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The Brave New World
 

The 1986 Tax Reform Act has raised new questions about virtually every compensation tool a company has
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TIME WAS WHEN EXECUTIVE COMPENSATION WAS A walk in the park. You paid your key people a competitive salary, threw in a merit raise once a year, and went about your business. Everybody was happy.

My, how times change. In recent years, executive compensation has more nearly resembled Mr. Toad's wild ride: just when you think you know where you're headed, something comes along and sideswipes you, spinning you around and sending you off in another direction. First it was persistently high inflation, which made 10% cost-of-living raises an accepted annual ritual. Then inflation abated, competition intensified, and the hot issue became "pay for performance" -- that is, compensation tied to the achievement of clear goals. Scarcely had that concept taken hold than we found ourselves in the Age of the Entrepreneur, with hundreds of new companies being started every day, and the challenge of retaining key people became tougher than ever.

But all that, it turns out, was a mere taste of things to come, most of which came in 1987. It is no exaggeration to say that this year has brought more change to the world of executive compensation than any since the dawn of modern management. Granted, companies are still searching for ways to be more competitive, still looking for formulas to motivate and keep their best and brightest people. But whether you are aware of it or not, the context in which you sort through your options has been utterly transformed. No matter what business you're in, the 1986 Tax Reform Act has -- to one degree or another -- raised new questions about virtually every compensation tool you have.

This is not to suggest that companies are rushing to revamp their pay systems for top managers. Judging from the results of INC.'s ninth annual survey of executive compensation, most business owners are taking a wait-and-see attitude. Just 18% of the survey respondents have adjusted any of their executive compensation practices during the past year, and only 37% say they are actively considering making such changes in the coming year.

Nor do the majority appear to worry much in general about the effect of the tax laws on compensation. As in years past, respondents say that they have the most difficulty in determining the worth of a job and setting pay levels (58%), developing annual incentives and bonuses (51%), and coming up with appropriate long-term incentives or equity-participation plans (43%). Developing tax-effective compensation plans was listed as a concern by only 37% of the respondents -- a higher percentage than in previous surveys, but still a distinct minority.

There is, indeed, a good argument to be made against tailoring reward systems to fit the tax laws. Moreover, companies should be cautious in restructuring something as important as compensation. But caution is not the same as ignorance, and no company owner can afford to remain in the dark about the implications of tax reform. They are simply too far-reaching. They affect everything you do in the area of compensation.

Take, for example, the most basic ingredient of compensation: cash. Under the old tax code, it wasn't that difficult to convince a highly paid, middle-aged executive to defer some of his annual compensation into his retirement years. By then, after all, his income would probably be lower, and so would the tax liability on the money in question. As it was, he was getting only half of each incremental dollar paid out currently (assuming he was in the 50% tax bracket). So he had a strong economic motive for setting aside a chunk of his salary or bonus and investing it on a tax-deferred basis. As for his employer, deferring compensation meant improving cash flow.

Under the new tax law, however, deferred compensation has lost its luster. It's a matter of simple math. As corporate tax rates fall from 46% to 40% to 34%, companies are faced with increasing aftertax costs of compensation and benefits in general. Meanwhile, executives find that the value of that extra dollar of current income is rising. At today's top individual tax rate, it's worth 62.5?, rather than the 50? of a year ago, and it will be worth 9.5? more in 1988, when the rate drops to 28%. Small wonder that top executives are beginning to clamor for cash on the barrelhead. And if Congress is as likely to raise individual tax rates as many believe, there is all the more reason for executives to worry about the future value of a deferred bonus, and to push for getting their money now.

So cash has a lot more appeal now than it did a year ago. What about equity? There, too, tax reform has had a major impact. Only yesterday, it seems, executives and ambitious employees all over the country were demanding stock in their companies, and -- to some extent -- the rationale was economic. Equity, after all, offered the opportunity to build personal wealth through the increasing value of the shares, and the appreciation would be taxed at no more than 20%, the maximum tax rate on long-term capital gains. For an executive in the 50% bracket, the prospect of big gains and low taxes was hard to resist.

Tax reform has certainly not eliminated the appeal of capital appreciation. (Has there ever been a better way to build a nest egg than to have the value of your company's stock soar from $5 to $50?) But, starting next year, the appreciation will be taxed at the same rate as ordinary income. That change removes a significant part of the economic incentive for owning real shares of stock, and correspondingly strengthens the case for nonequity alternatives -- such as phantom stock and performance bonuses -- which can be structured to give employees a chance to reap the upside rewards of growth without actually becoming owners. From the company's perspective, moreover, such alternatives are often easier to administer than real equity, in that they are not subject to securities regulations. Granted, employees may still want ownership. "But there are many ways a private company can foster a feeling of ownership without giving away actual shares," notes Donald T. Sagolla, a principal in charge of management consulting with Peat Marwick Main & Co., in Hartford. Some of those other ways are more appealing than ever.

Tax reform's impact, however, goes well beyond the effects of changing tax rates. Indeed, the new law reaches into the furthest recesses of compensation, tinkering with many of the benefits that companies have used to fill out the package they offer top executives. And here there is an unmistakable trend. In various ways, the new law tends to level out tax-favored benefits. Congress is saying, in effect, that -- if you want to offer a tax break on benefits -- you have to provide all your employees with more or less similar rewards. You can no longer use the tax code to compensate your top people at a level that is far beyond what you are providing the rank and file.

Perhaps the most striking example of the trend involves the rules governing 401(k) retirement plans. Under the old tax code, a well-compensated executive was allowed to place up to $30,000 a year of pretax dollars into a 401(k) account. True, the maximum allowable contribution was sometimes less, depending on the level at which other employees participated in the plan. But, even so, the 401(k) offered key executives an attractive way to save for retirement.

The 1986 Tax Reform Act has all but eliminated the 401(k) as a tool of executive compensation. Not that it abolished the 401(k), but it did introduce a whole new set of guidelines for determining how much an individual can contribute. Now, instead of $30,000 a year, the maximum annual contribution per person is just $7,000. And that's only if other employees participate at a sufficient level. Otherwise, the maximum is less. Either way, the new law substantially limits the ability of companies to use the 401(k) as a means of rewarding top executives.

And the list doesn't end there. Tax reform will affect most other areas of compensation as well -- incentive stock options, bonus arrangements, nonqualified plans, you name it. What it all means is that the rules of the game have changed, and the way you play it may have to change accordingly. The question is: what should you do?

To listen to a lot of the experts, you should immediately set about restructuring your entire compensation system. Tax reform has meant a field day for consultants, who have spent the past few months scurrying around, designing orchestras of bells and whistles to play in harmony with the new tax code. They have looked at every angle, tested every scenario, run reams of spreadsheets, analyzed the financial implications of everything from cash bonuses to phantom equity to nonqualified deferred bonuses. The result, unfortunately, is utter cacaphony.

Consider, for example, the issue of deferred compensation. There is no denying that current cash is worth more now than it was last year, or that it will be worth still more in 1988. Nor is there much doubt that, given present interest rates, many executives would sooner take a $10,000 bonus today than $10,000 plus interest two or three years down the line.

But does that mean you should forget about deferring compensation, as some experts contend? Well, not necessarily. Yes, there could be circumstances under which you might decide to boost morale by paying out cash bonuses, even if they do cost more than they used to. Then again, cash does have certain limitations. Even your executives would probably concede that, unlike money invested in a company plan, paid-out cash often has a way of disappearing. More important, it won't do much to keep managers focused on longer-term goals. If you reward people strictly for short-term results, don't be surprised when you get short-term thinking. If that's not what you want, you might do better giving bonuses with, say, three- to five-year payouts, no matter what the experts say.

Similarly, beware of advice that suggests stock and stock options are now obsolete. Tax reform may have reduced the economic appeal of real equity, but employees seldom push for equity participation on economic grounds alone. Phantom stock is not the same as shared ownership, even if it is designed to provide identical financial rewards. Nor is it likely to produce the same level of commitment to the business that an honest-to-goodness shareholder feels.

What's more, it's doubtful that the nonequity alternatives will long remain on an economic par with real equity. "I don't know anybody who expects the tax rates we have today to stay in place for very long," says Heidi Toppel, a principal with The Wyatt Co., a compensation- and benefits-consulting firm with offices in New York City. The betting is that, within a couple of years, Congress will raise personal tax rates, restoring the preference for capital gains. If that happens, bona fide equity will once again enjoy a financial advantage over its ersatz look-alikes, and the clamor for real stock will generate as many decibels as before.

Of course, equity may not seem like a pressing matter at your company. It seldom does -- until a key employee threatens to leave, or actually leaves. Yet the issue of executive benefits is hard for any company to ignore, if only because of competitive pressures. Here, too, you have to weigh carefully your options under tax reform. Unfortunately, you may not have many, at least when it comes to retirement planning.

At first glance, you might be tempted to offset the new limitations on tax-favored programs by increasing your executives' current compensation. Then they can take responsibility for their own retirement and invest the money as they please. This approach, though, has a major drawback: it gives key executives little incentive to stick around your company beyond the end of the year. An alternative is to offer them nonqualified deferred compensation -- money that would only become available on retirement (or whenever you designate). Such a plan may not help your cash flow: unlike funds set aside under a tax-qualified plan, a company can deduct nonqualified retirement benefits only when the individual involved actually receives them. But at least it would give executives a reason to stay with you for the long haul.

That probably sounds good enough, and anyway you don't have many choices. There's a catch, however. Your executives probably won't take you up on a nonqualified retirement plan unless they have absolute confidence in the long-term viability of your company. That's because they'll be pinning their future, and their families' future, on the fate of the business. You can protect their retirement benefits in the event the company is sold -- say, by investing the money in a special trust. But there's probably no way to cover them if the business goes down the tubes. "In the end," says Steven E. Gross, a vice-president of Hay Management Consultants, in Philadelphia, "a company's promise to pay is only as good as its financial worthiness at the time that the money is due."

So how can you engender the kind of confidence that will lead to commitment? Well, you'll have to prove your competence and judgment as a leader. You'll have to convince your key people that the way you run the business makes sense; you'll have to give them a clear idea of where the company is heading; you'll have to demonstrate your own commitment to treating them fairly. You may also find that you can generate real confidence only by giving your executives greater control over the company's destiny -- which brings us right back to the question of equity. Says John F. Tallitsch, a partner with Cammock, Cammock & Tallitsch Inc., a Cleveland consulting firm specializing in benefits and compensation, "Tax reform will put more pressure on owners to give up a piece of the business." If they don't, the better executives will go to work for owners who do.

If all of this sounds a little overwhelming, there's a reason. The Tax Reform Act raises questions about executive compensation that speak to management issues lying at the heart of every business. How you meet the challenge may well play a crucial role in determining your company's success in years to come.

This is not an argument for haste, however, but for careful, throughtful planning. Don't worry if the choices seems confusing. Executive compensation is confusing -- all the more so given the changes in the tax laws. Today's waters are, to a large extent, uncharted; the best solutions are still waiting to be found. In searching for those solutions, the important thing is to keep squarely focused on the specific needs of your business and the people you want to motivate and retain. Yes, the rules have changed, but that doesn't mean you should redesign your whole company to fit them. In other words, don't allow the tail to wag the dog. Remember that compensation is, first and foremost, a management tool.

And one other point: don't expect the compensation system you settle on to carry you indefinitely into the future. The past 10 years of tumult have not been an aberration: they reflect important economic trends and, as such, are probably typical of what lies ahead. The simple fact is that the world of executive compensation is likely to go right on changing, and companies will feel pressure to change along with it. "What looks like a good compensation system today may have to be totally redone a couple of years from now," notes Ed Johnson, chief executive officer of The Johnson Cos., a benefits- and compensation-consulting firm located in New-town, Pa.

So there may be a silver lining to the clouds of confusion surrounding the implications of the Tax Reform Act. It may just force company owners to do what they should be doing anyhow: to step back and reexamine their compensation systems, and to make sure they serve both the business and the people who work for it. How you pay people, after all, is not just any management tool. It's one of the most powerful tools you have.

SERVICE

THE TYPICAL COMPANY

A profile of the typical service business

Total revenues $3,497,000

Employees 94

1986 payroll $979,000

Payroll as a percentage of revenues (median) 39%

Percentage that are privately owned 97%

EXECUTIVE COMPENSATION BY COMPANY SIZE

How much service company officers received in salary

and bonus, by annual company revenues

Annual revenues CEO COO CFO CMO

$10 million or more $190,506 $114,385 $78,279 $77,436

$5 million-$9.99 million 131,745 82,241 77,511 64,696

$1 million-$4.99 million 110,736 81,046 60,051 79,181

Less than $1 million 55,180 44,328 33,049 45,413

EXECUTIVE BENEFITS AND PERKS

The benefits and perks that service companies provided

to their top officers

CEO COO CFO CMO

Company car & expenses 79% 58% 56% 68%

Supplemental life insurance * 62 57 63 56

Supplemental medical insurance * 42 37 43 40

Tax-return preparation 53 38 31 24

Club dues & expenses 48 33 33 29

Personal tax & financial planning 30 17 12 11

Annual physical examination 29 28 28 32

Low- or no-interest loans 25 20 22 17

Supplemental retirement benefits * 15 10 16 17

Deferred compensation 17 17 19 11

First-class air travel 10 9 6 4

* Beyond customary companywide benefits

THE EXECUTIVE BONUS

How service companies provided bonuses to their top

officers

Companies paying bonuses 82%

Basis for allocation of bonuses *

Discretionary 59

Achievement of sales goals 26

Achievement of profits goals 31

Percentage of sales 9

Percentage of profits 24

Return on equity, assets, & sales 6

Companies with a bonus pool 73

Basis for establishing bonus pool *

Discretionary 69

By a fixed formula 15

By a formula set annually 17

* Totals exceed 100% because of multiple responses.

MANUFACTURING

THE TYPICAL COMPANY

A profile of the typical manufacturing business

Total revenues $8,440,000

Employees 109

1986 payroll $1,696,000

Payroll as a percentage of revenues (median) 26%

Percentage that are privately owned 91%

EXECUTIVE COMPENSATION BY COMPANY SIZE

How much manufacturing company officers received in

salary and bonus, by annual company revenues

Annual revenues CEO COO CFO CMO

$10 million or more $170,637 $96,773 $72,743 $90,854

$5 million-$9.99 million 115,822 65,539 60,300 64,807

$1 million-$4.99 million 95,267 59,389 49,313 52,816

Less than $1 million 49,828 42,440 50,701 44,688

EXECUTIVE BENEFITS AND PERKS

The benefits and perks that manufacturing companies

provided to their top officers

CEO COO CFO CMO

Company car & expenses 84% 67% 54% 72%

Supplemental life insurance * 67 63 63 60

Supplemental medical insurance * 38 41 43 38

Tax-return preparation 52 32 24 19

Club dues & expenses 39 22 17 21

Personal tax & financial planning 31 17 14 10

Annual physical examination 31 29 32 29

Low- or no-interest loans 24 14 18 13

Supplemental retirements benefits * 11 11 8 9

Deferred compensation 15 13 13 14

First-class air travel 13 8 8 9

* Beyond customary companywide benefits

THE EXECUTIVE BONUS

How manufacturing companies provided bonuses to their

top officers

Companies paying bonuses 91%

Basis for allocation of bonuses *

Discretionary 55

Achievement of sales goals 30

Achievement of profit goals 35

Percentage of sales 6

Percentage of profits 33

Return on equity, assets, & sales 13

Companies with a bonus pool 82

Basis for establishing bonus pool *

Discretionary 54

By a fixed formula 23

By a formula set annually 27

* Totals exceed 100% because of multiple responses.

WHOLESALE/DISTRIBUTION

THE TYPICAL COMPANY

A profile of the typical wholesale/distribution business

Total revenues $9,172,000

Employees 42

1986 paryoll $1,486,000

Payroll as a percentage of revenues (median) 13%

Percentage that are privately owned 97%

EXECUTIVE COMPENSATION BY COMPANY SIZE

How much wholesaler/distributor officers received in

salary and bonus, by annual company revenues

Annual revenues CEO COO CFO CMO

$10 million or more $161,625 $93,771 $65,265 $79,552

$5 million-$9.99 million 96,582 62,351 48,255 60,511

$1 million-$4.99 million 85,340 51,715 44,504 54,487

Less than $1 million 71,529 40,350 + +

+ Insufficient responses for purpose of comparison

EXECUTIVE BENEFITS AND PERKS

The benefits and perks that wholesalers/distributors

provided to their top officers

CEO COO CFO CMO

Company car & expenses 85% 69% 60% 84%

Supplemental life insurance * 73 65 51 57

Supplemental medical insurance * 37 35 32 35

Tax-return preparation 52 23 20 23

Club dues & expenses 46 31 25 24

Personal tax & financial planning 34 11 17 14

Annual physical examination 32 31 29 27

Low- or no-interest loans 30 16 20 27

Supplemental retirement benefits * 20 19 19 16

Deferred compensation 17 9 11 11

First-class air travel 10 7 6 5

* Beyond customary companywide benefits

THE EXECUTIVE BONUS

How wholesalers/distributors provided bonuses to their

top officers

Companies paying bonuses 85%

Basis for allocation of bonuses *

Discretionary 60

Achievement of sales goals 20

Achievement of profit goals 29

Percentage of sales 9

Percentage of profits 34

Return on equity, assets, & sales 5

Companies with a bonus pool 77

Basis for establishing bonus pool *

Discretionary 65

By a fixed formula 25

By a formula set annually 14

* Totals exceed 100% because of multiple responses.

RETAIL

THE TYPICAL COMPANY

A profile of the typical retail business

Total revenues $4,886,000

Employees 50

1986 payroll $909,000

Payroll as a percentage of revenues (median) 16%

Percentage that are privately owned 97%

EXECUTIVE COMPENSATION BY COMPANY SIZE

How much retail company officers received in salary and

bonus, by annual company revenues

Annual revenues CEO COO CFO CMO

$10 million or more $201,730 $121,175 + $68,495

$5 million-$9.99 million 89,367 + + +

$1 million-$4.99 million 56,144 40,693 + 39,667

Less than $1 million 48,330 + + +

+ Insufficient responses for purpose of comparison

EXECUTIVE BENEFITS AND PERKS

The benefits and perks that retail companies provided to

their top officers

CEO COO CFO CMO

Company car & expenses 83% 78% 62% 68%

Supplemental life insurance * 62 51 55 59

Supplemental medical insurance * 46 43 45 38

Tax-return preparation 54 35 45 41

Club dues & expenses 45 24 24 32

Personal tax & financial planning 30 14 14 18

Annual physical examination 22 35 17 35

Low- or no-interest loans 24 11 17 24

Supplemental retirement benefits * 14 ** 10 6

Deferred compensation 13 5 10 **

First-class air travel 11 8 ** **

* Beyond customary companywide benefits;

** means no response

THE EXECUTIVE BONUS

How retail companies provided houses to their top

officers

Companies paying bonuses 77%

Basis for allocation of bonuses *

Discretionary 56

Achievement of sales goals 17

Achievement of profit goals 25

Percentage of sales 9

Percentage of profits 27

Return on equity, assets, & sales 7

Companies with a bonus pool 56

Basis for establishing bonus pool *

Discretionary 67

By a fixed formula 22

By a formula set annually 18

* Totals exceed 100% because of multiple respoonses.

Last updated: Sep 1, 1987




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