Managing the Risks of Executive Retention, Recruitment and Succession in the Oil & Energy Industry

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1 Succession in the Oil & Energy By Cline Young Executive Benefits Consultant Executive Benefits

2 Managing risk is inarguably a critical part of achieving success within any company. This is especially true for the oil, gas, and energy-related industries; whether in drilling, E&P, distribution or oilfield service. Typically the term, risk management is linked to external exposures relating to the protection of property assets or exposure to liability. However there is another risk that is often overlooked and many times left unmanaged. This particular risk can leave profits and equity exposed and the very future of the company in jeopardy. This risk is a company s ability to recruit, retain and reward its executive and management personnel. Attrition among key management executives can result in lost revenue, added expenses, lower profits and a drop in equity or shareholder value. Historically, large energy companies are extremely generous in their executive benefit offerings. However, small to midsize energy companies place a relatively small value on providing any benefits in excess of their core benefit structure. Rather, they look toward stock options and perquisites as a means to recruit, reward and retain their executive group. Human resource specialists within the industry might be reluctant to expend political capital toward voicing their concerns of potential shortfalls in executive benefit offerings to their superiors, unaware that those gaps may in fact result in increased profit and equity risk. The talent pool is competitive In today s economy, energy companies like most all companies, are facing the issue of an aging workforce, especially among their engineering and management teams. Additionally, with the energy sector currently playing a significant role in the overall economy, many large companies are getting larger, and smaller companies are spawning to service those companies. Both are drawing from the same talent pool so compensation and benefit programs must be highly competitive. A typical core benefit program that provides health insurance, life insurance (typically with a maximum death benefit of 3 4 times salary), disability insurance (typically a taxable 60% benefit covering the first $200,000 of income) and a 401(k) retirement program with a generous match, is simply not enough to recruit or retain (for the long term) a highly sought after executive. Likewise, a competitive cash compensation package might be attractive in the recruiting process, but falls short with respect to long term retention. Smaller companies usually can t provide the necessary cash compensation needed initially to make up for shortfalls in their executive benefit offerings versus those provided by larger companies. Stock options are helpful in building long-term incentives, but can create unnecessary and unwanted dilution, and are many times too volatile to be perceived as a positive. ARTHUR J. GALLAGHER & CO. january 2014 :: 2

3 Assumes group LTD is 60% of base salary to a maximum monthly benefit of $10,000. Executive Annual after-tax disability gap Effective Tax Rate Monthly LTD Benefit After-tax LTD Benefit A $50K 13% $4,167 $2,500 $2,169 B $75K 14% $6,250 $3,750 $3,210 C $100K 17% $8,333 $5,000 $4,147 D $150K 20% $12,500 $7,500 $6,011 E $200K 22% $16,667 $10,000 $7,811 F $300K 25% $25,000 $10,000 $7,470 G $500K 29% $41,667 $10,000 $7,117 Capped Executives Employees Linear (Cap) LTD Plan Max $800, $800K $700, $700K $600, $600K disability gap chart LTD at 60% to $200,000 Annual Total Compensation $500, $500K $400, $400K $300, $300K $200, $200K $100, $100K $- $ Age 1 Examine the gaps What can companies do above core benefits to assist in the recruiting and retention process, and how can they afford such excess? How can they competently and effectively manage their profits and equity risk? The first step is recognition of both market and internal offerings to determine the gaps between the core benefits offered and the market benchmarks inherent within the energy sector. Typically these benchmarks are based on 3 contingencies: preretirement death, disability, and premature separation of service. The charts below illustrate a typical core benefit structure against market benchmarks for all three of these areas. In all three areas, the higher the compensation, the larger the gap between what is being provided at the core benefit level and what the market sector will offer. Additionally, the higher the compensation, the larger the needs gap of the individual. ARTHUR J. GALLAGHER & CO. january 2014 :: 3

4 Years Before Life Insurance Benefit is Exhausted Base Benefit: 5x, Capped at $500K Base+Voluntary Buy-up (Additional 5x, Capped at $500K) Assumptions Current Age: 40 years Mortality Age: 40 years Current Insurance Benefit: 5x capped at $500,000 Buy-up Option: 5x salary, capped at $500,000 Investment Earnings: 7% annually Annual Income Replacement: 80% current salary Years $50K $75K $100K $150K $200K $300K $500K monthly replacement of income 60% 50% Percent Replacement 40% 30% 20% 10% 0% $50K $75K $100K $150K $200K $300K $500K ARTHUR J. GALLAGHER & CO. january 2014 :: 4

5 Projected Retirement Savings Maximum 401(k) Savings Possible Target Retirement Savings Assumptions Current Age: 40 years Retirement Age: 65 years Mortality Age: 85 years Scale: 3% annually 401(k) Contribution: 5% 10% based on age, starting at age 25 Investment Earnings: 7% annually Target Annual Benefit at Retirement: 80% final income 401(a)17 Compensation Limit: $260,000 Max 401(k) Contribution Limit: $17,500; $5,500 catch-up $8M $7M $6M $5M $4M $3M $2M $1M retirement savings gap $- $50K $75K $100K $150K $200K $300K $500K Set the strategy Once the gaps are identified and deemed to be a hurdle in the recruitment and retention objectives of the company, several strategies can be used to close the gaps. First, a company should decide if they wish to be a facilitator or a contributor. A company acting as a facilitator creates the structure to solve the need of the participants, but only pays the administrative fees involved. Participation by an executive in the program is voluntary, and is most often used by those who have a particular need, such as supplementing their retirement account in excess of any core qualified plan such as a 401(k) or enhancing their life insurance or disability benefits. These programs, if corporately sponsored, can offer discounted costs, lessened requirements for insurability, portability and unlimited tax-favored contributions. These programs do little to satisfy a retention objective, but might be beneficial in the recruitment process. A company that is a contributor actually commits corporate dollars to the program, over and above administrative fees. These dollars are not necessarily hard dollars today, but are promises made for the future, which makes it affordable for any size company. These programs are designed with both recruitment and retention in mind. Additionally, they are used to reward certain executives for their tenure or contributions to the company s growth and success. Over 80% of the Fortune 1000 companies offer nonqualified deferred compensation plans to their employees 1. Smaller energy-based companies recruiting from larger companies are beginning to understand that they too must implement these types of programs to stay competitive with talent. ARTHUR J. GALLAGHER & CO. january 2014 :: 5

6 Stay competitive To manage profit and equity risk, energy companies at both the human resource and finance levels, must be both prepared and committed to exploring the world of executive benefits. Owners, shareholders and Boards of Directors would agree that protecting profits and equity, and management of risk, is certainly worth expending the political capital to uncover any shortcomings. Preserving and retaining engineering and executive talent is critical as the energy sector continues to grow. Regardless of size, energybased companies whether in drilling, E&P, distribution or oilfield services should examine the market benchmarks, decide where there might be gaps in their recruitment and retention offerings, and seek out strategies to fill them. A company can successfully protect its most vital and exposed risk: the loss of a key individual or individuals responsible for creating and managing the company s profits and equity. 1 Source: Executive Benefits A survey of current trends, 2012 The Newport Group ARTHUR J. GALLAGHER & CO. january 2014 :: 6

7 Cline Young About the Author Cline Young is an Executive Benefits Consultant with Arthur J. Gallagher & Co. The Executive Benefits team focuses on helping organizations attract and retain the right leadership team by offering a competitive executive benefits plan. Gallagher helps organizations structure a strategic compensation program that nurtures loyalty, meets specific financial goals and helps secure effective leadership. Cline has more than 35 years experience in executive benefits and nonqualified plan consulting and design. Cline Young Executive Benefits Consultant Executive Benefits Cline_Young@ajg.com Gallagher Benefit Services, Inc. is a non-investment firm that provides consulting services to employers regarding employee benefit plans. Gallagher Retirement Services is the national retirement plan services and consulting division of Gallagher Benefit Services, Inc. Securities and Investment Advisory Services offered through NFP Securities, Inc., Member FINRA/SIPC. Investment advisory services and corresponding named fiduciary services may also be offered through Gallagher Fiduciary Advisors, LLC, a Registered Investment Adviser. Gallagher Fiduciary Advisors, LLC is a single-member, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Not all individuals of Gallagher are registered to offer securities through NFP Securities, Inc. NFP Securities, Inc. is not affiliated with Gallagher Benefit Services, Inc., Gallagher Fiduciary Advisors, LLC, or the Gallagher Retirement Services division. Neither Gallagher Benefit Services, Inc., the Gallagher Retirement Services division, NFP Securities, Inc., or their affiliates, nor provide accounting, legal, or tax advice. GRS/NFP-CD(113645)(exp012015) 2014 Gallagher Benefit Services, Inc. Q:\2014\GBS\28\23762A ARTHUR J. GALLAGHER & CO. january 2014 :: 7