NONQUALIFIED DEFERRED COMPENSATION PLANS – THE MAIN POINTS

NONQUALIFIED DEFERRED COMPENSATION PLANS – THE MAIN POINTS

1. Nonqualified Plans are one of the Most Effective Tools for Recruiting and Retaining Key Employees 

New technology and advances in medicine and health care are enabling Americans to live longer than ever. This has made longevity risk – the risk of outliving one’s savings – a real issue for Key Employees. Consequently, Key Employees are more concerned than ever with a comprehensive benefits package. 

Nonqualified Plans are one of the most effective tools for recruiting and retaining Key Employees because they meet this goal. Statistics bear this fact out. In fact, nearly three-quarters of Fortune 500 Companies offer nonqualified deferred compensation plans currently.

Nonqualified plans are most effective when Key Employees have the ability to defer significant portions of their compensation and the opportunity for that compensation to grow tax-deferred through easy to track benchmark investment options. Nonqualified plans are attractive to both large corporations and small businesses (including the owner). This is because they do not have to follow the same non-discrimination rules imposed on qualified plans. Therefore, companies can offer nonqualified plans only to Key Employees in order to limit cost and incentivize talent.

In exchange, the employer can institute a vesting schedule that can act like golden handcuffs. However, the vesting schedule should be short enough to be reasonable to Key Employees. This provides an incentive for both recruiting and retention. When thinking about this issue, it is important to remember that benefits can vest years before the eventual distribution event.

Currently, unemployment rates are at all-time lows and wage growth is beginning to pick up. This is good news for job candidates. For employers, a comprehensive benefits package may be the difference in competing for a Key Employee considering multiple offers.

2. Nonqualified Plans Allow Companies to Limit Early Retirement and Competition by Executives After Termination 

Nonqualified plans are generally not subject to ERISA vesting rules which require qualified plans to vest over no longer than seven years. Consequently, nonqualified plans can be designed so benefits can be theoretically be forfeited by Key Employees. Typical forfeiture events that support these goals include the Key Employee’s termination before a certain date or the Key Employee’s employment with a competitor after termination. 

Payout options for the Key Employee are limited by Internal Revenue Code Section 409A to: death, disability, separation from service, change in control, an unforeseeable emergency, or a date or schedule determined at the time of deferral. These distribution rules ensure that Key Employee deferrals are essentially irrevocable. However, the employer must maintain a balance so the terms of the plan remain attractive to Key Employees. 

In certain jurisdictions and industries, non-competition agreements are becoming more difficult to enforce against Key Employees. Moreover, strict enforcement can often lead to reputational damage to the employer. Therefore, employers often consider using these tools in tandem.

3. Nonqualified Plans Allow Companies to Achieve Equality in Regards to Tax-deferred Compensation Opportunities Offered to All Employees 

Relative to their current compensation, rank and file employees will likely be able to secure adequate retirement income streams through social security and participation in qualified benefit plans like a 401(k). However, given the income-based limitations on qualified plan participation, it is unlikely Key Employees will achieve the same. 

Specifically, Code Section 401(a) limits the amount of compensation a Key Employee can recognize each year under a qualified plan. A Key Employee earning in excess of the limitation receives a benefit based on a smaller percentage of his or her total compensation under the employer’s qualified plan when compared with other employees.

Code Section 415 can limit a Key Employee’s qualified benefits even when the Key Employee earns less than the 401(a) limit. Moreover, the employer’s Social Security retirement contributions for a Key Employee are made only on their wages up to the Social Security wage base.

Together, these rules result in a reduction of a Key Employee’s compensation package and a surprising lack of equality. However, nonqualified plans designed to compensate for these statutory inequities are commonplace. This is because, without a nonqualified plan to offer additional tax-deferred investment opportunities, Key Employees are essentially left to invest a significant amount of additional after-tax dollars on their own.