Case study: Diagnosing effective deferred compensation programs for a governmental hospital’s executives

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By Dominick Pizzano | 01 July 2015

The challenge

A large governmental hospital maintains qualified plans (defined benefit and defined contribution) for its employees and a 457(b) plan for its executives. The hospital asked Milliman to assist it in evaluating whether its overall executive compensation packages (i.e., salary and deferred compensation and retirement benefits) were (1) competitive with similar employers and (2) sufficient to provide such executives with a target income replacement ratio upon their retirement that would fall in line with industry standards and competitors’ levels for such positions. If additional deferred compensation would be needed to elevate executives to the desired levels, Milliman would provide alternatives for accumulating the required funds on a tax-deferred basis and assist in making an informed decision regarding which alternative would be most compatible with both the hospital’s compensation philosophy and its financial resources.

The Milliman solution

Milliman first analyzed the hospital’s current compensation programs to see where it ranked in “regional” and “similar industry” comparisons. We provided the hospital with a compensation study that defined the standard by which to measure and compare its current executive pay levels. The comparison revealed some existing shortfalls in the level of compensation and overall benefits presently provided to the hospital’s executive team.

We met with the client to discuss the results of the compensation study and solicit feedback. This helped determine the desired target replacement income ratio to use for the next phase of the project: the development of a deferred compensation program.

During this phase, we worked with the client to gather the information needed to prepare a report that would illustrate (1) the available options for designing a program that would meet the desired targets and (2) the estimated variances in ultimate costs and benefits under each option. They expressed an interest in having the program initially be open to a small group of executives with the possibility of adding more in subsequent years. Once they had selected a targeted replacement ratio percentage, we created a model which could project the anticipated retirement income for each of the specified executives based on the benefit programs currently in place and estimated the shortfalls that would need to be made up to reach the desired targeted income replacement ratios.

We then provided the client with a comprehensive plan design report which reviewed the rules governing the deferred compensation vehicle (i.e., a 457(f) plan) available for accumulation of the desired benefits. The report highlighted the tax implications to participants and stressed the need for the hospital and participants to consult with their respective tax advisors before finalizing the plan design. The report also included an in-depth analysis of the issues to consider in determining whether to select a defined contribution or defined benefit approach and the variations in the GASB expense charge under each design and the fundamental philosophical differences (e.g. weighing paternalistic tendencies of the employer versus their thoughts on how much of a responsibility the employee should carry).

For example, the final decision between the two options would depend on whether or not the hospital was willing to bear total responsibility for ensuring participants reached the target income replacement. Namely, did the hospital wish to guarantee a “defined benefit” for the executives, thereby assuming the investment risk over the benefit accumulation period (i.e., the time between the plan’s effective date and the applicable vesting dates for the executives) or would it prefer only to be obligated to make an annual “defined contribution” and have the ultimate benefit payable to the executives depend on the investment results experienced over the accumulation period? The report compared the costs of each approach to further assist the hospital with this decision-making process.

As part of the analysis, the hospital requested that Milliman include several alternate statistical scenarios to illustrate the effect that different vesting schedules (under either approach) and investment return assumptions would have on the overall employer cost (under the defined benefit approach) or the ultimate benefits paid (under the defined contribution approach). Upon seeing the current age and service data of the initial group to be covered, Milliman recommended that only “post-plan effective date service” be counted toward meeting the vesting requirements. This would allow a “golden handcuff” feature to be attached to the program.

Projections were illustrated under two different vesting schedules (“62 and 5” and “65 and 5,” which referred to the later of attained years of age and completed years of post-plan effective date service) and three separate investment return scenarios (i.e., positive, flat, and negative). This gave the client an idea of the variances in ultimate employer costs and benefits paid depending on their selection of plan design, vesting schedule, and investment return assumption under various “actual” market conditions. The study included sensitivity analysis of selected assumptions on the cost projections and the consequences of variances between actual investment returns on any assets accumulated under the plan compared to assumed returns.

The outcome

Milliman consultants met with the plan sponsor to discuss the options presented in the report. The hospital is currently in the process of making the final plan design decisions regarding the vesting schedule and the defined benefit or defined contribution approach. Once the hospital makes its decision, Milliman will provide it with adjusted estimated benefit and cost projections. In addition, Milliman will draft the required 457(f) plan document as well as any employee communications and related materials for review by the hospital’s legal counsel.

In the final analysis, all of the hospital’s goals have been addressed. It now knows how its executive compensation pay scale and retirement programs rank with its peers and is in the process of revamping each of these areas based on Milliman’s findings. The client now feels secure in the knowledge that it will be dramatically improving its chances of retaining key leadership team members for the desired period by implementing an action plan that will provide (1) a more competitive current compensation program for executives and (2) a deferred compensation program designed to supplement existing benefits to afford executives sufficient total retirement income if they remain with the hospital for the entire vesting period.