What it means
Most pay is earned and received in the same period: a month's salary for a month's work. Deferred compensation breaks the link, so that work done now is paid for later.
The reasons vary with the type of arrangement. A deferred bonus, paid out over two or three years and forfeited if the employee leaves, is a retention device and, where results can later be revised, a means of holding back pay until the results are confirmed.
Share options and restricted share awards that vest over several years tie the value of the reward to the company's long-term performance and keep the employee's interest aligned with shareholders'. Pensions defer pay to retirement.
Elective deferral plans, common for senior executives in some countries, let the employee choose to postpone receipt of salary or bonus, typically to reduce or defer tax. The employer's accounting treats deferred compensation as a cost of the period in which the employee earns it, not the period in which it is paid.
If a bonus is earned for the year's performance and paid in cash next year, the whole cost is expensed this year with a liability for the unpaid amount. If the deferred portion depends on the employee remaining in service for a further period, it is being earned over that further period, and the expense is spread across it, with the liability building up.
Share-based awards are measured at their fair value when granted and expensed over the vesting period, with the credit going to equity rather than to a liability if the award will be settled in shares. Long-dated liabilities, such as pensions and multi-year deferrals, are discounted to present value, and the unwinding of the discount is a finance cost.
The employee's tax position depends on the jurisdiction and the design of the plan, and it is the main reason elective deferral exists. In many systems, pay is taxed when the employee receives it or becomes entitled to it without further conditions, so a bonus deferred for three years and subject to forfeiture is taxed in three years' time, at whatever rate then applies, with the money meanwhile growing untaxed.
The rules are detailed and the penalties for getting them wrong severe; in the United States, for example, a non-qualified deferred compensation plan that fails the statutory requirements can result in immediate taxation plus penalties. The employer's tax deduction is usually deferred to the same point, so the employer bears a timing cost that offsets the employee's benefit.
Risk is the other side of deferral. An employee who defers pay becomes an unsecured creditor of the employer for the deferred amount.
In a funded plan the money is set aside in a trust; in an unfunded plan, which is the norm for executive deferrals, it is simply a promise, and if the employer fails the employee stands in line with other creditors. Deferred bonuses in regulated industries carry a further risk by design: malus provisions allow unvested amounts to be reduced or cancelled if the results on which they were based turn out to have been wrong, if the employee's conduct falls short, or if the firm suffers a material loss, and clawback provisions allow amounts already paid to be recovered.
These provisions, introduced after the financial crisis, are now standard in banking and spreading elsewhere. For a finance professional, the practical questions are about measurement, disclosure and cash.
The liability for deferred compensation can be large, particularly in professional services and financial firms, and it must be measured on the right basis, discounted where appropriate and disclosed. The cash will go out in future years, so the amounts falling due must be in the cash forecast.
And where the deferral is designed to retain staff, the forfeiture rate, the proportion of deferred pay that is never paid because employees leave, is both a measurement input and a measure of whether the arrangement is working.
In practice
Real-world examples.
Example
A law firm's partners agree that 20% of each year's profit share will be deferred for two years and forfeited on departure, and the firm's liability for deferred profit shares reaches $9,000,000 within three years.
Example
A technology company grants restricted shares that vest in equal tranches over four years, and records an expense each year equal to a quarter of the grant-date value of each outstanding award.
Example
A hospital executive elects to defer $100,000 of salary into a non-qualified plan to be paid on retirement, and the hospital records a liability and invests a matching amount in a rabbi trust that remains subject to its creditors.
Think of it
“Deferred compensation is pay you've earned but will receive later-usually for tax benefits.
Formula
Calculation
Expense for the period = Amount earned in the period (for service-conditional deferrals, total award x Service period elapsed / Total service period)
Liability at period end = Cumulative expense recognised minus Amounts paid, discounted to present value where the payment is more than a year away
Present value of a deferred amount = Amount / (1 + Discount rate) to the power of Years to payment
Employee's value at payout = Deferred amount x (1 + Notional investment return) to the power of Years
Worked example. An executive is awarded a bonus of $300,000 for the year's results. Half is paid in cash immediately; half is deferred for three years and paid only if the executive is still employed, with malus applying to the deferred portion.
- Cash portion: expense $150,000 in the year; paid; no liability
- Deferred portion: because it depends on three further years of service, it is earned over those years; expense $50,000 a year for three years, with the liability building to $150,000 before payment
- At the end of year 1, the liability of $50,000 is payable in two years; discounted at 5% it is $50,000 / 1.05 squared = about $45,400, and the unwinding of the discount in subsequent years is a finance cost
- If the executive leaves in year 2, the unvested amount is forfeited: the liability recognised to that point is reversed as a credit to expense
Employee's view. At a 40% marginal tax rate, deferring $150,000 defers $60,000 of tax for three years. If the deferred amount is notionally invested in the company's fund at 6% a year, it grows to $150,000 x 1.06 cubed = about $178,650 at payout. If the executive's marginal rate falls to 30% by then, tax at payout is about $53,600 instead of $60,000 now. Against this, the executive bears the risk of forfeiture on leaving, of malus if results are revised, and of the employer's insolvency.
Retention effect. If the firm's annual staff turnover among bonus-eligible employees is 20% and the deferral reduces it to 12%, the firm saves the recruitment and productivity cost of replacing 8% of that population each year, which for a firm with 200 such employees at a replacement cost of $80,000 each is 16 x $80,000 = $1,280,000 a year.Case study
Seen in the real world.
A mid-sized investment bank, required by its regulator to defer a substantial part of variable pay for material risk-takers, introduced a policy under which 40% of any bonus above $100,000 was deferred over three years in equal annual tranches, subject to continued employment and to malus. A trader awarded a $500,000 bonus for a strong year received $300,000 in cash and $200,000 deferred, vesting at $66,667 a year. The bank expensed the $300,000 immediately and the $200,000 over the three-year vesting period, and reported the growing deferred liability, which across all staff reached $28,000,000 by the end of the second year.
In the second year, an internal review found that part of the trader's first-year profit had come from positions that had been valued optimistically, and that the true profit was about half what had been reported. The remuneration committee applied malus to the unvested tranches: the two remaining tranches of $66,667, $133,333 in total, were cancelled.
The first tranche, already paid, was subject to clawback under the trader's contract, but the committee decided the cost of pursuing it exceeded the amount. The bank reversed the liability it had built up for the cancelled tranches, a credit of about $89,000 to that year's expense, and reported the malus decision in its remuneration disclosures.
Two effects followed. The bank's turnover among bonus-eligible staff, which had been 22% a year before the deferral policy, fell to 12%, as the unvested amounts gave staff a reason to stay; the head of human resources estimated the saving in recruitment and lost productivity at over $2,000,000 a year.
And the trading desks' behaviour changed: with 40% of any bonus at risk for three years, traders showed more interest in the valuation of their positions and less appetite for trades whose profit was hard to verify. The finance director's observation was that the deferral had cost the bank nothing in total pay, since the amounts were the same, but had changed both who stayed and how they behaved, and that the accounting liability on the balance sheet was the visible sign of a real change in the firm's risk.
Watch out
Common mistakes.
- Expensing a deferred bonus entirely when paid rather than as it is earned, which understates the cost in the years of service and overstates it in the year of payment.
- Ignoring forfeiture, so that the liability assumes every employee will stay and be paid, when experience shows a proportion will leave and forfeit.
- Treating deferred amounts as risk-free from the employee's side; in an unfunded plan the employee is an unsecured creditor of the employer.
Questions
People also ask.
What is the difference between deferred compensation and a pension?
A pension is a form of deferred compensation paid in retirement, usually through a funded scheme with its own rules and regulation. The term deferred compensation in practice more often refers to deferred bonuses, share awards and elective executive deferrals.
When is deferred compensation taxed?
Generally when the employee receives it or becomes unconditionally entitled to it, so that pay deferred subject to forfeiture is taxed on vesting or payment. The rules vary by country and by plan type, and plans that fail the statutory requirements can be taxed immediately with penalties.
What are malus and clawback?
Malus reduces or cancels deferred pay that has not yet vested; clawback recovers pay that has already been paid. Both are used, particularly in financial services, to adjust pay when results are later revised, when losses emerge or when conduct falls short.
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