Was Frank Vatrano’s $18M contract extension which included $9M of deferred compensation in his best interest? While Frank will receive the first $9M of compensation over the next three years (3 x $3M), the remaining $9M will not begin to be paid for another ten years. In 2035, Vatrano will begin receiving the back half of his contract via $900,000/year payments over a ten year period (ending in 2044). There has been much debate throughout the hockey world if this was a good or bad idea. After reading a number of perspectives which were missing pertinent considerations, I felt compelled to share my thoughts and analysis for the benefit of the Hockey Family.

The deferred compensation story began to make headlines over the past year with the extensions of Seth Jarvis, Jaccob Slavin, and Jake McCabe. However, Vatrano’s ten-year deferral is by far the most extreme to date and the Ducks were able to benefit by reducing the contract’s present value to $4.57 AAV (instead of $6M AAV). The terms of the contract clearly demonstrate Anaheim was not willing to commit $6M of cap space over the next three years, but was willing to pay $18M if some of the value was deferred well into the future.

Although the NHL has approved these contracts, there have been reports the League does not love the concept, and the topic will likely be addressed in the upcoming Collective Bargaining negotiations. With the current CBA set to sunset after next season (2025-2026), there is a reasonable probability the option to defer compensation will be eliminated moving forward. Therefore, the upcoming year may be the last opportunity for contracts to be negotiated with portions of deferred compensation. While many pundits commenting on this topic take a hard stance on one side or the other, our team believes each player and their agent should understand the risks and potential benefits of deferred compensation through the lens of each family’s long-term financial plan.

The Implied Discount Rate

The higher the interest rate environment, the more incentive NHL teams have to negotiate deferred compensation into contract structure. The discount rate used to calculate the contract’s present value (which determines AAV) was originally found in the CBA (Article 50, Section 2(a)(ii)(A)), which ordered a discount rate of 1-yr LIBOR + 1.25%. However, after LIBOR was discontinued in 2023, the League now uses a similar formula with SOFR. It is worth pointing out that the discount rate at the time the SPC is registered is locked-in for the entire length of the compensation.

The following illustrates the benefit NHL teams have to structure deferred compensation when interest rates are high:

· The implied rate of deferral locked on Vatrano’s contract is roughly 5.41%, meaning the present value of the contract is reduced to approximately $13.71M (and how the cap hit gets reduced to $4.57M annually for three years).

· Now let’s assume the exact same $18M contract structure with the only difference being the interest rate environment sits near historic lows such as during the Covid pandemic. If we use a 1.25% discount rate (rather than 5.41%), it would change the present value of Vatrano’s contract to $5.57M AAV; a full million dollars more of eaten cap space in each of the next three years.

While $1M of extra cap room is helpful on a 3 x $6M, you can imagine the benefit to a team if they were able to leverage deferred compensation on a franchise player’s long-term deal.

The Length of Deferral

Similar to higher interest rates helping NHL teams, the same applies to the length of deferral. The longer the deferral, the deeper the discount to present value, meaning a lower AAV.

The future is always unknown. From a player’s standpoint, the longer the deferral, the greater the uncertainty surrounding future inflation and the tax code (more on this later). While the Jarvis and McCabe deals payout the full deferred compensation in the year following contract expiration, the Vatrano deal will not be paid in full for nearly 20 years.

Therefore, if a player and their agent is willing to defer salary, it would be wise to counter with increased demands for more nominal dollars and/or longer contract term to compensate for accepting additional risk. As we will discuss later in the wealth management section, assuming Vatrano’s true worth as a hockey player is $4.57M/year (as the present value suggests), the ultimate question becomes: In today’s interest rate environment, is a player better off signing a traditional 3 X $4.57M or instead a 3 X $6M with a portion of salary deferred years into the future?

 

Are There Tax Benefits for Players?

Players can potentially reduce their lifetime tax bill through a deferred compensation strategy. Without question, this was the primary motivation for Frank Vatrano. After including California’s new uncapped payroll tax, the all-in top marginal tax rate is 14.4%. By electing to defer $3M of salary in each of the next three seasons, a rough calculation shows Frank will save roughly $1,000,000 in California state income taxes.

The ideal follow up step in this tax strategy would be for the Vatrano family to retire in a state that has no income tax when deferred compensation begins paying $900k/year between 2035-2044. By residing in a state such as Florida, Frank will still pay Federal taxes, but will theoretically pay zero state income tax on the final $9M of salary.

The aforementioned tax strategy does not come without risk. For example, on a much larger scale, Major League Baseball star Shohei Ohtani’s deferred compensation contract with the Los Angeles Dodgers is already under scrutiny with the state of California. Last spring, the California State Senate began pursuing legislation in an effort to eliminate the ability for athletes and corporate executives to not pay state tax on income they earn while living in the state. Only time will tell how this will play out.

The tax risk I see least discussed with deferred compensation contracts is the absolute uncertainty of what U.S. Federal tax rates might be in the future. While I really appreciate the concept of Vatrano’s tax planning strategy, there is risk the entire tax savings could be eliminated should U.S. Federal tax rates move higher in the next 10+ years. The current top marginal tax bracket in the United States is 37%. Given the growing concerns of U.S. Federal debt levels, it would not be shocking to see tax rates increase in the future. Should Federal rates increase to 50% or more (like they have been many times in the past), the entire $1M California state income tax savings could be washed away by higher Federal taxes.

What About Inflation Risk?

Anyone that has taken a single course of finance understands a dollar paid to you today is worth more than a dollar paid tomorrow (or ten years from now in Vatrano’s case). As we have seen in recent years, purchasing power can quickly deteriorate during inflationary periods. Whether you purchase a dozen eggs or are looking to buy a condo in a growing city, there are practical examples of how it costs more money to buy the same goods in the future. This is why the $9M of deferrals Vatrano will receive between 2035-2044 are actually worth only $4.71M today. The challenging part of this analysis is that inflation is exceedingly difficult to forecast. We have no way of knowing how much purchasing power the deferred compensation will have in the future. The United States had gone roughly 40 years without major inflation concerns until 2022 when the cost of living suddenly spiked nearly 10%. Fortunately, short-term inflation concerns have mostly subsided, and if cost of living increases stick around a 2-3% target, Frank’s deferrals could maintain reasonable purchasing power. However, simulations showing multi-year inflation above target in the coming decades has disastrous impact on deferred compensation being received 10-20 years from now.

Opportunity Cost & Critical Wealth Management Adjustments

Deferred compensation acts much like a bond investment. In Frank’s case, he is effectively allocating $4.71M (present value of $9M deferred comp) into a bond that will pay him $900,000/year coupons for the ten years spanning 2035-2044. To conceptualize the contract’s discount rate another way, he will earn an annualized 5.41% pre-tax return on the money he is deferring, which is comparable with other conservative asset classes, U.S. Treasuries, Investment Grade bonds, etcetera.

Most the articles I have read surrounding this debate correctly point out that investments (such as the stock market) have historically earned an annual rate of return that is higher than 5.41%. The opportunity cost for Frank’s inability to prudently invest these funds in a globally diversified portfolio might cost him 8-10%/year. While the previous statements are true, those market outcomes are not guaranteed to hold true over the next ten years. There have been multiple times in the past 100 years the U.S. stock market experienced negative returns over a decade (1930s, 2000-2009).

Therefore, while accepting multi-year deferred compensation is likely suboptimal in 99% of market simulations, it may be a conservative alternative for a player who would prefer to mitigate market risk. However, one must not forget that multi-year deferred compensation is also subject to significant erosion of purchasing power through inflation. Therefore, a family deferring a meaningful amount of salary into the future should almost certainly adjust other parts of their wealth management strategy to tilt existing portfolios toward longer-term growth assets.

In summary, given the current interest rate environment, I expect more GMs will try to negotiate deferred compensation into upcoming contracts. If players/agents are willing to entertain the idea, they should push for more nominal dollars and/or longer contracts to maximize the present value of the agreement. Deferred compensation may only be worth considering for players who have an aversion to market risk and/or have an opportunity to implement tax savings strategies based on the tax jurisdiction of their NHL club, and where they plan to reside when deferrals are being paid.

Keeping deferrals shorter (less than 5 years) helps reduce inflation risk and increases the probability that tax savings strategies could be successfully implemented. The best case scenario for deferred compensation might be a player who is signing their final hockey contract and has confidence their family will reside in a tax-friendly state immediately following the contract’s expiration. Should a player ultimately sign a multi-year deferred compensation agreement, it is of critical importance to make wealth management adjustments to account for changing risk factors.