Blog: Managing Risk by Staying the Course

Strategy, preparation and execution are integral to accomplishing goals. Cumulatively, this means “staying the course,” a practice that requires discipline and dedication to the mission despite obstacles.

The importance of staying the course is easily seen in aviation. Pilots diligently chart routes while taking into consideration factors like weather patterns, wind currents, and potential obstacles. When airborne, aviators often rely on the “1 in 60 Rule,” a widely known heuristic in aviation which articulates the notion that for every 60 miles travelled, a one-degree deviation from the intended flight path results in the plane being one mile off course. For example, Dallas is just over 1,500 miles from New York; therefore, every uncorrected degree flown off course between Dallas and New York is equivalent to 25 miles – 12 degrees amounts to 300 miles off course. Even the slightest navigational error can have compounding ramifications.

To manage this risk, aviators calculate flight paths prior to take off, and onboard navigation systems continuously track the aircraft's position in real-time while airborne. Pilots work in close coordination with air traffic controllers who conduct surveillance throughout the journey. The collaboration ensures that planes stay precisely on course, maintaining safety, adhering to regulatory guidelines, and optimizing the efficiency.

NQDC Plan Risk Management: Asset-Liability Matching
In the world of nonqualified deferred compensation plans – much like in aviation – developing and executing an effective risk management strategy is paramount to operating a successful plan.

Unlike qualified retirement plans, such as 401(k) plans, the compensation deferred via a nonqualified deferred compensation plan (NQDCP) is retained by the employer as an asset (as opposed to becoming the property of the employee as it does in a 401(k)). NQDCP participants can typically deem compensation deferred into the NQDCP to be notionally invested in funds made available under the plan. Depending on plan rules, participants are typically able to spread deferred compensation investments across any number of the funds offered under the plan; however, for the plan sponsor, participants’ balances are a liability for the corporation and the sponsor will need to pay out the account balance in the future based on a participant’s distribution election.

Since plan participants’ deferred compensation is deemed to be invested in funds, prudent NQDCP sponsors do not let the deferred compensation they retain as an asset sit idle on their books. Rather, many plan sponsors choose to invest the retained compensation in a manner consistent with their plan participants. In doing so, the plan sponsor is aiming to stay aligned with the plan participants by matching their assets and liabilities. To that end, since fund balances (and therefore, plan participants’ account balances) will change based on market fluctuations and continued deferrals into the plan, it is important for a sponsor company to balance plan assets and liabilities to ensure that there little or no “investment breakage” that will flow through to the Profit and Loss Statement. This is especially true in times of increased market volatility and for large-scale plans.

The Role of An Administrator
NQDCP sponsors often rely on third-party administrators to carry out the administrative services required to operate the plan; these services include plan design and setup, keeping records of deferrals and investment activity, communicating plan activity to the sponsor, fund management, facilitating participant enrollments, and more. Additionally, administrators operate websites that plan participants use to manage their accounts and make investments elections. In some cases, NQDPC sponsors may authorize the administrator to make trades in the investment funds to match participant investment activity.

If an NQDCP sponsor is similar to an aviator operating a plane (the plan), then the administrator is much like the air traffic control team in the flight tower relaying information to the plane and ensuring that all external elements are accounted for, to the extent possible.

Coordination is Key
While the aforementioned 1 in 60 rule is the heuristic pilots rely on to coordinate the path between their takeoff and destination, there are many approaches NQDCP sponsors and administrators can take to manage NQDCP risk by calibrating assets and liabilities.

Karr Barth Administrators has been a leader in the administration of nonqualified plans for 50 years. To help clients manage their risk, Karr Barth created its own proprietary tool called Auto-Hedge^SM. Auto-Hedge^SM is a utility that tracks activity in NQDCP participants’ accounts and then makes corresponding trades in plan sponsors’ asset accounts to ensure that the plan liabilities and plan assets match on a fund-by-fund basis.

Importantly, Karr Barth’s Auto-Hedge^SM is performed daily, even for assets invested in company-owned variable universal life insurance policies (i.e., COLI). This frequency is unparalleled in the industry. Other plan administrators may make transactions to match NQDCP plan assets and liabilities on a weekly, bi-weekly, monthly or even quarterly basis. The practice of matching assets and liabilities on the last day of an accounting period is commonly referred to as “window dressing.” However, in cases of window dressing, assets and liabilities do not match on a fund-by-fund basis every day during the accounting period, meaning that their investment results will differ, with the investment breakage borne by the plan sponsor.

The frequency of recalibration is very important to effectively matching assets and liabilities. Much like the 1 in 60 Rule suggests, deviations from the charted course can become much more significant as the space (time and/or distance) grows between the onset of the deviation and when it is course corrected. Equity markets have seen great volatility in the past 20 years and plan sponsors should acknowledge this risk and pursue efforts to mitigate its effect on the performance of their NQDCP. While there are many differences in account size (dollar amount) and participant size (number of participants actively making investment allocations/trades) between funds present in NQDCPs, the importance of tracking this data as frequently as possible cannot be overstated for any plan sponsor. That is why Karr Barth prepares a monthly report known as an Asset-Liability Breakage Report, which measures the true monthly performance of client assets as compared with liabilities, and highlights any differences in amount.

Staying the Course
Just like an aviator who relies on the control tower for assistance in adhering to their flight path, NQDCP sponsors have financial professionals who can help steward their plans so they operate efficiently and effectively. Karr Barth is honored to enter its 50^th year of serving clients in all of their NQDCP needs, especially when using Auto-Hedge^SM to align participant account balances with corporate funding assets on a fund-by-fund basis to mitigate the plan sponsor’s market exposure. For more information about Karr Barth’s Auto-Hedge^SM please visit Kbadmin.com or contact us at planadmin@kbadmin.com.