Restorative benefits and equity-based performance plans for highly compensated executives

As the U.S. economy continues to work its way back from the recession and the jobs market gradually improves, companies should review their executive compensation arrangements, both in recruiting new hires and in keeping key executives from being lured to competitors. In addition, the loss of financial security experienced by many Americans from the recession may affect an employee’s decision to retire or to work significantly longer to shore up retirement savings.

This dilemma is highlighted further in the executive ranks because of the limitations under IRS rules governing participation in retirement and other deferred compensation plans by “highly compensated employees” (referred to as executives in this article). According to the Congressional Research Service, the Code provisions under ERISA Title II “require plans to cover rank-and-file workers, and they include ‘nondiscrimination rules’ that prohibit qualified plans from favoring highly-compensated employees with respect to eligibility or benefits” (Summary of the Employee Retirement Income Security Act, p. 56 (tinyurl.com/ct2xvwg)). While these nondiscrimination rules ensure that qualified plans do not discriminate against rank-and-file workers, in many cases they result in significant reductions of benefits for executives.

Example. Manufacturing Co. Inc. (MC), the American subsidiary of a Japanese company, produces sophisticated circuit board components used in many of today’s leading tablet and cellphone platforms and employs nearly 1,500 people. MC offers the following employee benefits: group health insurance coverage, group life insurance, group short-term and long-term disability benefits, and a company matching contribution on employee pretax contributions equal to 50% of the first 3% of compensation contributed to the company’s 401(k) plan. Rank-and-file employees make up 95% of the workforce, and MC has approximately 80 executives based in Georgia as well as in sales offices throughout the United States. The executives do not have any equity-based compensation plans or additional pretax saving vehicles to supplement their retirement savings.

Within MC’s employee benefit offerings, the following benefit limits are in place:

• Group life insurance: two times compensation to a maximum of $250,000 death benefit.
• Group long-term disability insurance: 60% of base salary to a maximum monthly benefit of $10,000.
• 401(k) contributions: Because of the limited participation of rank-and-file employees in the 401(k) plan, the executives are limited to an annual pretax contribution of $4,500 to the plan (the 2012 IRS limit on employee pretax contributions under Sec. 402(g) is $17,000, plus $5,500 in catch-up contributions for those over 50).

Approximately 50 MC executives are having their benefits capped because their total compensation exceeds the levels for which benefits are available.

Chief of Electronics John Doe provides an illustrative case study. John has a base salary of $175,000 and is on track to earn a performance bonus of $75,000. Exhibit 1 outlines John’s employee benefit picture:

To ensure they can compete for highly qualified executives, companies should review executive employee benefits that may be limited under current arrangements. If a company determines that benefit limits are creating a problem with recruiting or retaining key personnel, it should think about tackling its executive benefit shortfalls with a carve-out executive benefit plan.

NQDCs

Carve-out benefit plan designs are usually nonqualified deferred compensation (NQDC) arrangements, subject to the rules of Sec. 409A (rules for inclusion in income of deferred compensation under nonqualified plans). Such plans must be properly documented and then adhered to.

An NQDC plan is any elective or nonelective plan, agreement, method, or arrangement between an employer and an employee to pay the employee compensation sometime in the future. The employee is not taxed on the deferred compensation until it is actually paid to him or her. Under an elective NQDC plan, participants’ contributions to the plan reduce their current taxable incomes because they invest pretax rather than after-tax dollars. The accounts grow on a tax-deferred basis, and pretax deferrals for highly compensated employees are not capped by IRS annual limits. The participant pays no income tax until he or she receives distributions from the plan. The company can make greater matching and nonelective contributions than under a qualified plan. Finally, the plan design can generally be discriminatory, i.e., the company decides on the participant group covered under the plan.

SERPs

In addition to NQDCs that give executives the ability to defer their compensation, more companies are considering supplemental executive retirement plans (SERPs) that are funded by the company and not by employee contributions. The amount of the company’s contribution may be based in part on the company’s performance (so the benefit may be indirectly linked to the company’s stock).

A SERP with a traditional defined benefit or defined contribution design can be implemented to meet each party’s interests, while reducing the executive’s exposure to volatility in the company’s stock price because the benefit is not linked to the stock price. The SERP can be designed to provide flexibility for the company for contributions and benefits credited to the executive, while also providing greater certainty to the executives about the performance measurements they must meet to receive the benefits. To ensure the executive is not overpaid, the company may be able to reduce existing equity-based arrangements to offset the value of any contributions to the SERP. A well-designed SERP enhances the company’s ability to attract and retain top-notch executives, who generally prefer a less risky approach to their total compensation package.

Example. MC decides to implement a SERP for the top 1.5% of its employees, which is an especially effective tool since the stock of the Japanese parent company is not traded in U.S. financial markets, making shares unavailable to U.S. executives. The SERP plan incorporates performance and financial metrics that provide for a defined contribution for the executives. If all metrics are accomplished, the executive could receive up to 20% of final compensation in retirement, beginning at age 65. Partially accomplishing the objectives will result in a reduced contribution for that period. This supplemental retirement benefit contributes significantly toward the executive’s ability to meet his or her financial goals in retirement and, when combined with a vesting schedule, results in a powerful retention tool for MC for its key executives.

PLAN DESIGN CONSIDERATIONS: EQUITY- OR NONEQUITY-BASED ARRANGEMENTS?

Supplemental benefit plans can be an important part of the overall financial plan for an executive team. Benefits can be offered in many forms, including equity-based and nonequity-based plan designs. Not all equity-based plans are subject to Sec. 409A (e.g., incentive stock options (ISOs)), but they have to meet specific requirements to avoid being subject to those rules.

While equity-based incentive programs allow an executive to share in the appreciation in the company’s stock price and align the executive’s interests with those of the company, the following disadvantages should be considered:

– For the executive, there may be great discomfort over having a significant portion of his or her net worth tied directly to the company’s stock price. An executive may feel that his or her incentive compensation opportunities are tied to market forces and other factors beyond his or her control. This may lead the executive to consider other employment opportunities with companies that offer a more diversified approach to total compensation.

– Equity-based plans may be difficult for the company to explain and, consequently, for the executive to understand clearly. This may lead to disputes over the metrics that are used to determine whether the executive is entitled to receive amounts under the plans, as well as over the application of the related legal requirements, including complicated rules under Sec. 409A.

– An executive’s exercise of rights under these types of plans may lead to undesirable tax consequences for the executive. For example, the spread between the purchase price and grant price for an ISO is subject to the alternative minimum tax (AMT). Should it become applicable, this amount must be included as a “preference item” when determining the executive’s AMT (see Sec. 56(b)(3)).

– Equity-based plans often create difficulties for the company when valuing the executive’s interests under such plans, particularly for stock of closely held corporations or where there is no readily tradable securities market (see, e.g., Rev. Rul. 59-60).

– Equity-based plans may trigger adverse treatment for the company under GAAP, including the rules for recognizing stock-based compensation expenses under FASB Accounting Standards Codification Topic 718, Stock Compensation.

– For privately held companies, there may not be a readily tradable securities market for the executive to sell his or her company stock. This may cause problems for executives who need liquidity for a home down payment, tuition payments, and other large purchases.

PROVIDING RETIREMENT INCOME

Whether a company decides to offer equity-based or nonequity-based plans, providing additional retirement income for executives must be addressed. Most financial planners say that the average employee will need 60% to 90% of his or her preretirement income in retirement (see, e.g, “Estimating Your Retirement Income Needs,” 360 Degrees of Financial Literacy, AICPA, 360financialliteracy.org). The inability of executives to save the maximum in a qualified 401(k) or other retirement plan can be detrimental to their retirement savings goals.

In the example, if MC were to implement a nonqualified deferred compensation plan using a carve-out design, John could make an additional pretax contribution of $12,500 (the difference between the maximum annual 401(k) contribution amount of $17,000 and John’s limited contribution amount of $4,500). Based on John’s current ability to contribute up to $4,500 annually to MC’s 401(k) plan from age 40 until age 65, assuming a 6% gross investment return in his 401(k) portfolio, John will have approximately $247,000 in tax-deferred savings at age 65. If John also contributes an additional $12,500 a year to the NQDC, he would have total tax-deferred retirement savings of approximately $933,000.

In a 2010 executive benefits survey of 85 companies in various industries conducted by Clark Consulting, respondents said restoring lost 401(k) pretax savings because of qualified plan limitations, attracting and retaining talent, and providing an additional platform for retirement and preretirement savings were their predominant reasons for offering an NQDC plan for highly compensated employees.

CONCLUSION

The past few years have been times of significant cost-cutting and headcount reductions for many companies. In many cases, wages and benefits have been frozen or even reduced. As employers begin to evaluate restoring compensation opportunities and benefit plan contributions, a close review of all compensation and retirement arrangements should be completed for executives who may have fallen further behind because of their limited ability to participate equally in all benefit plans provided by the company. Both equity-based and nonequity-based restoration plans are powerful tools that can be employed to help a company achieve its business goals and create a better retirement program for its executive team.

EXECUTIVE SUMMARY 

As the employment market and the economy both improve, the competition for the best employees increases.

Many of the employee benefit rules intended to prevent discrimination in compensation limit the ability to provide adequate retirement and other benefits for executives.

Carve-out benefit plans permit employers to compensate their executives sufficiently to avoid losing them to other companies. These plans can be equity-based or nonequity-based, although many executives prefer not having the volatility and uncertainty of an equity-based plan.

One way to compensate these executives involves setting up a supplemental executive retirement plan (SERP), a plan for executives that is funded entirely by the company and is usually not equity-based.

Geoffrey M. Rhines (geoffreyr@401kadvisors.com) is the managing director of Executive Benefits Consulting at 401(k) Advisors in Atlanta. Securities and investment advisory services offered through Financial Telesis Inc. 401(k) Advisors and Financial Telesis Inc. are not affiliated companies. W. Andrew Douglass (wadouglass@seyfarth.com) is a partner in the Employee Benefits & Executive Compensation Department of Seyfarth Shaw LLP in Chicago.

To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at sschreiber@aicpa.org or 919-402-4828.

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Portions of the example used in this article previously appeared on Mr. Rhines’s blog for SHRM–Atlanta.