One of the often-overlooked ways employers can reward key executives is through the creation of a nonqualified deferred compensation plan. "While traditional retirement plans such as 401(k) and pension plans remain extremely attractive ways to benefit senior executives, a growing number of area businesses are adding nonqualified deferred compensation plans to provide supplemental benefits that help them attract and retain their best people," states Leo Thomas, manager of the Los Angeles office of Price, Raffel & Browne, one of the nation's largest firms specializing in pension plans and retirement planning.
For human resources managers, nonqualified deferred compensation plans often are the benefit of choice since they provide the potent combination of flexibility and the ability to tie key employees to the company. Since the introduction of 401(k) plans in the mid-80's, Congress has passed numerous laws to reduce the amount of qualified retirement plan benefits that companies can provide to highly compensated and midlevel executives. "As a result of legislative changes, qualified plans, while still attractive, are only a starting point in successful executive compensation and retirement benefit planning," Thomas notes.
Companies of all sizes are increasingly using nonqualified plans for a variety of reasons, the retirement plans executive notes. "With a nonqualified plan, it is possible to target benefit dollars to a select group of executives," Thomas states. "Additionally, the design of a proper nonqualified plan allows these designated executives to defer the receipt of certain amounts of pay and, as a result, exclude these amounts from current income."
To maximize the effectiveness of a nonqualified plan, employers must consider a number of factors, including issues of participation, taxation, funding of the plan, security and, ultimately, the form of distributions. Under the Employee Retirement Income Security Act of 1974 [ERISA], a typical nonqualified plan may be offered to a "select group of management or highly compensated employees" (often referred to as the top-hat or select group).
"Avoiding taxation at the time of deferral is essential when a company designs a nonqualified plan," the Price, Raffel and Browne executive explains.
The IRS's general position is that income may not be deferred once it has been earned. To satisfy the IRS, an employee's election to defer compensation must be made before the period in which the income will be earned. "So, for example, an agreement for a key executive to defer salary for the year 2000 must be established during the prior year," Thomas states.
Nonqualified plans are often used for bonus deferrals, though this may pose problems. The current IRS position treats a bonus as earned during the entire period and thus requires that a deferral election be made before the period in which the bonus is earned. For example, if a corporation pays a bonus to an executive in February 2000 based on the results of the fiscal year ended December 31, 1999, the employee's election to defer that bonus must generally have been made before the beginning of fiscal year 1999 (before January 1, 1999).
Because nonqualified deferred compensation programs are generally not subject to the nondiscrimination rules applicable to tax-qualified retirement plans, they can be designed with a significant amount of flexibility. These programs may be classified into two types, unfunded and funded. Each type has different income tax implications. In general, participants in unfunded programs are taxed when the amounts are distributed, while those in funded programs are taxed when the amounts are no longer subject to a substantial risk of forfeiture.
To avoid applying regulations imposed by ERISA, nonqualified plans recommended by Price, Raffel typically are 'unfunded'.
"Monies are set aside in the form of an annuity, life insurance policy or some other form of financial product," Thomas says. "However, unlike their qualified counterparts such as a 401(k) plan, a nonqualified plan is a general unsecured creditor of the employer.
"Even though the employer may set up a bank account, annuity or another fund to reflect the deferred compensation under the plan, the corresponding assets must remain general assets of the employer and subject to the claims of the company's general creditors (the employee becomes one of the creditors)," Thomas explains. For tax purposes, the employer sponsoring the program is able to deduct the deferred compensation amounts generally when the employee takes the deferred amount into account as income.
Human resource managers should be aware that the unfunded nature of nonqualified plans may cause executives to be concerned about two risks: the risk the employer cannot afford the future payment of benefits and the risk the employer will not pay the benefits for nonfinancial reasons.
"To address these risks, many employers establish informal funding vehicles such as a Rabbi trust, offshore Rabbi trust, life insurance or indemnity insurance," Thomas explains. "These funding strategies provide the recipient with the peace of mind knowing that employer has set aside funds to meet the future obligations to provide the compensation that is deferred under a nonqualified plan."
One constraint that causes the most concern for plan participants is the IRS' rules for distributions from nonqualified plans. The IRS safe-harbor rules require that a participant elect a distribution method when the deferral election is made.
"This requirement is especially difficult for younger executives who are many years from retirement and yet must make decisions regarding their future retirement distribution needs," Thomas adds.
While the IRS takes a very restrictive position, the courts have been more flexible and in many cases have supported taxpayers' ability to change their elections at a date later than the date on which they made the deferral election. As a result, more plan sponsors are allowing participants to change or make their elections after the deferral election.
"Nonqualified deferred compensation plans can be an extremely useful technique for rewarding executives and highly compensated employees," Thomas concludes. "Because no nondiscrimination rules apply to these programs, they can provide a high degree of flexibility. However, employers should proceed cautiously to ensure that the design satisfies the various IRS and Department of Labor requirements and to ensure that the programs will realize the goals for both the company and its executives."
Jesse Slome is a freelance writer. For more information on both qualified retirement and nonqualified plans, contact Price, Raffel & Browne at (310) 551-3125.
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