Why Deferred Compensation Plans?

Sheltering your income can prove a beneficial task.  Many employers offer creative, cutting-edge benefit programs to attract potential employees.  It’s important to know what the different plans are and how a trusted advisor’s guidance can help you determine what works best for your financial situation.

While deferred compensation plans might be foreign to you,

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You may have established an irrevocable life insurance trust (ILIT) as an integral part of your estate plan.  An ILIT is a trust that is constructed to primarily hold a life insurance policy (or policies) on the grantor during the grantor’s lifetime.  As the name indicates, an ILIT generally cannot be revoked, amended or modified after it has been drafted and executed.  Once the grantor contributes property or

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Post-mortem planning is a concept derived from the inability of estate planners to predict the future.  Given how quickly tax laws and circumstances can change, it is unlikely that a planner will be able to anticipate every variable that an executor or trustee will face after your death.

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The London Inter-Bank Offer Rate (LIBOR) currently underpins approximately $400 trillion of mortgages, bonds, corporate loans and derivatives globally.  To help put this number in perspective, the World Bank estimates the annual value of global economic activity, or GDP, at $80 trillion which is “only” one-fifth of this amount.

LIBOR is set by a group of banks that provide estimates of the rate they will lend to other banks over various time periods.  It is based on non-binding prices in the unsecured money market and this creates perverse incentives that led to several financial institutions manipulating or rigging LIBOR rates to help benefit derivatives traders.  The discovery of this collusion among financial institutions on LIBOR rates in 2012 has resulted in regulators demanding reform via a more durable, tamper-proof alternative to LIBOR and as a result, LIBOR will be phased out by the end of 2021.

In the effort to replace LIBOR, several new rates have recently been conceived.  The United States created the Secured Overnight Financing Rate or SOFR.  Similarly, the United Kingdom has created SONIA (Secured Overnight Inter-Bank Average Rate), the European Central Bank has created ESTER (Euro Short-term Rate), Japan has created TONAR (Tokyo Overnight Average Rate) and Switzerland has created SARON (Swiss Average Rate Overnight).

Switching from LIBOR to this acronym soup of new rates is going to be far from simple.  SOFR et al. are calculated using completed transactions and/or trade quotes and they lack term structure (LIBOR is available in overnight rates, one-month, three-month, six-month and 12-month terms etc.).  Banks, companies and investors also require a rate that reflects the credit risk when lending funds.  Since SOFR is derived from the rate to borrow cash overnight using US Government securities, it is effectively a risk-free rate that does not properly reflect underlying credit risk.  This is also problematic because in times of financial stress, SOFR could experience a decline due to investors seeking the safety of government issued securities while in economic reality the actual credit risk being linked to SOFR would likely increase.  Many investors and companies are also currently unable to buy and sell debt linked to SOFR et al. because their legacy accounting and trading systems are not properly configured.

This has led some banks to budget more for this transition than for Brexit.  According to the consultancy Oliver Wyman, virtually no loans linked to these new rates have been made to date and little has been done to move existing contracts that last beyond 2021 off LIBOR.  This is concerning as most of the $35+ trillion LIBOR based contracts surviving beyond 2022 cannot simply be switched from one benchmark to another because most of these contracts do not have adequate fallback terms stating what rate should apply when LIBOR vanishes.

The New York Fed’s general counsel has referred to the demise of LIBOR as a “Defcon 1 litigation event” and we strongly encourage investors to revisit and fully evaluate any securities they hold linked to LIBOR that mature after 2021.  For example, preferred stocks that pay investors the higher of a fixed or floating rate linked to LIBOR will likely end up owning what effectively becomes a permanent fixed rate security in 2022.  We do not think that the current prices for most of these preferred stocks properly reflect this risk.  In addition, because SOFR is secured and LIBOR is not, securities that are able to legally transition to SOFR will likely receive interest payments that are lower than they would have received under LIBOR.

The clients of Inlet Private Wealth^® can take comfort in knowing that the risk posed by LIBOR’s demise has been proactively addressed in their accounts.  However, we invite investors that own securities linked to LIBOR held external to Inlet Private Wealth to contact us should they have concerns.