More Than Golden Handcuffs

U ntil recently, an executives retirement income package comprised qualified plan benefits, Social Security, income from personal investments and benefits from any nonqualified plans. Most packages were designed to provide benefits from the first two sources of between 50% and 75% of the executives average final pay. Unfortunately, companies now find it increasingly difficult to achieve this objective using qualified plans because the compensation limit used to determine eligible contributions has been lowered, the definition of employee for coverage purposes has become more complicated and comprehensive and the amounts that can be contributed have been restricted. As a result, companies are using nonqualified deferred compensation plans to bridge the gap created by qualified plan restrictions and uncertainty over Social Security. In addition, many companies are finding that good communication between employer and employee will improve the effectiveness of all retirement benefit plans. This article gives companies information they need to develop retirement programs that are fair to both parties.

MIXED APPEAL OF QUALIFIED PLANS

Favorable tax and nontax benefits have led most companies to adopt some type of qualified plan as part of their executive retirement planning, including defined benefit and defined contribution plans. (See the glossary below.) Under Internal Revenue Code sections 404 and 402(a)(1), these plans provide significant tax benefits to both employer and employee. Amounts contributed are tax deductible by the employer, while the employee does not recognize any taxable income until distributions are made. Under IRC section 501(a), earnings within the plan also are exempt from current taxation.

Since qualified plan assets are held in trust, they are safe from the creditors of either the employer or the beneficiaries. In Patterson v. Shumate , 112 S.Ct. 2242 (1992), the U.S. Supreme Court held that not even the bankruptcy court could reach a bankrupt beneficiarys interest in a qualified retirement plan.

Despite these advantages, a number of factors have diluted the appeal of qualified plans for highly compensated executives (HCEs):

• In the past, key executives were more likely to stay with one company for most of their careers. Today, executives move freely from company to company. Since qualified plan benefits depend on years of service with the employer, the buildup of benefits is hampered by the limited number of years executives are able to accrue benefits.
• Legislation in the 1980s and 1990s significantly restricted the usefulness of qualified plans by limiting contribution and benefit amounts. The Tax Reform Act of 1986, for example, reduced the maximum compensation that can be taken into account for qualified plan purposes to $200,000. The Omnibus Budget Reconciliation Act of 1993 reduced it further to $150,000. (Beginning in 1997, the compensation limit, which is indexed for inflation, increased to $160,000.) Exhibit 1 outlines other limitations for 1997.
• Legislative activity in Congress has significantly increased the employers cost of establishing and maintaining a qualified plan. To satisfy nondiscrimination requirements, plans must provide coverage, benefits and contributions to both HCEs and non-HCEs. The sheer complexity of qualifying under the Employee Retirement Income Security Act of 1974 (ERISA), as amended, and IRC administrative requirements greatly increases the burden of maintaining qualified plans, especially for small employers.
• Limitations on the maximum benefits available under Social Security and qualified plans result in non-HCEs being able to retire at a higher percentage of their final compensation from these sources than HCEs.

Exhibit 2 and exhibit 3 illustrate the restrictions on qualified plan benefits for HCEs, assuming an employees bonus does and does not qualify—respectively—as part of the benefit formula. Normally, a company tries to structure its pension plan so employees receive 50% of their final salaries. Most executives who accumulate benefits in qualified plans over extended periods discover, however, that those plans provide a maximum benefit of only 35% of final pay, or in many cases much less.

NONQUALIFIED PLANS FILL THE GAP

As a result of the increasing gap between the amount of retirement income executives need and that provided by qualified plans and Social Security, the importance of nonqualified retirement benefits has increased. A carefully drafted, well-conceived, nonqualified retirement plan provides a powerful financial incentive for key personnel to remain with the company and manage it in a way that enhances long-term profitability and solvency.

Conversely, a compensation philosophy that ignores deferred compensation and emphasizes short-term performance over long-term corporate management provides little incentive for an employee to remain with a company. When employees do stay, succession planning is more difficult without deferred retirement compensation plans. Thus, nonqualified deferred compensation is not just a matter of perks but also of sound corporate management.

A nonqualified deferred compensation plan—sometimes called a “top hat” plan—is an arrangement under which a small group of key executives receives compensation after retirement. Since these plans are restricted to a few key employees, they are generally unfunded (not funded in advance) and not required to comply with the ERISA or IRC rules governing qualified plans. Benefits can be made available on a discriminatory basis and the terms may be structured to meet the individual needs of the company and its key executives.

A company can, for example, match employees deferrals differently. One group of employees may receive a 50% match on the first 6% of compensation deferred, while another group can be promised a 100% match. Another example would be where an employer promises a target benefit of 70% of final pay for one level of management and 80% to another.

HOW FLEXIBLE IS IT?

Because todays key executive is more likely to work for several companies during his or her career than was typical as recently as 10 years ago, companies seeking continuity of leadership face a serious dilemma. A change in management is unsettling and may disrupt long-range plans when new management adopts different corporate strategies. Most important, many businesses have discovered that their most valuable asset is the personal and professional relationships created and sustained by key executives. When these people depart—even if they leave on the best of terms—the company they leave behind lacks the credibility their presence provided.

The “golden handcuffs” approach of deferred compensation is the ideal solution in such a situation. A company can implement a nonqualified deferred compensation plan that pays a key employee a significant amount upon retirement at a predetermined age (annually or in a lump sum) or pays an actuarially reduced amount if early retirement is caused by disability or a death benefit if death occurs before retirement. The amount can be structured so benefits are front-loaded (more accrues at an earlier age than nearer to retirement). With such a plan, a key employee considering a competing employment opportunity also must consider the value of the deferred compensation package that he or she would lose. A new employer not only must offer higher current compensation but also pay for the deferred compensation benefits the employee leaves behind. Because of the participation and vesting requirements applicable to qualified plans, only nonqualified plans have this flexibility.

Employee or competitor? Noncompete agreements—a common way to protect a businesss proprietary interest in its goodwill and customer base—can be difficult and costly to enforce. The former employer must take the initiative to enforce the agreement and demonstrate it is reasonable as to areas covered, time and scope of employment. However, when deferred compensation is contingent on the former employees agreement not to compete, the employer has two advantages. Practically and psychologically, the former employee knows that any attempt to compete will be costly; the flow of deferred compensation will cease and the former employee may have to hire an attorney to get the money from his or her former employer. The courts generally use a different standard to enforce forfeiture provisions than they do in deciding whether to prohibit competition. It is much easier to persuade a court to permit forfeiture of deferred compensation than it is to persuade it to order someone not to enter into employment with a competitor.

THE TAX CONSEQUENCES

An unfunded deferred compensation plan, representing the employers unsecured promise to pay the employee a future benefit, does not result in current taxable income to the employee. Income is not recognized for tax purposes until the funds are available for immediate distribution. Under IRC section 404(a)(5), a promise to pay benefits in the future also does not result in a current tax deduction to the employer, even if it is an accrual-basis taxpayer.

To the extent a nonqualified deferred compensation plan becomes funded, the employee recognizes taxable income (see revenue ruling 60-31, 1960-1 CB 174) unless his or her rights are subject to a “substantial risk of forfeiture,” as defined in IRC section 83 and related regulations. Generally, if property is transferred as compensation for services, regulations section 1.83-3(c) says the recipient is taxed after receipt of the property is no longer subject to a substantial risk of forfeiture.

COMMUNICATION AND COMPUTATION

As recently as 10 years ago, base pay (salary) typically accounted for 75% of a key executives compensation. Today, base pay is 40% to 50% of total compensation; in many cases, HCEs receive up to 80% of their income from performance-based pay—usually bonuses—making computation formulas for determining retirement benefits important. Most older qualified and nonqualified deferred compensation plan formulas, however, use only base pay and do not include performance awards. In addition, most plans average an employees final wages over five years, further reducing the amount of compensation being considered.

Example: An executive receives $150,000 in salary and $150,000 in bonus, for total compensation of $300,000 (see exhibit 2). Under a 50% benefit formula, the executive may be entitled to a $150,000 per year pension benefit. However, if the plan formula provides a benefit equal to only 50% of average base pay, the executive may be unpleasantly surprised to discover her benefit is only $75,000 per year (see exhibit 3).

This misunderstanding illustrates one of the most serious shortcomings of qualified and nonqualified deferred compensation plans: lack of effective communication by the employer or plan administrator. Key executives who are not adequately informed about the value and terms of their deferred compensation packages are unable to plan effectively for their retirement and the protection of their families. Employers shortchange themselves as well if they do not choose an administrator who will communicate the plans features and benefits adequately. Retirement plans are an important part of motivating key employees. If communication is poor, key employees may not understand the value of the benefits provided.

Exhibit 2: Qualified Deffered Compensation Plan as a Percentage of Final Compensation

Bonus Does Qualify

FUNDING PROVISIONS

Key executives often complain that benefits are payable when they are no longer in control of the company, leaving their retirement subject to the whims of another generation of management. If a change in circumstances beyond key managements control occurs (the company is acquired by new and potentially hostile owners), the executive may suddenly find his or her deferred compensation in jeopardy. Yet, many employers are uncomfortable funding deferred compensation obligations because this may create a liquidity problem for the company that accounting practices often will not highlight. Clearly, there is greater concern at both the executive and corporate levels about unfunded benefits.

From the corporate perspective, the legislation of the 1980s and 1990s dramatically reduced the percentage of total executive retirement compensation companies can fund through tax-deductible contributions to qualified retirement plans. Consequently, the level of nonqualified retirement benefits has risen to fill the gap. For a company committed to providing a retirement package for its executives based on a percentage of final compensation, a key issue is how to fund the nonqualified part of the program. Some companies contribute the same amounts they normally would contribute to qualified plans (but for the limitations) to fund nonqualified benefits.

Exhibit 3: Qualified Deferred Compensation Plan as a Percentage of Final Compensation

Bonus Doesn’t Qualify

Even companies that have traditionally chosen to cover retirement benefits on a pay-as-you go basis are becoming concerned over the level of unfunded liabilities. Many have concluded they no longer can saddle future management with these obligations and that it is their fiscal responsibility to see that nonqualified benefits are financed during the careers of the executives who will receive them. Just as companies are required to properly fund qualified plan liabilities, they are now prefunding nonqualified obligations. However, to avoid immediate taxability to the employee, a deferred compensation plan must remain unfunded or provide for a substantial risk of forfeiture, as noted earlier. This is consistent with the desire of corporate boards of directors to make key executives nonqualified deferred compensation benefits contingent on maintaining the companys fiscal solvency and profitability.

Many executives also are concerned about the security of nonqualified benefits. The pay-as-you-go approach is unacceptable when the executive realizes only a small percentage of his or her retirement benefits—those from qualified plans—is secure. Executives want to fund their nonqualified deferred compensation benefits with investments that generate returns similar to the company pension, profit-sharing or 401(k) plan.

Rabbi trusts. One mechanism available to respond to these security concerns is the rabbi trust. A separate trust is established to fund the employers obligations to pay deferred compensation benefits in which trust assets are treated as company assets, subject to the claims of the companys creditors. Similarly, any income the trust generates is taxable to the company under the IRC grantor trust rules.

The use of an independent trustee ensures that a change in control of the company will not result in the arbitrary refusal of new management to pay deferred compensation benefits. Because trust assets are subject to the companys creditors and the executive has no immediate rights to such funds, he or she recognizes no income currently. And, until payment is made from the trust, the company has no corresponding tax deduction

In revenue procedure 92-64, 1992-2 CB 422, the IRS provided a model rabbi trust and said that except in unusual circumstances it will not rule on unfunded deferred compensation arrangements that use a form other than the model. Rabbi trusts are structured to be legally “unfunded” for ERISA purposes and hence not subject to most of its restrictions.

Secular trusts. A secular trust, sometimes known as a vesting trust, is an irrevocable trust created to fund deferred compensation. Unlike a rabbi trust, which protects only against the companys unwillingness to pay and not its inability to pay, employer contributions are placed in a secure trust in the employees name—outside the reach of the companys creditors.

Unless other provisions are inserted restricting the executives ability to withdraw assets (such as the creation of a substantial risk of forfeiture under IRC section 83), the executive has current taxable income as a result of the companys contributions to a secular trust. The employer normally has a corresponding income tax deduction for the amounts it contributes. If the plan is structured with the employee rather than the employer as the grantor for tax purposes, the employee is taxed on the trust income. An obvious problem is that the employee may have to recognize taxable income before he or she has an immediate right to receive the funds represented by that income.

Companies should take care in drafting the trust document to avoid having the trust taxed when the income is earned and the employee taxed a second time when distributions are made. (For a more detailed explanation of this issue, see private letter ruling 9302017.) These trusts may be structured as “funded” for ERISA purposes and therefore subject to several provisions of its title I. This may create significant compliance issues, as well as severely limit the flexibility normally associated with nonqualified plans. To the extent an employee recognizes income when contributions are made to the trust, the employee has a basis for tax purposes, resulting in nontaxable distributions at retirement.

Insurance. Insurance is being used increasingly to finance nonqualified deferred compensation benefits. The main reason for this is that an insurance contract allows the company or the executive to accumulate assets on a tax-deferred basis through increases in the policys cash value. If the executive dies before retirement, the policy proceeds are used to pay a death benefit. Since many companies use insurance to recover the aftertax costs of these benefits, and since the insurance proceeds are tax-free at death, the return on investment can be equal to and in some cases greater than the return a company generates in its qualified plans. The company itself can own the insurance contracts or they can be transferred to a rabbi or secular trust.

KEEPING KEY EXECUTIVES

Companies seeking to attract, retain and motivate key executives need to consider some type of nonqualified deferred compensation plan. As tax rates rise and the government moves to further restrict the usefulness of qualified plans, nonqualified plans are increasingly important. They should be drafted with the needs of the employer and employee and with tax and ERISA consequences in mind. Fortunately, nonqualified plans allow a maximum of flexibility and may be adapted to a wide range of circumstances.