Executive Benefit Solutions for the Energy Industry

Firms in the oil, gas, and energy-related industries must manage a wide range of risks in their core operations on a daily basis. The ability to do so effectively is a critical component of these firms’ success. Typically management is focused on potential risks to property or liability exposure. However, they often overlook risks associated with their companies’ most valuable assets: the key employees most critical to an organization’s success. The loss of one or more of these executives could leave profits and equity exposed, and in some cases could leave the very future of the company in jeopardy. Managing this risk requires a creative, cost effective strategy for recruiting, retaining, and rewarding top talent.

Historically, large energy companies have done an effective job of implementing these strategies through generous executive benefit offerings. However, many small to midsize energy companies offer few or no benefits specifically for their executives, only providing the same core benefits that they offer to all of their other employees. They may also provide cash-based, short-term incentives to their key employees, but these offerings lose any retention value once they are paid to the executive. If small to midsized energy companies are going to compete with larger organizations, they will need to look beyond core benefits and cash compensation to differentiate their executive compensation and benefits packages from their peers.

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The loss of one or more of these executives could leave profits and equity exposed, and in some cases could leave the very future of the company in jeopardy.

Competing for top talent

Like most organizations, energy companies are facing the issue of an aging workforce, especially among their engineering and management teams. Building a group of rising talent is critical to a successful succession plan as current executive management retires. While this process is important to any organization, small to midsize companies must be particularly creative in order to compete with larger organizations. While offering a significant signing bonus or including a generous match on a 401(k) plan may be important starting points for the recruiting process, these steps alone simply aren’t enough to ensure that a company can acquire and retain top performing executives.

One way many large companies address this issue is to offer stock-based benefits to their executives. Some small to midsized companies may attempt to do so as well. However, doing so leads the dilution of existing stockholder equity, a particularly unattractive outcome for the owners of many privately held firms. Also, potential price volatility and the lack of a highly liquid market for the company’s stock may reduce the perceived value of a stock-based benefit plan by executives at smaller companies.

The challenge of using qualified retirement plans to address the needs of highly compensated executives (HCEs)

Given the challenges of using cash or stock as retention tools, energy companies may attempt to use generous retirement benefits as long-term retention tools. Qualified retirement plans, including 401(k)s, do allow many employees to build significant retirement assets relative to their pre-retirement income. These assets, combined with Social Security benefits, can provide a comfortable retirement for these employees. However, ERISA nondiscrimination rules and dollar caps on qualified plan contributions and benefits make these plans far less effective tools for executives to prepare for retirement. HCEs can only contribute modest amounts of money relative to their incomes. Company contributions also face dollar limits, and they cannot be structured to favor the HCEs. The result is that the larger an executive’s income is, the smaller the percentage of their retirement income that is likely to come from company-sponsored qualified retirement benefits. 

Source: Ball's Deferred Compensation Plan Enrollment presentation

The chart illustrates the diminishing value of 401(k) plan benefits as income increases.

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Company contributions also face dollar limits, and they cannot be structured to favor the HCEs. The result is that the larger an executive’s income is, the smaller the percentage of their retirement income that is likely to come from company-sponsored qualified retirement benefits.

Using Nonqualified Deferred Compensation Plans to Recruit and Retain Top-Performing Employees

Thus far we have identified a number of potential shortcomings in the strategies that many energy companies, particularly small to midsize ones, are currently using to recruit and retain key employees. Fortunately, there are options available that are far more effective in achieving these goals—nonqualified deferred compensation plans (NQDCPs). Eighty-three percent of Fortune 1000 companies offer an NQDCP¹, and a growing number of privately held companies offer these plans as well. Unlike a qualified plan, the employer can choose who participates in an NQDCP, what the amount of their benefits will be and when participants can receive benefits. The employer can also customize the vesting schedule applicable to any employer contributions. For example, a distinct vesting schedule can be applied to each contribution, meaning participants will leave unvested money on the table if they leave the organization.

While sponsors have the option to include employer contributions, there is no requirement to do so. In their simplest forms, NQDCPs allow executives to defer virtually unlimited amounts of income from current taxation in addition to what they are contributing to the 401(k) plan. In addition, participants can choose to receive distributions while they are employed for goals such as college funding without being subject to penalties for withdrawals prior to age 59½. Participants are typically offered a menu of equity and fixed income funds that will determine their account balances, similar to the selections they make in a 401(k) plan. These features alone can make an NQDCP a cost-effective recruiting and retention tool to compete with other energy companies that only offer a 401(k) plan to their executives. The value of NQDCPs to participants can be meaningfully increased if a company chooses to make employer contributions. Sometimes these contributions are used to address the “reverse discrimination” inherent in qualified plans. For example, an employer could choose to extend matching contributions in an NQDCP to all income, not just up to the amounts allowed under IRS 401(k) plan limits. Employer awards can also be completely discretionary, or they can be determined based on criteria chosen by the employer. Many companies base contribution amounts and/or crediting rates on the achievement of companywide, departmental or personal goals. Payouts can vary based on the percentage of a target goal that is achieved. Contributions typically have a vesting schedule assigned to them as retention tools. Once a benefit vests, employers can pay out benefits to participants, or they have the option to allow participants to defer benefits into the future as a tax-planning tool.

The example below illustrates how employer contributions to an NQDCP can translate to substantial participant benefits over time. It also shows the potential retention value of having large unvested amounts at risk if a participant leaves the company:

Assumptions

  • Employer Contribution Amount: 0.1% of company revenue.
  • Crediting Rate on Account Balances: 0% for company profit margin less than 1%. 2% will be credited for each 1% of company profit margin of 1% or higher, to a maximum of 10%.
  • Class Year, With Five Year Cliff Vesting: Benefits paid in a lump sum when vested.
  • Accelerated Vesting: Age plus years of service equal 70 (after year 10 in this example.) Any remaining balance is paid in a lump sum at this time.

Sample Participant Account Growth


 Year Company Revenue   Company Profit Margin  Employer Contribution  Crediting Rate on Account Balances  Distributions (End of Year) Distributions (End of Year)
 1  $100 million  5.00%  $100,000.00  10.00%  0  $110,000.00
 2  $101,500 million  4.00%  $101,500.00  8.00%  0  $228,420.00
 3  $102 million  2.00%  $102,000.00  4.00%  0  $343,636.80
 4  $100 million  1.00%  $100,000.00  2.00%  $128,543.50  $452,509.54
 5  $98 million  1.00%  $98,000.00  2.00%  $123,355.02  $432,976.23
 6  $99 million  2.00%  $99,000.00  4.00%  $121,667.07  $429,900.26
 7  $101,500 million  3.00%  $101,500.00  6.00%  $121,575.32  $441,617.20
 8  $103 million  3.00%  $103,000.00  6.00%  $126,152.27  $455,718.91

 9

  $106 million  4.00%  $106,000.00  8.00%  $137,434.80 $480,504.16 
 10  $110 million  5.00%  $110,000.00  10.00%  $512,119.78  $512,119.78
 11  -  -  -  -  $512,119.78  -
             

While NQDCPs have many benefits, one key differentiator between them and qualified plans is that NQDCP benefits are subject to the creditors of the employer. However, participant benefits can be protected from other risks, such as a change of heart on the part of management or a change in control by using a “rabbi trust.” A company cannot access rabbi trust assets for its own purposes; they must be used to pay plan benefits.

Conclusion

To manage profit and equity risk, energy companies at both the human resource and finance levels must be prepared and committed to exploring benefits such as NQDCPs that are customized and offered only to their most valuable employees. Regardless of size, energy-based companies—whether in drilling, E&P, distribution or oilfield services—should examine market benchmarks, decide where there might be gaps in their benefit offerings and seek out solutions to fill them. Gallagher’s Executive Benefits experts would welcome the opportunity to help you examine how executive benefits can be key components of an effective recruiting, retention and rewards strategy.

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