What it means
Most pay is earned and received in the same period, such as a month's salary for a month's work, while deferred compensation breaks the link so that work done now is paid for later. 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 way of holding back pay until they are confirmed.
Share options and restricted share awards that vest over several years tie the reward to long-term performance, pensions defer pay to retirement, and elective deferral plans, common for senior executives in some countries, let the employee postpone salary or bonus, typically to 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, but if the deferred portion depends on the employee remaining in service for a further period, it is earned over that period and the expense is spread across it. Share-based awards are measured at fair value when granted and expensed over the vesting period, with the credit going to equity rather than a liability if they will be settled in shares, while 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 severe (in the United States, a non-qualified deferred compensation plan that fails the statutory requirements can result in immediate taxation plus penalties), and the employer's 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, because 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, but 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 turn out to have been wrong, the employee's conduct falls short or the firm suffers a material loss, and clawback provisions allow amounts already paid to be recovered, both now standard in banking since the financial crisis 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. Where the deferral is designed to retain staff, the forfeiture rate, the proportion of deferred pay 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 1
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 2
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 3
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 (service-conditional deferral) = Total award x Service period elapsed / Total service period
Liability at period end = Cumulative expense recognised minus Amounts paid, discounted where payment is more than a year away
Present value of a deferred amount = Amount / (1 + Discount rate)^Years to payment
Employee's value at payout = Deferred amount x (1 + Notional investment return)^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.
- Cash portion: expense $150,000 in the year; no liability remains
- Deferred portion: it depends on three further years of service, so the expense is $50,000 a year for three years, with the liability building to $150,000 before payment
- At the end of year 1, the $50,000 liability is payable in two years; discounted at 5% it is 50,000 / 1.05^2 = about $45,400, and the unwinding of the discount in later years is a finance cost
- If the executive leaves in year 2, the unvested amount is forfeited and 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 at 6% a year, it grows to 150,000 x 1.06^3 = about $178,650 at payout. If the executive's marginal rate has fallen to 30% by then, tax at payout is about $53,600 instead of $60,000 now, but the executive bears the risk of forfeiture, malus and the employer's insolvency.Case study
Seen in the real world
This is a fictional, illustrative scenario. 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 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 across all staff the deferred liability 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, 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.
Two effects followed. Turnover among bonus-eligible staff, which had been 22% a year before the policy, fell to 12%, and the head of human resources estimated the saving in recruitment and lost productivity at over $2,000,000 a year. Trading behaviour also changed: with 40% of any bonus at risk for three years, traders took more interest in the valuation of their positions and less in trades whose profit was hard to verify.
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.
Watch