement without including their workers, who by law would have to be part of any pension or 401(k) plan.
--In most cases, because the money remains in the business's coffers, the company and its shareholders pay taxes on it instead of the executive, and therefore effectively subsidize the tax breaks.
--The Government's rationale for allowing special deferred-compensation plans for executives is that they typically do not cost the Treasury. But a lot of companies, following the advice of an army of consultants, are reducing their own tax bites by buying life insurance policies on the executives. Under Government rules for insurance, this allows the deferred money to grow for years without being taxed. An analysis for The New York Times by Coopers & Lybrand, the accounting firm, shows that the Government would typically lose half of the taxes it would have collected. About 300 of the 1,000 largest public companies are now using life insurance to finance their deferred compensation, according to one survey.
--All this is happening with no attention from the Government. Top officials at both the Treasury and the Labor Department said they were not aware that there was much growth in the deferral plans or in the use of life insurance to underwrite them.
--The Government has no idea how many billions of dollars are being deferred, or how much this might cost. In most cases, it requires companies to write a letter informing the Labor Department that deferred compensation is being offered. But it does not require companies to disclose the amount, even on the executive's W-2 tax form. Many companies never bother to file anything with the Labor Department. And its list is riddled with inaccuracies. For example, it does not include Exxon, Ford and Wal-Mart -- though they all offer deferred compensation.
--Companies are not required to disclose to their shareholders how much their top executives are deferring, even though Federal rules require disclosure of almost every other element of executive compensation. A review of the public filings of more than 300 companies shows that only a few disclose how much of an executive's pay is deferred. Critics say deferrals can amount to a stealth pay raise that should be reported to shareholders.
--In theory, the money promised to executives can be lost if a company runs into financial trouble. But in many cases where a company has gone bankrupt, top executives ended up getting their deferred money even as less powerful managers and rank-and-file workers lost some of their savings.
Deferred compensation is perfectly legal and always has been. Like awards of stock and supplemental pensions, it is one of a growing number of techniques that companies use to attract, reward and retain executives. Still, its growth troubles some people familiar with the arrangements, who say such plans are widening the gap between the American manager and the American worker. Deene Goodlaw, a San Francisco lawyer who teaches pension law at the University of California at Berkeley, has prepared hundreds of deferred-compensation plans. And she says that some companies are paying for these plans partly by cutting retirement benefits for the rank and file.
Ms. Goodlaw said she quit the tax department of a prestigious law firm after she was directed to prepare a lavish deferred-compensation plan for one company's executives on the same day she was told to draft a plan that let it cut most of its low-paid workers out of its pension plan.
"That is where they are getting the money to pay for what the executives get in their deferred compensation," Ms. Goodlaw said. "If you quote me on this I'll probably never get another job drafting deferral agreements. But that's the truth, what is going on is wrong. It's immoral."
Of course, many companies are not slashing benefits for their rank and file. But experts say that exclusive benefits like deferred compensation are a significant departure from the way things used to be. In 1980, executives at large companies derived 90 percent of their retirement benefits from regular company pension plans -- the ones offered to most employees -- according to corporate consultants. But today, only 30 percent comes from the company plan; the rest comes from deferred compensation and supplemental pensions.
"You sever that linkage between executives and the rank and file, and you are going to have a problem," said Jack Vanderhei, research director of the Employee Benefit Research Institute, a nonprofit group.
He said that any executive whose company was failing to place enough money in its pension plan would "start to worry if he's expecting to get most of his benefits from it." But if most of his benefits came from other plans, he said, then the executive might think, "What do I care?"
Executives say the Government created these problems by imposing regulations that have made it impossible for companies to offer pension plans and 401(k)'s that can satisfy their highest-paid employees, leaving companies with no choice but to expand the deferral plans. And the Government's attempt to rein in multimillion-dollar executive salaries encouraged companies like General Electric, McDonnell Douglas and Westinghouse to shift from cash compensation to a much greater reliance on deferrals, which are exempt from the new limits.
Deferred compensation is off-limits for the vast majority of workers. Federal law allows employers to include only "a select group of management or highly compensated employees" in deferral plans meant to provide retirement savings. That generally means less than 3 to 5 percent of the work force. The reason is that such plans do not have the safeguards required for pensions and savings plans for the rank and file. Unlike the funds for pensions and 401(k)'s, deferred money is subject to claims by a company's creditors if a company fails. Also, the deferral plans are not backed by the Government's pension insurance fund.
But to judge by the numbers, that risk has not frightened many business leaders.
Why Delay Pays: A Business Response to Government Limits
Since the Government created the income tax in 1913, wealthy Americans have always found ways to avoid or delay paying taxes. Deferring income can be as simple as a real estate broker shifting the collection of a fee from one year into the next.
Many companies began letting executives defer pay as the highest tax rate surged from 7 percent to 94 percent during World War II. But even though the top rate stayed at 70 percent or higher through 1981, the deferral programs at most companies remained limited, and they were mainly used by a handful of executives nearing retirement.
One reason was that in the 1950's and 1960's, most large companies had basic pension plans that offered adequate benefits to both executives and the rank and file. But in 1974, Congress passed the Employee Retirement Income Security Act, which included measures to expand and protect the retirement money of regular workers.
That law set the first limits on how much executives could draw from basic company pension plans. And it said that if they wanted to save more, they would have to use other vehicles that did not have the same safeguards. These were mainly the special deferred-compensation plans and supplemental pensions.
But deferral plans did not take off until Congress made more changes. This happened even as the top tax rate was being slashed, to 50 percent in 1982 and then to a low of 28 percent from 1988 through 1990.
Two big changes involved I.R.A. and 401(k) accounts. Shortly after the Government introduced Americans to the impressive compounding power of tax-deferred savings, Federal officials became alarmed by how much revenue the Treasury was losing.
The Government allows individuals and companies to deduct immediately their contributions to I.R.A.'s, 401(k)'s and company pension plans that include the rank and file, but the workers do not have to pay taxes on that money until they receive it many years later. This gap between the tax deduction and the tax collection has long been one of the single biggest tax breaks, now costing about $70 billion a year.
So in 1986, Congress eliminated some of the generous deductions. It ruled that most employees covered by other pension plans could no longer deduct their contributions to an I.R.A. (a maximum of $2,000 a worker a year, plus $250 for a nonworking spouse). It also slashed the cap on an individual's annual contribution to a 401(k) plan from $30,000 to $7,000. (Inflation adjustments have since lifted that to $9,500.)
Then, in 1988 and in 1993, Congress again tightened limits on what executives could get from regular pension plans. Before these changes, the pension benefits paid to top managers could be based on no more than $200,000 to $250,000 of annual salary. But Congress cut this to $150,000.
Congressional leaders said they were trying to be fair, by aiming the cuts at people who could afford to save without help.
Their main motivation, however, was not to adjust the nation's retirement policies but rather to increase tax revenue by billions of dollars and lower the Federal budget deficit.
For executives, the new limits felt like "a multiple nuclear warhead attack" on their retirement security, said Bill C. Wilson, of the accounting firm Deloitte & Touche.
There was one other fusillade.
President George Bush signed a bill in 1991 lifting the top tax rate to 31 percent, from 28 percent. President Clinton raised it further in 1993, to 36 percent on all taxable income over $140,000 for married couples, and to 39.6 percent on any portion over $250,000.
At the same time, Mr. Clinton and Congress took a swipe at sharp increases in executive pay -- a trend that had been angering many people as pay soared even for the chief executives of companies that were laying off thousands of people.
New measures banned companies from deducting basic salary and bonuses that exceeded $1 million for any one executive.
But there were exemptions. Companies that tied an executive's compensation to his performance did not have to adhere to the $1 million cap. A company could also defer pay above $1 million and still take a deduction on its taxes once the executive took the money. So now the rush for alternatives was on.
An Irresistible Deal: Tax Advantages and Secrecy, Too
Among the evidence that deferred compensation is spreading are surveys of the 1,000 largest public companies by Compensation Resource Group Inc. They found that 74 percent offered such programs for at least their top executives in 1995, up from 62 percent in 1994. The consulting firm expects that number to rise to more than 80 percent in a survey being conducted now.
In a new poll of executives by The New York Times and CBS News, 52 percent of top executives at large companies had been offered deferred compensation. And 85 percent of that group had signed up for it.
Many large companies let executives defer as much as half their salary and all of their bonus.
A growing number of plans also allow executives to save for short periods, rather than just for retirement. They can take the deferred money in as little as two or three years with no penalty, while I.R.A.'s and 401(k)'s require a 10 percent penalty on withdrawals before age 591/2. That is a big advantage in saving for a child's education or a car, a boat or a house.
Deferring pay could reap larger benefits -- at the Treasury's expense -- if Congress lowers income tax rates as Bob Dole, the Republican Presidential nominee, has proposed in calling for a 15 percent cut.
Deferred-compensation plans provide one other benefit for many executives: published tallies of how much executives make almost never disclose how much of that pay is being deferred. Few companies will disclose anything about executive pay they are not required to, and none of the chief executives mentioned in this article would discuss their deferrals. So it is impossible to make a comprehensive list of who deferred what.
Deferred compensation "is at times used to hide the true income of executives," said Eugene Steuerle, a former Treasury official.
"I've been reading proxy statements for 20 years," added Stephen Selbst, a New York lawyer, "and I have trouble finding information about deferred compensation."
But a review of corporate filings and numerous interviews provide a sense of how lucrative the programs have become. Many deferral plans pay 8 to 12 percent interest and some go higher.
BellSouth has paid interest rates from 8 to 22 percent on deferrals since the mid-1980's.
General Electric promised Mr. Welch, one of America's most successful chief executives, an interest rate of 14 percent when he deferred $1 million of his $2 million base salary last year. It also gave him a $35,000 matching contribution, the same 3.5 percent rate that the company gives other employees on their 401(k) savings.
At 14 percent, his money will nearly double within five years, to $1.88 million. After taxes, he will have $1.07 million.
If Mr. Welch had not deferred, he would have paid Federal and state taxes last year on the $1 million. So he would have been left with $571,680. Even if he could receive 14 percent interest in a safe investment, within five years he would end up with $810,000 -- $263,000 less than with the deferral.
Time Warner Inc. offers Gerald M. Levin, the chief executive, and other top officers this perquisite: a portion of what the company saves through tax deductions when the executives get the money.
Over the last three years, Mr. Levin has deferred at least $1.05 million. If that were to grow to $4 million by the time it was paid out, Time Warner would give Mr. Levin not only that amount but also an extra $1 million under the formula involving the tax deduction.
Some who defer, like Mr. Clendenin and Mr. Levin, are mainly bolstering their savings for retirement. But others, like Mr. Welch, Mr. McDonnell of McDonnell Douglas and Mr. Jordan of Westinghouse, have an added motivation: They are helping their companies hold on to tax deductions on their pay in excess of $1 million.
Norm LaFlamme, General Electric's manager of executive compensation, and officials at McDonnell Douglas and Westinghouse all said their companies encouraged the executives to make the deferrals. Under the 1993 law that capped salary deductions at $1 million a year, the companies would have lost any chance to claim the deductions if they had paid out more than that. But by deferring the rest of the money, the companies can preserve the deductions for later.
For the companies, which pay taxes on their profits at rates of up to 35 percent, the deductions are valuable, saving them up to $350,000 on $1 million in salary.
Mr. LaFlamme said General Electric had also given 3,000 other executives a chance to defer money in recent years and that the company used high interest rates as a "hook" to keep executives from leaving. If Mr. Welch or any of the others were to quit within five years of a deferral, the interest rate would drop to 3 percent.
Mr. LaFlamme said the aim was a "win-win for the employer and the executive." But he also said that "we don't like to manage our executive-compensation programs based on tax law."
Other companies are using the deferral programs to link their executives' pay more closely with their performance.
Over the last two years, for example, the Ford Motor Company has deferred $5.4 million in bonuses for Alex Trotman, its chief executive. The amount will rise or fall with the value of Ford's common stock, and he will be paid in Ford shares when he retires.
In a new twist, companies like Chrysler and American Home Products plan to allow executives to defer gains when they exercise options to buy their company's stock at discount prices. Normally, executives owe income taxes on any gains from exercising stock options. But the new method allows them to transfer the gains into deferral accounts and delay the taxes.
Some companies also pick up the cost of insurance that eliminates the risk of deferred compensation. Last year, the CSX Corporation, a giant transportation company, spent $421,000 to reimburse its chief executive, John W. Snow, for insurance that guarantees his deferred compensation if the company is taken over.
Copyright 1996 The New York Times Company
