Insights > Articles > Book Smarts: Accounting for Deferred Compensation Plans

Book Smarts: Accounting for Deferred Compensation Plans

by Louise Hanson - Financial Institutions Practice
October 2013

With the economy improving, many companies, including credit unions, are evaluating their benefit plans. One particular area of focus is deferred compensation plans.

These can be a great incentive for both management and employees, helping them feel more invested in the credit union and its operations. As a result, some credit unions are starting new plans, and others are evaluating the current needs and costs of existing deferred compensation plans.

However, in either case it’s important to bear in mind the accounting impact of the different types of plans, since sometimes the economic concept and its related accounting don’t seem to match. As the investment community continues to devise different investment vehicles, sell insurance policies, and develop other creative post-retirement benefits, all under the umbrella of deferred compensation plans, it’s important to understand the financial statement impact of each type of plan.

There are some general things to keep in mind related to the accounting for deferred compensation. Conceptually, there will be an expense to recognize over the period the employee is providing service. If prior service will be considered when computing the amount of deferred compensation benefit, there may also be a “day 1” expense recognized for this past service. From there it can get complicated, and it’s important to review the components of your specific plan to determine the correct way to account for your plan.

Certain plans are set up with individual contracts and allow participants to defer a portion of their salary. This a more straightforward plan that provides flexibility to participants, allowing them to defer a portion of their own funds tax free until retirement. Typically, these plans have a specified rate (generally with a maximum determined by the IRS to stay within limits that wouldn’t require additional taxes), and the funds will accrue interest and vest over a specified time frame.

The related accounting for this type of plan follows ASC 710 and assumes an estimate of payout at the full eligibility date, which is generally when the participant can access the funds. The accounting estimates include interest earned, the full eligibility date, and the correct periods during which to recognize the expense.

Another common method for deferred compensation plans is to purchase life insurance policies to fund a future payout to certain executives. Generally, a credit union lends funds to the executive to purchase two credit union–owned life insurance policies and pay the premiums on them. The loan is set up as an interest-free, no-payment loan, due upon death or termination of employment. The participant is the beneficiary of the policy; however, the proceeds are first assigned to the credit union. Upon death or retirement, one life insurance policy is used to repay the loan plus interest and the other is used as the supplemental income or benefit for the participant.

Because the cost of the life insurance policies is offset by the loan to the executive, this type of plan appears to be a simple way to reduce the cost to the credit union. However, in this scenario there are more components to consider from an accounting perspective than what’s on the surface.

The imputed interest is recognized as a cost to the credit union for originating and holding an interest-free loan. As the life insurance policy’s cash surrender value increases, the increase offsets the cost of the imputed interest on the loan. In addition, a receivable is recognized related to the present value of the loan plus imputed interest; however, the receivable would never be larger than the cash surrender value of the policy, since that’s the sole source of repayment.

The pitfall is that there’s an expense to recognize over the period the participant is providing service—from the inception of the plan through the expected retirement date—based on the cost of funds specified in the contract. This makes the accounting quite complex. The good news is that there are firms that can help credit unions set up the procedures required to account for this and other similar scenarios involving insurance policies and other supplemental executive retirement plans.

Another accounting consideration related to postemployment death benefits is whether there’s a split-dollar life insurance policy. If so, a liability should be accrued for the death benefit over the period the employee is providing service, to the expected retirement date. The liability is relieved upon the death of the employee, and the credit union no longer has an obligation.

It’s also common to see deferred compensation arrangements that are tied to certain credit union metrics. In this setup, funding of the plan depends on hitting certain goals, which can be financial or nonfinancial in nature. If the goals are met, funds are allocated to participants’ accounts. There are generally service requirements tied to these plans as well. This estimated expense is generally recognized in the income statement, throughout the year. However, the plan is funded only if the specific goals are achieved for the year. If they’re not, the estimated expense is reversed for that year and no additional funds are added to the plan. Generally, payouts begin for a predetermined time upon retirement.

Not as common anymore (because of the general cost and uncertainty of future obligations) are defined benefit plans. These are generally funded by the credit union, and, based on certain actuarial assumptions, project earnings out to a certain date. Based on those assumptions, credit unions are expected to have enough to pay out in the future. Participants receive a specified annuity upon reaching retirement age. Many state and governmental programs have this in place, as well as some private organizations.

Defined benefit plans have significant accounting estimates involved related to actuarial assumptions as well as complex accounting and disclosures in the financial statements. Most benefit plan providers are familiar with the disclosure requirements and can help obtain information to include in the financials, however management still needs to understand and agree with the underlying assumptions being used and the resultant accounting. Many past issues with defined benefit plans were due to unexpected changes in market conditions. Companies didn’t sufficiently fund many of these plans and were unable to make the huge contributions necessary to fund the defined payouts employees relied on.

Each method of deferred compensation has its advantages and disadvantages, and choosing the one that’s right for your credit union won’t necessarily revolve around the accounting complexities each type of plan introduces. But those complexities are nonetheless important and should be a factor as you evaluate your options.

As with anything compensation related, a close read of the substance and language of each agreement is necessary to determine the correct accounting for your credit union and the personal tax effects for each participant. Your accounting firm should be able to help.

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