PAY DIRT
By many means, including the relentless cuts to pensions and retiree health benefits, executive pay tied to stock performance and earnings continues to climb. But how much are executives really taking home? For all the hand-wringing by compensation critics, the magnitude of executive pay has remained an elusive figure. But given that so much of it creates an ongoing liability for both the supplemental pensions and deferred compensation, knowing how large the total is can help investors, at least, gauge the pension headwinds ahead.
An indirect way to calculate the percentage of pay executives collectively receive at U.S. companies is to look at payroll tax data compiled by the Social Security Administration, which most people know as FICA. The key: Only earnings up to a certain ceiling are subject to a U.S. payroll tax of 12.4 percent, split between employer and employee, which finances Social Security retirement benefits. The ceiling, which is indexed to the average growth in wages, was $106,800 in 2010. (Employers and employees also each pay 1.45 percent on an individual’s total income, with no salary ceiling, to fund Medicare.)
The Social Security data shows that 6 percent of wage earners have pay that exceeds the taxable earnings base, and that their “covered earnings” above the taxable maximum totaled $1.1 trillion in 2007. Adding the portion of their pay below the taxable wage base, $991 billion, produces a total of $2.1 trillion. In other words, by 2008, executives were receiving more than one-third of all pay at U.S. companies—more than $2.1 trillion of the $6.4 trillion total compensation.
The 6 percent of those taking home one-third of all pay includes everyone earning more than the wage base. But the top 2 percent of earners account for the lion’s share of the $2.1 trillion. And that’s just the pay top earners receive or defer. The figure understates executive pay because it includes just salary and vested deferred compensation, including bonuses.
It doesn’t include unvested employer contributions and unvested interest credited to deferred-compensation accounts. Nor does it include unexercised stock options (options aren’t subject to payroll tax until exercised) and unvested restricted stock (which isn’t subject to payroll tax until vested; the subsequent appreciation is taxed as a capital gain).[11]
Also not included in the total compensation figures are types of executive pay that are never subject to payroll tax at all. This category includes incentive stock options (which are generally taxed as capital gains) and compensation characterized as a benefit (certain benefits, including pensions, aren’t subject to any Social Security taxes). The compensation data also leave out compensation paid to hedge fund and private equity managers. The billions they receive isn’t considered pay; it’s treated as “carried interest,” which is taxed as a capital gain.
And what about the other half of the compensation equation—benefits? In addition to $6.4 trillion in wages and salaries, private companies pay $1 trillion in benefits, which include contributions to retirement plans—both pensions and 401(k)s—health care, and life insurance contracts. It isn’t possible to tell what portion represents benefits—and liabilities—for executives.
At the giddy height of the mortgage bubble in 2006, economists at Goldman Sachs analyzed what had been the biggest contributors to record corporate profits. The lead items on their list weren’t productivity, innovation, or the quality of management. “The most important contributor to higher profit margins over the past five years has been a decline in labor’s share of national income,” they wrote. They weren’t talking about pensions and benefits, but the patterns are parallel.
SHADOW PLAN
Even if the public doesn’t know or care how big the executive liabilities are, finance officers certainly do, and they have come up with various ways to deal with it.
The life cycle of pension plans at drug wholesaler McKesson Corp. may provide a hint about how this trend will play out at the many companies with frozen pensions and growing executive liabilities.
McKesson froze its employees’ pensions in 1997, and the next year established a SERP for top management. The frozen pension plan soon had a surplus because workers were no longer building pensions and the liability was falling with every dollar paid out to retirees. Thanks to gains from curtailing the pension, plus asset returns, the frozen plan began to generate income. This offset the annual expense of the unfunded executive pensions.
Essentially, frozen employee pensions, like the one at McKesson, provide shadow funding for executive pensions. This isn’t necessarily a cash resource (see Chapter 8, “Unfair Shares”). Rather, the pension income offsets the drag the unfunded executive pensions create on income. This is one reason why companies freeze pension plans rather than terminate them: They can be worth more alive than dead. Why kill the fatted calf when you can continue to milk the cow for years?
In 2007, McKesson acquired Per-Se Technologies and merged that company’s underfunded frozen pension with McKesson’s overfunded frozen pension. This relieved McKesson of the need to contribute to the Per-Se plan. Indirectly, McKesson had monetized the surplus assets in its frozen pension plan. Over time, assuming McKesson doesn’t extract the assets, the plan will have a surplus that will continue to build, especially when interest rates begin to rise from their historically low levels. Once again, the frozen plan will be a shadow fund for the executive pensions, including the more than $90 million owed to chief executive John Hammergren.
Chapter 7
DEATH BENEFITS
JUST BEFORE CHRISTMAS 2008, Irma Johnson, a widow in Houston with two young children, got a check in the mail for $1,579,399. It was the death benefit proceeds from the life insurance policy on her husband, Daniel, who’d died of a brain tumor at age forty-one the summer before. But the check wasn’t payable to the Johnson family. It was made out to Amegy Bank, the company that had fired her husband six years before he died.
The check was accompanied by a note from the U.S. Postal Service, saying that the original envelope had become damaged in processing. But there was no other explanation. Mystified, Johnson called the insurer that had issued the check, Security Life of Denver Insurance Co. The person she spoke to told her that Amegy Bank of Houston was the beneficiary of a life insurance policy on her husband’s life. The insurer had already sent the bank a check to replace the one lost in the mail.
This was the first time Johnson had ever heard of the policy, and she was appalled. The bank had taken out a life insurance policy on her husband and now was going to keep the money. But she would have been even more outraged if she had known where the money would go.
In recent years, as the costs of salaries and benefits for executives have put huge IOUs on corporate books, companies have begun stuffing billions of dollars into new and existing life insurance contracts taken out on the lives of their employees. The insurance policies serve as pseudo pension funds for executives: companies deposit money into the contracts, which act like giant IRAs. Like an IRA, the money in the policies is allocated among investments and grows tax-free. When the employees die—no matter how long it’s been since they’ve left the company—the death benefit goes to the company tax-free. The primary goal, though, isn’t to harvest the death benefit but to reap tax benefits and to use the investment income to offset the cost of the executive obligations.
Technically, it’s illegal for companies to buy life insurance on workers as a tax dodge, but companies can buy it to finance “employee benefits.” This loophole was created in the 1990s when companies and life insurance lobbyists convinced lawmakers that they could use the insurance to pay for “retiree benefits.” What they didn’t tell Congress was that the retiree benefit they were referring to was executive deferred compensation.
This corporate-owned life insurance, or COLI for short, was initially nicknamed “janitors insurance,” because
