Deferred Compensation Contracts

In the cap-strapped NHL where every dollar under the salary cap can make or break a team's season, front offices are constantly searching for innovative ways to structure contracts. One such strategy is deferred compensation, a financial maneuver that can subtly but significantly alter a team’s cap hit.  But how does deferred compensation actually work, and why isn’t it more common in the NHL? Here are the intricacies of this contract strategy and examine how teams like the Carolina Hurricanes are leveraging it to their advantage.

Teams and players can include deferred compensation in a contract as outlined in the Collective Bargaining Agreement.  Some key notes:

• The compensation needs to be tied to a season in the contract when it is earned. A portion of the contract cannot be just generally deferred; it needs to be a portion of the payment earned during a specific season that is deferred.
• The deferred compensation needs to be paid after the contract expires for it to be considered deferred
   

Time value of money

Money that you have now is worth more than the same amount in the future because you can invest it and earn interest. So, $100 today is more valuable than $100 a year from now, because if you had $100 today you could invest it and it would be worth more than $100 in a year. Discounting a future payment means adjusting its value to reflect what it's worth today. Because money loses value over time, a payment you’ll receive in the future is worth less than the same amount today. Discounting calculates what that future payment is equivalent to in today’s dollars.  In order to discount a future payment, an interest rate is needed. This can be thought of as the potential earnings the money could earn during the period.  So if you take $105 one year from now at a 5% interest rate, it’s worth $100 today; the underlying assumption is that if you had $100 today and earned 5%, it would be worth $105 in a year.

How is the cap hit calculated in a deferred compensation contract?

In a standard contract, the cap hit is the total compensation divided by the number of years.  It’s the same concept if compensation is deferred, except that if compensation is earned in a season but then paid after the contract (deferred), then the compensation is discounted (adjusted down) to the present value of that compensation in the year it was earned.

For example, if $2,000,000 is earned in the final season of the contract but paid out 1 year after the contract, the $2,000,000 is discounted to the value of it in the final season of the contract, and that’s the compensation number used to determine the cap hit of the contract.

If a contract is $4,000,000 per season for 4 seasons, the usual cap hit calculation would be:

Cap Hit = Total Compensation of $16,000,000 divided by 4 years = $4,000,000 Cap Hit  

However, if $2,000,000 of that compensation in Year 4 is deferred for 1 year, assuming a 6% interest rate, it is treated as $1,886,792 of earnings in Year 4. Therefore, the Cap Hit is as follows:

Cap Hit = Total Compensation of $15,886,792 divided by 4 years = $3,971,698 Cap Hit  

Note: There is only a Cap Hit during the contract term. There is no cap hit when the deferred compensation is actually paid out.

Why isn’t this more common?

• As you can see in the example, there is only a meaningful reduction in the cap hit if the amount deferred and/or the deferral period are significant.  Furthermore, if the interest rate is lower (like it was prior to recent years), the cap savings from the deferral is lower. 
• The player needs to agree to structure the contract like this. In most cases, players prefer to receive compensation earlier, not later. That is why players with bargaining power typically receive a large portion of their contract compensation in the first few years of the deal (front-loading)

Examples

The Carolina Hurricanes entered two contracts that included deferred compensation this summer:

• Seth Jarvis deferred $4.95M of a signing bonus from Year 1, $4.95M signing bonus in Year 2, and $5.77M signing bonus in Year 3. All the deferrals were paid out 1 year after the contract (Year 9). This reduced the cap hit from an average cash amount per year of $7,900,000 down to an actual cap hit of $7,420,087
• Jaccob Slavin deferred $4.55M of signing bonus from Year 7 until 1 year after the contract (Year 9). This reduced the cap hit from an average cash amount per year of $6,461,125 down to an actual cap hit of $6,395,955

Deferred compensation in NHL contracts allows teams to reduce cap hits by paying players after their contract ends. Though this strategy offers cap advantages, it's rare due to the potentially minimal impact on cap savings and players’ preference for immediate earnings. Recent examples from the Carolina Hurricanes highlight how it can be used.

Check out PuckPedia's Deferred Compensation Cap Hit Calculator!