In a similar case in 1998, in which a family challenged whether NCS had an insurable interest in the deceased employee, the company argued that it did, indeed, have an insurable interest in its workers because, without workers, “NCS would not generate revenue and would cease to exist as a viable entity.” The Texas court in that case suggested that NCS consider liability insurance.
A Texas jury was also unimpressed with an employer’s claim that it had an insurable interest in a part-time employee. Peggy Stillwagoner was a temporary employee who had been at her job only two months when she died in 1994. A nurse, she had been on her way to a home-care appointment when another driver slammed into her Geo Metro. She underwent emergency surgery, but died soon after. She was fifty-one.
Facing tens of thousands of dollars in medical bills, Stillwagoner’s family asked her employer, Advantage Medical Services, if it provided any life insurance or other benefits. The owner of the company said it didn’t. But a few months after the accident, when an insurance company investigator contacted Peggy’s husband, Kenneth, asking him to sign papers releasing her medical records, he learned by chance that AMS held a $200,000 insurance policy on his wife’s life.
The family sued in state court, arguing that the company had no insurable interest in Peggy’s life, since she’d been replaced the day after her death. The family was seeking the benefit the company had collected upon her death. The company insisted that it did have an insurable interest, because the field nurse had the “opportunity to attract or create new business and was therefore a valuable employee.” The family lost in the lower court, but in late 1998 the appeals court reversed the lower court’s ruling and found that Kenneth Stillwagoner had a right to challenge the insurance payment to AMS. Subsequently, the company and Travelers Insurance Co., a unit of Citigroup Inc. that sold AMS the coverage, settled with the family for $395,000.
HOLY BOLI
The bad publicity that lawsuits like these generated spurred lawmakers to draft fresh proposals to rein in the practice. In 2003, Congressman Gene Green, a Texas Democrat, proposed requiring employers to tell all employees, past and present, about any coverage bought on their lives since 1985. Once again, insurance lobbyists fought back. COLI provider Clark/Bardes and insurance-industry groups led the opposition, aided by Ken Kies’s lobbying practice, which Clark/Bardes had acquired. The industry took out radio ads in the Washington area attacking proposals to curb what it called “business insurance.” The proposals went nowhere.
But lawmakers continued to press for more restrictions on COLI, and in 2006 it appeared they had succeeded. Congress enacted new rules that limit companies to buying life insurance on just the top one-third of earners, who must provide consent.
But the rules turned out to be a boon to insurers and employers. For one thing, they specifically permit employers to buy life insurance on the top third of earners—those most likely to participate in deferred-compensation programs. This was the first time the law deemed the practice legal. (Insurance lobbyists aren’t paid top dollar for nothing.) And though the new rules require employers to obtain employees’ consent, the rules weren’t retroactive. Thus, companies still hold old policies covering millions of employees, including lower-level workers and former employees who aren’t entitled to benefits of any kind, as well as retirees. The rules don’t require employers to notify people covered prior to August 2006.
In fact, these “restrictions” fueled the sale of billions of dollars more in COLI. Banks led the way, not only because of the new rules but because banking regulators in the Bush administration specifically affirmed the use of life insurance to finance deferred compensation.
Banks took out billions of dollars’ worth of this life insurance during the mortgage bubble, when executive pay—and the IOUs for their deferred compensation—surged. By the end of 2008, banks had a total of $122.3 billion in life insurance on employees, nearly double the $65.8 billion they held at the end of 2004. (Unlike other companies, banks are required to disclose their total life insurance holdings in regulatory filings.)
At the end of the first quarter in 2009, Bank of America had the most life insurance on employees: $17.3 billion. The bank won’t disclose how much it owes executives and insists that “Bank of America uses this insurance to help defray the cost of employee benefits.” But filings show that the bank had an unfunded obligation of only $1.3 billion for retiree health benefits; it also owes $2.6 billion for supplemental executive pensions. This suggests that at least $15 billion of the BOLI is intended to back the deferred-compensation obligations. JPMorgan Chase had $11 billion in BOLI and, coincidentally, $10 billion in deferred-compensation obligations. The size of its retiree health obligations? Only $1 billion.
Citigroup had $919 million in unfunded retiree-health obligations, $586 million in supplemental executive pension obligations, and roughly $5 billion in deferred compensation. Offsetting these obligations: $4.2 billion in life insurance. Citigroup said it had bought BOLI because it was “an attractive use of capital” and for “the tax-free nature of the death proceeds.”
Wachovia Corp. had $12 billion in BOLI at the end of 2008, when it was acquired by Wells Fargo (which had $5.7 billion). None of the banks would say how many employees it had life insurance policies on, or whether they were still employed by the bank.
UNDERGROUND
Life insurance on employees accounts for an estimated one-third of all sales of cash-value life insurance. The amounts companies hold can exceed the size of their pension plans. Yet companies and insurers are required to report almost nothing on it, making it impossible for employees, regulators, and lawmakers to determine just how much money companies have stashed away in the insurance.
Insurance regulators, who often accommodate the wishes of the industry, help keep the practice a mystery. The National Association of Insurance Commissioners says it has no data about the scope of the sales, and, though banks report their total holdings to regulators, other companies aren’t required to.
Even bank regulators, including the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corp., have little data. Banks are required to disclose the total cash surrender value of their policies in quarterly bank filings. This is the amount of money they have stuffed into the contracts, plus interest. But they don’t have to disclose anything else, including how much the investments are contributing to earnings. In 2007, the IRS began requiring companies to report the number of employees they purchase insurance on, and the total amount. But companies don’t have to provide any figures for insurance they held prior to these new disclosure rules.
The insurance industry won’t talk about it, either. The American Council of Life Insurers, which has lobbied strongly to oppose restrictions on COLI, says it doesn’t have any data on the product. The National Association of Life Underwriters, despite devoting one-third of its annual conference on life insurance to COLI, says it doesn’t know how much companies are buying.
The Life Insurance Marketing and Research Association says it doesn’t ask companies how much of the insurance they have, and A.B. Best Co., which sells a report on COLI on its Web site, says it doesn’t know how much employers buy or what percentage of life insurance sales it accounts for.
Some insurance consultants used to provide figures to the public, but they stopped. CAST Management Consultants in Los Angeles reported in the early 2000s that sales of new corporate-owned life had risen 60 percent. But it has kept mum since.
Insurance companies that sell COLI don’t even mention the products in their SEC filings. Hartford Life, a major COLI provider, used to. In 2001, it had janitors insurance with a face value of $4.3 billion in force among its clients, according to its annual report. COLI in all its forms brought the company $37 million of its $1 billion of net income that year. But Hartford stopped providing such disclosures. The insurers also stopped mentioning in filings that they owned policies on their own employees. Hartford
took out an undisclosed amount of insurance on about eight hundred of its own managers in 2002, but current filings don’t mention it.
Prudential Insurance Co. of America had four groups of policies on workers’ lives, valued at $813 million, in the early 2000s. MetLife Inc., a big seller of corporate-owned life insurance, bought policies on “several thousand” of its own employees in 1993, 1998, and 2001. (There’s sometimes a bit more disclosure when insurers buy life insurance on their own employees; if they buy the policies from a subsidiary, they have to disclose the purchases as related-party transactions.)
The SEC requires that companies report increases in the amount of life insurance they have—but only if the increases are “material.” Materiality isn’t defined. “So some large companies with COLI don’t need to report it at all,” says a former government tax official.
Further, when companies report the holdings, they commonly report all their life insurance in aggregate. This includes “key man” policies taken out on top executives, and split-dollar policies, which are used to funnel lavish retirement benefits to top executives.
For investors, another challenge is knowing how much life insurance might be contributing to a company’s bottom line. Companies commonly aggregate the insurance-related income with other items in the “other income” section of their filings.
Clark/Bardes, the COLI consultant, is also vague. A footnote in the income section of its 2000 filing says the “other income” category “includes $1 million in life insurance proceeds.” The company received the $1 million when an employee died in a plane crash.
Chapter 8
UNFAIR SHARES
Using Employees’ Pensions to Finance Executive Liabilities
BUYING LIFE INSURANCE on workers is one way many companies informally fund executive deferred compensation. Tapping the regular pension plan is another. Intel, the giant semiconductor chip maker, moved more than $200 million of its deferred-compensation obligations into the regular pension plan in 2005. This move converted an unfunded liability—deferred compensation for the top 3.5 percent to 5 percent or so of its workforce—into a fully funded, regular pension benefit.
When these 12,000 or so highly paid employees and executives at the chip maker get ready to collect their deferred salaries, Intel won’t have to pay them out of cash; the pension plan will pay them.[13]
There was another benefit as well: Intel contributed $187 million to the pension fund to cover the executive obligations. Normally, companies can deduct the cost of deferred compensation only when they actually pay it, often many years after the obligation is incurred. But Intel’s contribution to the pension plan was deductible immediately. Its tax saving: nearly $70 million in the first year.
Meanwhile, the pension contribution enabled Intel to book as much as an extra $136 million of profit over the ten years that began in 2005 (thanks to the pension accounting rules that let companies immediately record noncash income from pension-plan contributions, based on what they expect the assets to earn when invested). The $136 million was Intel’s estimate of the returns on the contribution. The company’s effective guaranteed return on the contribution in the first year: 40.6 percent.
Intel’s move wasn’t illegal, though it had a peculiar result: It turned a pension plan for a company with more than fifty thousand workers primarily into a fund to pay for the deferred compensation of the company’s most highly paid employees, roughly 4 percent of the workforce.
If it were this easy for all employers to just shift executive liabilities into their employee pension plans, they would all have done so long ago. But tax rules put up a roadblock. To get tax breaks, pensions have to be open to a broad group of employees and can’t discriminate in favor of the highly paid.
Benefits consultants, however, found a loophole in the discrimination rules that has enabled a growing number of large companies to shift hundreds of millions of dollars of executive liabilities into rank-and-file pensions. Using complex and proprietary formulas, the consultants determine how much discrimination a pension plan can achieve without technically violating discrimination rules.
The result might be a dollar amount, say, $200 million, which would be allocated to highly paid employees in addition to their regular benefits from the plan. In Intel’s case, the participants got their regular pension, plus an amount of their deferred compensation paid from the pension. These arrangements are often called QSERPs, which stands for “qualified supplemental executive retirement plan.”
The shift doesn’t increase the total amount a person receives; when the executive liability is moved to the pension plan, an equivalent amount of deferred compensation or supplement executive pension is canceled. The goal of the maneuver isn’t to boost executive benefits but to harness the pension plan to pay them. “QSERPs clearly offer a tremendous opportunity for some employers to prefund key executive retirement benefits,” noted Watson Wyatt’s marketing material.
OVERLOADED
Intel and its pension plan were healthy. But companies in financial distress have an incentive to do this, and when they shovel executive obligations into underfunded pension plans, the result can backfire.
In December 2002, Oneida Ltd., a flatware maker in upstate New York, amended its pension to give then chairman and CEO Peter J. Kallett an additional pension of $301,163 a year in retirement. This was in addition to the $116,000 a year he was already eligible for in the regular pension. The company then transferred the liability for that additional amount from his executive pension.
The company made a similar amendment for another executive in April 2004, boosting his pension from less than $33,000 a year to a minimum of $246,353 a year in retirement. The timing wasn’t great. The company was struggling financially, and the pension plan was already significantly underfunded. Two weeks after awarding the pension increase to the second executive, Oneida was supposed to make a mandatory $939,951 contribution to its pension fund. But it didn’t. Instead it froze the pension, which meant that employees would no longer build any benefits. But the freeze didn’t affect executives’ pensions under the QSERP, because these were already set at a certain amount that wouldn’t grow over time anyway. Neither the company nor the plan survived. In 2006, Oneida terminated its pensions in bankruptcy court and transferred the obligations to the PBGC. It also laid off most of its employees. Donald Grogan, who was fifty-two at the time, had worked in manufacturing and shipping at Oneida for twenty-two years before he lost his job. Because the pension plan had been handed over to the PBGC, he had to wait until 2009, when he turned fifty-five, to begin drawing his pension. To make ends meet, he got a truck-driving job with no benefits.
On the other side of the country, a similar drama left Chester Madison with a gutted pension. He had been a middle manager at Consolidated Freightways Corp., a trucking company based in Vancouver, Washington. In late 2001, when the company was clearly in trouble, it transferred most of the retirement IOUs for eight top officers into its pension.
The executives believed this would protect most or all of their supplemental pensions—which could reach $139,000 a year when they retired—because they’d be paid from the pension plan’s trust fund instead of the company’s operating cash.
They also felt more secure knowing that once executive liabilities are transferred into a “qualified” pension plan, they, too, are covered by the PBGC. When consulting firms market these strategies to upper management, that’s a key selling point. By contrast, deferred compensation and supplemental executive pensions are unsecured promises, which creditors can claim if the employer goes under. Many Enron executives learned about this risk the hard way when they lost millions in deferred-compensation savings when the energy giant collapsed in 2001.
CFC executives soon found out how secure they actually were. The company hadn’t been contributing to the pension plan, which was growing steadily weaker. Adding the executive liabilities to the lifeboat swamped it. The plan’s funding went from having about 96 perce
nt of the assets needed to pay promised benefits to having just 79 percent.
The next year, Consolidated filed for bankruptcy, and in 2003 it handed its pension plan over to the PBGC. Consolidated executives lost a chunk of their pensions because the maximum PBGC payout at the time was $44,000 a year at age sixty-five, and is far less at earlier ages and when other factors are applied.
When Chester Madison retired in 2002, after thirty-three years, his pension fell to $20,400 a year from $49,200, which forced him, at age sixty-two, to take a job selling flooring in Sacramento.
Consultants have since devised solutions to reduce risk for the top managers. In 2005, when Hartmarx shifted executive liabilities into the regular pension plan, it also established an unfunded trust to benefit fewer than a dozen executives, including chief financial officer Glenn R. Morgan. A Chapter 11 bankruptcy filing would trigger the funding of the trust, assuring that the executive benefits it had transferred into the regular pension would be paid even if the pension plan failed.
That was a smart move by the Chicago-based maker of high-end men’s suits. In 2009, when its lenders cut off its credit, the company filed for Chapter 11. The company survived: It was acquired by SKNL North America BV, a subsidiary of an Indian textile maker, and renamed HMX. The pension plan didn’t: The new owners had no interest in being saddled with the underfunded pension plan covering thirteen thousand employees and retirees and dumped the plan on the PBGC’s doorstep. At that point, the pension plan was only 47 percent funded.
No one knows how many hundreds of millions of SERP and deferred-compensation obligations have been transferred into employee pension plans since the practice emerged in the 1990s. The Milliman consultant who advised employers to tell only the participating executives about the arrangements was also concerned about the IRS’s reaction. He advised employers that in “dealing with the IRS,” they should ask it for an approval letter, because if the agency later cracks down, its restrictions probably won’t be retroactive.
Retirement Heist Page 14
