Compensation:
Impact bonus based on net income; new goals figure impact

Equity:
If goal based on net income there is impact; Multi-year equity goals are typical, changes to the payout structure in the middle of a performance period might constitute a modification and trigger adverse accounting consequences

For companies that pre-fund, pension contributions for 2017 tax year can still be made well into 2018, last chance for a 35% deduction

Funding
Accelerated funding often requires debt or other creative financing

Repatriation can unlock a range of investments in compensation or benefits

Companies now scrambling to minimize tax—foreign and U.S. pension funding may play a role

Debt more expensive for some corporations, who must now weigh benefits of “pension debt” vs “hard debt”

Benefits continue favorable tax treatment but less favorable; cash employees will receive at lower tax rate vs.health or other benefit needs that are tax deferred

Maximize Roth and post-tax 401(k) in 2018–2025 window? Consider DC designs and features. HSA continues tax favorable treatment if available.

A number of provisions in the newly passed tax reform law will directly impact executive compensation, specifically equity award programs. Among them are revisions to Internal Revenue Code (IRC) Section 162(m) and the reduction in the corporate tax rate.

What’s Changing
Previously under IRC Section 162(m), the CEO, along with the four highest paid named executive officers—intentionally excluding the CFO—were covered by the rule, which held that qualified performance-based compensation (which includes stock options, performance-based equity awards and certain commission arrangements) were not subject to the $1 million tax deductibility limit. In other words, when calculating the company’s tax deduction for these employees, the performance-based equity awards and commissions were not included in the calculation of the $1 million and were deductible in any amount under Section 162(m).

The rule has now been expanded to redefine “covered” employees to include the CEO, CFO, and the three highest paid named executives underneath them. There is also a new stipulation: “Once a covered employee, always a covered employee.” Essentially, that means that if someone steps down from a covered position or no longer works for the company, they will still be covered under IRC Section 162(m). Thus, the $1 million limit would continue to apply to all compensation paid to that person, even after retirement or termination of employment, as long as compensation is being remitted to that person.

Additionally, performance-based awards and commissions will no longer be exempt from the $1 million deduction limit. (There is transition relief for qualifying written binding arrangements entered into on or before November 2, 2017.) That means companies will lose the tax deduction for all compensation in excess of $1 million, resulting in a significant increase in the cost of executive compensation. When calculating the tax deduction, limited to $1 million, absolutely nothing awarded after November 2, 2017 is exempt from the calculation, and the company must include all compensation in their 162(m) calculations. This change in deductibility is unlikely to cause companies to stop granting performance-based equity or change their commission structure, as Institution Shareholder Services (ISS) and Glass Lewis are still expecting to see performance-based compensation in order to have plans pass shareholder approval. It will be increasingly important to plan for the timing of vesting and payout to avoid inadvertent clusters of vestings that would push executives above that limit. Taxation strategy will be key.

While these changes only impact the top executives covered by Section 162(m), the biggest and most wide-reaching impact is related to the new corporate tax rate. On the surface, this change appears straightforward to implement merely by altering the tax rate in the accounting system. In reality, however, it’s anything but simple, as the change in the corporate tax rate will yield a significant impact on multi-year performance awards tied to net income, earnings per share, profit margin, etc. If performance goals were set utilizing forecasts that were dependent on the 35 percent rate, for example, those goals may no longer be realistic, as they may be too easy to attain since net income will artificially increase under the lowered tax rate. However, companies may find that modification accounting on equity awards for net income and earnings per share will be necessary to align the payout with the original intent of the award.

Aon’s Perspective Since multi-year goals are typical, changes to the payout structure in the middle of a performance period in order to absorb the impact of the tax reform might constitute a modification and trigger adverse accounting consequences. Companies operating on a fiscal year basis have a number of options, including timing the issuance of grants, compensation, or bonuses, so they are grandfathered in under the old rules, or accelerating awards into the 2017 fiscal year to get beneficial tax treatment by deducting them under the 35 percent rate (or a pro rata blended rate). In addition to determining how the new tax law will impact any multi-year performance goals, organizations must analyze the impact to the company, its shareholders, and award participants to ensure the original intent of the award and performance goal is retained within the final design of the goal.

We advise focusing solely on 2018 and then moving on to outstanding cycles. There are a number of potential actions that can be taken, such as retroacting the current tax reform legislation back to a base year to equalize the two periods or modifying the awards entirely, whether that’s changing to a different metric or changing the payout schedule so it takes the artificial growth into consideration. Determining the right course should be a concerted, coordinated effort between HR, Finance, and anyone else involved in the compensation process. Lastly, while tax considerations are important, organizations must remember that the goals they choose and the timeframes they cover should, first and foremost, be ones appropriate for their business and that advance their strategy.

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From the elimination of the individual mandate and the introduction of the FMLA tax credit to the delay of three ACA taxes, the newly passed tax bill could have a significant and long-term impact on the cost of health care.

What’s Changing
Effective December 31, 2018, the Tax Cuts and Jobs Act effectively repeals the ACA’s Individual Mandate by zeroing out the penalty for not buying health insurance. The elimination of the mandate is likely to result in four million people forgoing insurance in 2019, with 13 million opting not to buy health coverage by 2027, according to the Congressional Budget Office. In most cases, it’s likely to be younger, healthier people who choose to drop their coverage, leaving the exchanges largely populated by less healthy people who have no other options for health insurance. This is likely to cause an increase in uncompensated care costs, particularly through Medicaid, as the Congressional Budget Office (CBO) projects roughly 40 percent of that decrease to come from individuals dropping Medicaid coverage.

This increase in the number of uninsured individuals will potentially result in greater shifting of uncompensated care costs to employer group health plans and other private payers. The repeal of the mandate is likely to cause destabilization of the individual insurance market, leaving California, Maryland, and other states to consider following Massachusetts’ example and enacting their own individual mandates to purchase health insurance in an effort to stabilize their individual insurance markets. The lack of a viable individual market could lead employees and their dependents to elect COBRA instead of buying coverage elsewhere. The instability of the individual market also hinders strategies employers have considered for pre-Medicare retirees.

While some GOP lawmakers pushed to eliminate the Employer Mandate, it ultimately remained in effect in the final version of the bill. Employers still have to comply with the requirement to provide affordable essential coverage to full-time employees and their children up to age 26 or be subject to penalties. The government has signaled it will be enforcing the mandate and IRS is attempting to collect penalties from companies that didn’t comply with the mandate.

The new law also delays implementation of three ACA taxes. The Excise Tax on higher cost plans has been delayed until 2022, while the Medical Device Tax has been suspended until 2020. A moratorium on the Health Insurance Tax was put into place until 2019. However, the tax remains in effect for 2018, and many employers have already seen the tax built into their 2018 premium rates.

For 2018 and 2019, eligible employers will be allowed to claim a general business tax credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on FMLA leave. The rate of payment must be at least 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent. To claim the tax credit, an employer must allow all qualifying full-time employees at least two weeks of annual paid family and medical leave.

Aon’s Perspective Employers have a range of actions they can take when responding to the new tax law. Above all else, they must consider what they need to do to attract and retain talent and then determine what kind of health care plan best suits their talent strategy. Employers have long been challenged to provide competitive benefits, while controlling costs, but now, they must factor in the potential cost implications of an increase in the number of uninsured and what the individual market is going to look like moving forward.

Companies have historically had to manage rapidly accelerating health care costs via cost-sharing and through other traditional strategies such as vendor re-negotiations and implementing disease and condition management programs. Aon strongly encourages employers to get bolder about adopting strategies and programs that enable them to manage cost for themselves and their employees, improve employee health and wellbeing and optimize the use of high-quality, lower cost providers within the health care delivery system. This could include a number of approaches, including:

• Controlling prescription drug costs through new and more aggressive strategies, including participating in a purchasing coalition, 4th tier copay for specialty drugs and carving out specialty drugs from medical benefits
• Implementing newly emerging programs aimed at impacting chronic conditions, such as condition-specific high performance networks
• Adopting Center of Excellence (COE) strategies for certain non-transplant procedures
• Offering integrated delivery models (patient-centered medical homes or ACOs) to improve care delivery effectiveness
• Impacting the overall efficiency of the care delivery system by challenging the way employers pay for services and exploring options for value-based arrangements.

Employers that are using or considering the Pre-Medicare individual market as a coverage vehicle for groups such as part-time workers or Pre-Medicare retirees may need to revisit their strategy if the individual market becomes unstable and is no longer a viable alternative for Pre-Medicare coverage. The Medicare individual health insurance market continues to be a robust, competitive, and cost-effective alternative to traditional employer-sponsored group coverage.

The waiver of the Health Insurance Fee (HIF) for 2019 will make group and individual market Medicare Advantage Part D products more financially favorable for 2019, so employers not already leveraging Medicare Advantage on a group basis or through an exchange may want to consider doing so beginning next year.

It’s also important to note that while most of the ACA taxes were delayed, they have not been repealed. These taxes could potentially take effect at some future date, so employers shouldn’t abandon the strategies they had previously devised to deal with them.

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The Tax Cuts and Jobs Act (TCJA) contains few direct changes to US corporate retirement plan provisions. However, the reduction in the corporate tax rate from 35 to 21 percent is spurring many organizations to consider pre-funding their pension plans. In less than two months since the bill’s passage, more than $25 billion in accelerated contributions have been made or announced by corporate pension plan sponsors. This amounts to a 1 percent improvement the funded status of US corporate defined benefit plans due to contributions alone. This trend has a lot more room to run before it comes to an abrupt halt in September 2018, when 2017 contributions for calendar plan year pension plans are due.

What’s New
The new tax law’s reduction in the corporate tax rate will increase the after-tax cost of pension contributions. However, special rules permit retirement plan contributions to be deducted up to eight and one half months after the end of the plan year – September 14, 2018 for most US plans. Plan sponsors that accelerate pension funding into this window can benefit from the higher 35 percent deduction. Pre-funding also yields several ancillary benefits, including improved GAAP earnings and reduced PBGC premiums. For example, moving a $1 million contribution intended for plan year 2018 up by a couple of months could give plan sponsors multiple benefits, including:

• An additional $140,000 reduction in taxes
• A $38,000 reduction in PBGC variable rate premiums for 2018
• An accounting benefit of around $5,000 in GAAP income for every month the contribution is accelerated into the plan

The tax reform bill also makes untaxed overseas earnings available as a funding source for accelerated contributions. Companies with earnings in foreign subsidiaries will no longer be forced to pay a 35 percent tax to bring those earnings back to the US. The new tax law creates a mandatory but low transition tax on those earnings, making them more easily accessible to bring back onshore. While these earnings will certainly be used for dividends or share buy-backs, companies are also considering them as a source for pre-funding pension contributions.

Aon’s Perspective
All taxable organizations should be giving serious consideration to this time-sensitive opportunity. In particular, companies that considered pre-funding in the past because of rising PGBC premiums should revisit their funding decisions. When making critical decisions regarding how much to pre-fund—or whether to pre-fund at all—it’s important to remember that one size does not fit all.

Pre-funding is likely to be more attractive for organizations that are cash taxpayers at marginal rates significantly above 21 percent in the 2017 tax year. However, some companies are not in a cash taxpaying position, or were taxed at lower rates because they fell under the Alternative Minimum Tax (AMT) or were able to take advantage of various expiring incentives such as the Domestic Production Activities Deduction. Those organizations may not find the math any more compelling than it was before. However many low-tax or no-tax organizations that are paying PBGC variable rate premiums are still able to reduce these annual “taxes” on their pension deficits, regardless of their income tax status.

Organizations are also likely to be attracted to the opportunity to earn an additional return on the money saved. Even if companies invest in corporate bonds, they might reasonably expect a four- to five-percent return, depending on capital market assumptions and the time horizon. There is an opportunity to earn a cumulative 20- to 25-percent over the next several years.

Since the financial crisis, a sizable fraction of sponsors have adopted de-risking “glide paths” and other systematic investment-based de-risking programs to dial back the various risks embedded in their pension plans. Organizations that have already committed to such programs have, in effect, committed to closing part of their pension deficits by funding rather than simply out-earning their pension obligations. Such organizations may view large 2018 contributions as merely an acceleration of amounts they already planned to contribute in later years. On the other hand, companies that intend to “earn their way out” of their deficits may find accelerated funding a non-starter.

When it comes to determining how much to fund, one possible answer is to consider funding up to a designated percentage of the liability target. There are a number of factors to consider:

• PBGC/Variable Rate Premium Liability: The PBGC’s single-employer plan took in $7 billion in premiums in 2017, of which nearly $5 billion were variable rate premiums determined according to a formula based on the size of each covered plan’s deficit on this basis. Sponsors can eliminate this variable rate premium by funding up to this target, making this one obvious funding threshold.
• Projected Benefit Obligation (PBO): If an organization is underfunded on a PBO basis, this deficit shows up as a liability on its balance sheet, similar to debt. In fact, some rating agencies view this as equivalent to “hard debt” and have applauded sponsors that have taken proactive steps to reduce these liabilities via accelerated funding.
• End State Liability: This is most relevant for a frozen plan targeting plan termination over the near- to medium-term. Here, they gain the opportunity to do so with an 18 percent discount by taking advantage of this additional tax deduction.
• Present Value of Benefits: Plans open to accruals for current or future employees should understand the long-term costs of those future benefit accruals. It can be helpful to think about funding “X” years of service cost.

The second possible answer is to consider pre-funding relative to future cash expectations. Once again, there are a number of factors to evaluate:

• Set appropriate baseline: Organizations may find it helpful to articulate the existing deficit in terms of how much is expected to be paid or funded with contributions versus investment returns or assets out-earning or out-returning liabilities.
• Cash budgeting: There are definite benefits to thinking through various alternatives. For example, a comparison can be made between the contributions an organization was otherwise planning to make over the next three-to-five years and those same contributions accelerated into the current year.

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¹Contributions made for 2017 may realize an 18% discount: (1 – 35%) / (1 – 21%)

• Investment policy implications: Accelerated funding may trigger a change in investment policy, either explicitly via a glide path or a desire to otherwise protect the contribution. It’s important to consider the cost associated with a lower than expected portfolio return, balanced with risk reduction.

The pre-funding opportunity presented by the new tax law is significant but fleeting. We believe organizations must act now to consider their options and determine how best to proceed in the coming months.

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This document has been produced by Aon Hewitt’s Global Investment Management (GIM) Research Team, a division of Aon plc and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and nonproprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all inclusive. Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.

This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such, i) in any jurisdiction where such an offer or solicitation is against the law; ii) to anyone to whom it is unlawful to make such an offer or solicitation; or iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside.

Aon Hewitt Limited is authorized and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810. When distributed in the US, Aon Hewitt Investment Consulting, Inc. (“AHIC”) is a registered investment adviser with the Securities and Exchange Commission (“SEC”). AHIC is a wholly owned, indirect subsidiary of Aon plc. In Canada, Aon Hewitt Inc. and Aon Hewitt Investment Management Inc. (“AHIM”) are indirect subsidiaries of Aon plc, a public company trading on the NYSE. Investment advice to Canadian investors is provided through AHIM, a portfolio manager, investment fund manager and exempt market dealer registered under applicable Canadian securities laws. Regional distribution and contact information is provided below. Contact your local Aon representative for contact information relevant to your local country if not included below.

The newly passed Tax Cuts and Jobs Act comes at a time when public funding for social and environmental issues is diminishing, while funding demand among communities supported by non-profits is increasing. These dynamics elevate pressure on non-profit finances, including endowment and foundation assets. The provisions that may have significant impact on non-profit endowments, foundations and health care include changes in the standard deduction, maximum cash deduction, estate tax exemption, UBIT, advance refunding bonds, along with a new excise tax on certain private colleges and universities.

What’s Changing
Under the new law, the standard deduction has nearly doubled, which is likely to result in fewer people itemizing deductions. This reduces the financial incentive to make charitable donations, as such gifts can only be deducted if itemized. However, those tax payers who still qualify to itemize will benefit from an increased limit—from 50 percent to 60 percent of Adjusted Gross Income—on cash gifts to public organizations. The new law also doubles the estate tax exemption to $11.2 million per person and $22.4 million per couple. This may reduce the incentive to make charitable bequests because fewer estates will be subject to the Federal Estate Tax.

The most evident provision impacting endowments and foundations is a new 1.4 percent excise tax on net investment income. It applies only to private colleges and universities with at least 500 tuition-paying students and at least $500,000 in assets per full-time student, which is about an estimated 30 institutions at this point in time. While the definitions of terminologies used in the provision, such as that of “endowment” or “investment income” have yet to be clarified, the resulting expected reduction in endowment payout could challenge some of those private institutions affected. Fundraising from existing donor base may also be challenged if donors feel less of their contributions would serve the purpose of the endowment, potentially translating to less money available for instruction, research and building maintenance, along with reductions in scholarships, resulting in higher costs for students. Additionally, this may incentivize decisions made by organizations currently not impacted to avoid a future impact.

This puts additional pressure on endowment fiduciaries, which are already under scrutiny for issues such as endowment offshore investments, ESG (Environmental, Social, Governance) considerations and growing spending needs on the endowment. They are openly questioning whether to change their investment strategies or adopt new fundraising initiatives in order to address the external forces, while remaining true to their fiduciary obligation to the endowment and the mission of the institution it supports.

Aon’s Perspective
These issues are significant and warrant not merely an exercise by the institution’s Treasury office and investment committee, but a more comprehensive and collaborative effort to assess financial implications across the institution. As part of the ongoing and regular asset allocation review process, we advise non-profit investment fiduciaries to evaluate risks to the endowment stemming from the proposed tax provisions by focusing on three key areas:

For more information about Aon or latest news from Aon, click here.
Click here for additional information on the Tax Cuts and Jobs Act.

This document has been produced by Aon Hewitt’s Global Investment Management (GIM) Research Team, a division of Aon plc and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and nonproprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all inclusive. Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.

This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such, i) in any jurisdiction where such an offer or solicitation is against the law; ii) to anyone to whom it is unlawful to make such an offer or solicitation; or iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside.

Aon Hewitt Limited is authorized and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810. When distributed in the US, Aon Hewitt Investment Consulting, Inc. (“AHIC”) is a registered investment adviser with the Securities and Exchange Commission (“SEC”). AHIC is a wholly owned, indirect subsidiary of Aon plc. In Canada, Aon Hewitt Inc. and Aon Hewitt Investment Management Inc. (“AHIM”) are indirect subsidiaries of Aon plc, a public company trading on the NYSE. Investment advice to Canadian investors is provided through AHIM, a portfolio manager, investment fund manager and exempt market dealer registered under applicable Canadian securities laws. Regional distribution and contact information is provided below. Contact your local Aon representative for contact information relevant to your local country if not included below.

• Review Spending Expectations and Thresholds: Most endowments and foundations conduct a spending analysis as part of their regular strategic asset allocation review. We suggest conducting a comprehensive spending analysis to better understand the impacts of varying the spending rate and methodology. Additionally, it may be useful not only to identify the endowment’s low-end and high-end spending rate thresholds, but also to stress test those thresholds under various revenue and expenditure scenarios.
• Work Cross-Functionally to Better Understand Short-term and Long-Term Financial Implications: While endowment fiduciaries generally focus on oversight of investments, they can have more mission-informed decision-making by understanding how rule changes can impact the institution’s budget and strategic programming. For example, could the portfolio need more liquidity due to greater current or expected funding burden? It’s important to test the endowment’s investment liquidity profile relative to fiscal scenarios with the rule changes to see if any changes to the investments are needed.
• Review the Endowment’s Investments: Consider if changes are needed to investments. Would the regulatory changes affect the endowment’s views on risk and return trade-offs, and if so, how should that affect current and future investments? Are there other investment models and mechanisms that can serve a dual purpose to address the institution’s mission and target a market rate of return? For example, could the endowment participate or lead infrastructure development projects that are structured to generate financial return alongside social return for the institution’s beneficiaries and/or communities?