September 2003 | Table of Contents

Executive Compensation and Benefits

Understanding Nonqualified Deferred Compensation Plans

By William L. MacDonald
Chief Executive Officer / Chairman, Retirement Capital Group

THE RECRUIT-RETAIN-REWARD CHALLENGE

Boards of directors, top officers, and their human resources executives have come to realize that having the best leadership is the most critical corporate asset of all. For that reason, it is important to build benefit plans that succeed not only in recruiting, but also in retaining and rewarding the best executive talent. An attractive benefits package, along with compensation, can make or break the executive’s decision to accept your offer or stay with your company, particularly when the opportunity to defer compensation and taxes through a nonqualified plan is presented.

All types of financial and economic issues directly affect a company’s ability to successfully address the recruit-retain-reward challenge. For example, the average total remuneration for CEOs at the nation’s top 200 corporations reached a record $11.3 million in 2000. Yet, at the typical firm, nearly 60 percent of that figure was represented by the present value of stock options, which, owing to recent economic trends, have in many cases not retained the worth they once enjoyed.

Add to this the low ceiling on contributions to company-sponsored pension plans and 401(k) retirement plans, and it’s easy to understand why companies need to help executives defer money that is not subject to large income liabilities or taxation. Indeed, the caps on qualified plans and Social Security benefits mean that higher paid executives will typically retire at 30 to 50 percent of their salary. This level falls far short of the 70 to 80 percent of income experts predict that most executives need to maintain their pre-retirement standard of living. It is also far below the 70 to 90 percent of final pay your lower-paid employees will most likely receive at retirement, according to the American Society of Pension Actuaries.

As a result, companies are rapidly learning to bring compensation and benefits together into a more unified and powerful package with the type of inventive solutions that effectively address the recruit-reward-retain challenge, deepening the trend toward expanded benefits programs. By improving your ability to reward this top talent, you can enhance the executive’s retirement plan; restore an executive’s retirement benefits lost to restrictions on qualified plans; and offer a short-term investment vehicle to accumulate savings on a tax-deferred basis. To achieve this, professionals are fine-tuning plan objectives where necessary, boosting plan security, and implementing the principles of best practices throughout the process.

In the following pages, we will discuss how deferral plans and, more specifically, nonqualified deferred compensation plans work. We will discuss the various types of available plans and establish the standards for best practices. We will give you an easy-to-follow, seven-step process for successful plan design. And, we will discuss options for securing and funding the plan you ultimately choose. All to help you more effectively recruit, retain, and reward your most important executives in this competitive business climate.

QUALIFIED VERSUS NONQUALIFIED: HOW DEFERRAL PLANS WORK

Deferred compensation plans (DCPs) were created in response to the limited amount of retirement income an executive will derive from his or her 401(k) investment or qualified pension plan. Under a DCP, an executive elects to defer a portion of future income into the plan, enabling him to reach his target income at retirement. Retirement plans can be either qualified or nonqualified. Qualified plans are fully subject to Employment Retirement Income Security Act (ERISA) guidelines and have precise contribution limits. As a result, while senior and mid-level executives have faced dramatically lower pension benefits, their opportunity to defer income in qualified plans has also evaporated. For example, an executive with an annual compensation limit of $160,000, who contributes the maximum $10,500 to his 401(k), is only allowed to make a maximum deferral of a mere 6.6 percent of compensation.

A Nonqualified Deferred Compensation (NQDC) Plan is a nonqualified retirement plan under which a participant voluntarily elects to defer some portion of his or her salary, short-term incentives, or other compensation until a future date, usually retirement or termination of employment. Most often, deferrals will be credited to an account and interest will accrue. When the time is right, the account balance will be distributed to the participants in a lump sum or over time. Contributions to NQDC plans provide tax-deferred growth, are not limited per year, and are not subject to current tax. As a result, executives derive two distinctive benefits from deferring current compensation:

• No current tax. Pre-tax deferrals go directly into the plan, enabling the executive to reduce current income tax. Without that tax burden, a larger portion of his compensation, up to 100 percent, is productive during the period of the deferral. Unlike a 401(k) there are no ceilings on the amount of the deferral.
• Tax-deferred growth. The interest/increments earned by the plan are not taxable until distributed. Thus, the executive has an opportunity for compounded growth without the contribution limitations of a 401(k) plan.

By deferring stock options and other types of incentives into a NQDC plan, executives still have an excellent vehicle?depending on age, individual risk tolerance and other factors?to build their retirement portfolios and maintain the flexibility to address future cash needs. This characteristic is compelling to a current or prospective executive who may be ambivalent with regard to joining or leaving your company.

Unlike a qualified plan, the IRS does not contain well-designed rules on specific tax treatment of nonqualified plans. Regarded ‘safe harbors’, NQDCs seek exemption from most of the burdensome funding, participation, vesting and disclosure requirements that apply to qualified plans. The NQDC plan may also include an employer contribution. Keep in mind that NQDCs represent a company’s unsecured promise to pay a future cash or stock benefit to a plan participant, representing a contractual agreement between the employer and a select group of key executives. With a NQDC plan, the employer defers deductions for his contributions to the plan until the participant actually receives distributions and recognizes the income. In turn, the plan is not subject to the IRS’s nondiscrimination rules, the majority of ERISA requirements, and the other rules and regulations that are imposed on qualified or 401(k) plans.

Basic Deferral Plan Types
The basic deferral plan types are:

1. Elective Deferral Plans
Elective or voluntary deferral plans provide current deferral of compensation, where the deferral must be an irrevocable election to defer a portion of income before the amount is actually determinable.

2. 401(k) Wraparound Plan
The dual option 401(k) wraparound plan enables executives to defer funds into a nonqualified plan and 401(k) plan simultaneously.

3. Stock Option Gain Plan
Pioneered by CBC-CRG, stock option gain plans enable executives to defer the gain on a stock option to a future point in time.

While there are no requirements by law on minimum or maximum deferral elections, the most common practice is 50 percent of base salary and 100 percent of bonus. Executives may also defer commissions, long-term incentives, stock options and gains, performance shares, phantom stock, and restricted shares. It is essential, however, that care be taken in the timing of deferral elections and actual deferrals.

Top Hat Plans
One of the most difficult considerations for an employer when establishing a NQDC plan is the scope of participation. The goal of most NQDC plans is to define eligibility in a way that does not subject the plan to ERISA provisions. This goal can be accomplished if the plan is considered a Top Hat plan, which is intended for select executives and highly compensated employees. A Top Hat plan may be designed to restore qualified plan benefits lost to voluntary salary deferrals under a qualified 401(k) plan or NQDC plan. These plans are often referred to as “benefit restoration plans.” Thus, a highly compensated executive can participate in a 401(k) plan and a voluntary NQDC plan. His salary deferrals reduce current compensation and, consequently, reduce his benefits under the 401(k) plan. As a result, the most common type of NQDC is the Top Hat plan.

Plans can be also structured in a variety of ways and combinations, including nonqualified supplemental executive retirement plan (SERP); split-dollar plans; death benefit only plans; or nonqualified benefit swaps.

Supplemental Executive Retirement Plans
Employers can assist executives in reaching target retirement goals through a SERP. SERPs are employer-sponsored plans designed to restore benefits lost to regulatory restrictions on compensation used to calculate qualified pension benefits, in effect providing additional retirement benefits. In SERPs, executives do not defer current salary or bonus because the dollars used are provided entirely by the employer.

SERPs add a highly attractive element in core compensation programs and have proven very effective in recruiting and retaining key employees by creating post-retirement income. SERPs help to establish performance benchmarks that must be reached before supplemental retirement benefits are awarded. They also require continued employment for executives to reap benefits through the so-called ‘golden handcuffs’ incentive and, importantly, protect these executives from a change-of-control in management, the so-called ‘golden parachute’ provision. There are many types of SERPs, including offset plans or excess benefit plans, which may be tied to the employer’s qualified retirement plan.

Split-Dollar Plans
The split-dollar plan enables the purchase of life insurance for key executives at a lower cost than the executive could have otherwise obtained. The company and the executive share in the cost of the premiums. As a result, the plans specify that the company and executive will “split” the proceeds of the policy and will determine how to share costs and benefits, such as death benefits, cash values, dividends, and ownership.

Split-dollar plans are used as a key fringe benefit in many large corporations, with some companies using the plan to fund post-retirement SERP benefits and deferred compensation liabilities. As few as one or two executives in smaller companies can also make use of split-dollar plans. Types of Split-dollar plans include:

• Endorsement. The employer owns the policy and endorses the right to name the beneficiary of a portion of the death benefit to the executive. Both parties designate the beneficiary to receive a proportionate share of the death benefit, with the employer naming it through a corporation or trust.
• Split-Ownership. Employer and executive jointly own specific portions of the policy. Taxes may not be due at rollout because there is never a transfer of ownership or interest.
• Sole Ownership. The executive owns the policy; however, the employer makes the premium payments and, in return, the executive provides an unsecured promise to repay the employer with no assignment of values. Thus, the employer has no interest in the policy, and no transfer occurs.
• Reverse Split-Dollar. The executive owns the policy and endorses a portion of the cash value and death benefit to the employer. Both parties pay the premiums with the cash value owned by the executive. The employer retains the right to a smaller amount of the cash value and a majority of the death benefit; the executive pays a larger portion of the premium.
• Second-to-Die. Two separate individuals are insured and benefits are paid after the death of the second person. These plans are useful if a key executive has problems with passing a medical exam or underwriting requirement for coverage.
• Split SERPs. The employer and executive enter into two separate and unrelated agreements, an endorsement split-dollar plan and a SERP. The employer is the owner of the policy and has complete control over the cash values. The executive may name a beneficiary to receive a portion of the death benefit, if he or she dies prior to retirement. At that time, the plan is terminated and the endorsement cancelled. The employer may then use the policy to informally fund the promised SERP benefits or pay the benefits out of the general asset account.
• Group-Term Carve-Outs. This type of plan literally takes the executive group and carves out all amounts of group-term coverage that is provided under the existing plan. All amounts that exceed $50,000 of coverage are replaced with a permanent and portable life insurance policy.

Death Benefit Only Plans
A death benefit only (DBO) plan is an employer-sponsored plan that offers key executives an added fringe benefit. While an employer may opt to informally fund or finance the benefit with a life insurance policy, DBOs are not true life insurance plans. They are unsecured, unfunded promises to pay the executive’s designated beneficiary a specific sum of money, either in a lump sum or in installment payments over a certain period of time. No lifetime benefits are paid to the executive in these types of plans. From a tax standpoint, the benefit is not taxable to the employee, but the beneficiary is required to report the proceeds as ordinary income in the year received and pay the applicable income tax.

Nonqualified Benefit Swaps
An important type of NQDC plan is the nonqualified benefit swap, a company-sponsored plan that offers the highly compensated executive an innovative tool for estate planning purposes, promoting a more equitable transfer of wealth by avoiding income and estate taxes. A simple definition of a swap is a direct exchange of all or a portion of the nonqualified cash account. The swap can be done by redirecting the nonqualified contribution amount to pay premiums on a split-dollar life insurance policy on the life of the executive and his or her spouse. The executive can decide how he wants to apportion any current or future nonqualified balances to result in the desired size of the policy. The company pays the annual premium, and the cash value accumulates on a tax-deferred basis. When the second insured (either executive or spouse) dies, the company is repaid premiums accumulated in the policy.

EFFECTIVE, THOROUGH PLAN DESIGN

Deferral plans offer a defined contribution or a defined benefit, and are designed in many different types and hybrids. A well-designed NQDC plan brings several advantages to both executive and employer, including flexibility and customization. NQDC plans allow you to custom-design your plan through a wide range and degree of benefits. Best of all, these plans give employers and plan participants welcome freedom from ERISA and IRS restrictions.

Best Practices
Recently, there has been an increased acceptance of certain best practices, or key design features, found in state-of-the-art DCPs. Simply put, Best Practices refer to a standard of planning and implementation that is beyond average, one that encompasses a wide range of contingencies and strives to offer a level of exceptional quality in benefits planning. Because all NQDC plans are not equal, companies preparing to design NQDCs will find it highly beneficial to adopt the following five Best Practices design guidelines:

1. Build Flexibility of Payout Options. A well-designed NQDC plan should offer participants short-term distribution options, especially among younger participants who are faced with shorter-term obligations such as college tuition for their children. Individuals may receive partial payout prior to retirement without the 10 percent penalty they would otherwise incur for partial withdrawals from a qualified plan. There should be enough flexibility to allow participants to determine how and when they wish to receive their benefits as often as the funds are needed. Short-term distributions most often have a five-year minimum payment period.
   
   
2. Create Investment Diversity with Unlimited Ability to Reallocate Funds. The rate at which interest is credited to the account of DCP participants can vary widely. That’s why a high quality NQDC plan provides participants with the unlimited ability to reallocate their deferrals. This diversity allows participants to select an individualized wealth-building strategy from a variety of investment options.
   
   
3. Develop Appropriate Security Devices. Consideration of risk management is a key aspect of plan design. NQDC plans are not covered or insured by the government against loss, leaving plan participants exposed as unsecured creditors. As a result, you should take extra precautions to protect the plan against unforeseen events. In employer insolvency or bankruptcy, an executive would lose promised benefits, as company assets go to secured creditors first. Other risks may include an employer's inability to pay benefits due to cash flow demands; a hostile takeover; an unfriendly change in corporate control; a management change of heart; or the decision to simply eliminate the plan.
   
   
4. Develop Appropriate Funding Vehicles. The funding question can be complex because a number of competing factors must be taken into account. To avoid unnecessary charges to a company’s income statement, a DCP should be designed to minimize its expenses, including the impact on cash flow at the point of payouts. What’s more, for a plan to be successful, the participating executives must feel comfortable that they will be paid when scheduled.
   
   
5. Offer Stock Option Gain Deferrals. A critical feature to include in your plan is the ability to defer any gains in the value of an employee’s stock options back into his or her compensation account. A nonqualified equity plan enables the executive to defer taxes normally due when stock is granted, as well as defer capital gains when stock income is realized. Equity plans are often viewed as an appropriate way to align the interests of the compensated executive with the objectives of the corporation. Equity plans can become part of a NQDC plan designed to include stock that is granted or stock that is already optioned.

Before you focus on the specific steps recommended for a Best Practices benefits plan, decide who within your company should be involved in the design process. Consider establishing a project study group comprised of representatives from your human resources, employee benefits, legal, and finance departments. You may also wish to add a senior member of management and the compensation committee. Plan on holding four to six meetings over a period of sixty to ninety days, depending on group availability. As you move forward in your benefits project, you will quickly discover that a clear understanding of the tax, legal and financial implications of the plan can minimize potential problems. You may wish to consult key advisors in these areas?early and often.

When designing the plan, it is important to remember that compensation and benefits are most effective when woven together as a seamless whole. In this way, you can create the opportunity to drive the type of executive behavior and performance that reflects your commitment to Best Practices. It is also essential to tie the benefits plan to the overall strategic direction of your company. You can create the right strategic framework by answering these key questions:

• What do you want to reward in the company? What type of behavior or performance?
• How long is your business horizon? What must happen for the business plan to succeed?
• What is your competitive posture in the marketplace?
• Is your market leadership built on the contributions of a handful of senior managers?
• Are you in an emerging market with an immediate need to attract top talent?
• Are you in a mature market where new generations of leadership are not being cultivated?
• Are you in a financial downturn and need to transition key executives?

Once you gain perspective from this exercise, communicate as effectively as possible with all stakeholders. After getting feedback, you can develop a well-reasoned strategy. We urge you to create a clear process before you begin plan design because it will streamline and simplify all aspects of plan building. It is also advisable to build in sufficient flexibility to adapt to the inevitability of business change. Finally, remember to incorporate Best Practices in plan design using the guidelines discussed above.

Seven Steps to Sound Plan Design

Step 1. Discuss Objectives and Design Issues
It is essential that you begin your design process with a comprehensive understanding of current objectives for your benefits program, from the perspective of both the company and the executive participants. Conduct a series of executive interviews to gain in-depth opinions and consult your newly formed project study group to gather and formalize feedback, as well as to evaluate timeline expectations. We also recommend that you review and discuss the prevalence of data surrounding current trends on benefit plans. It is always helpful to understand how other companies have benefited from sound plan design. As a precaution, we also urge you to fully understand pertinent legal, tax, ERISA, and accounting issues specific to your corporation. Third party advisors will be invaluable in this regard.

Step 2. Preliminary Plan Design
Determine the structure of your plan by deciding upon eligibility, benefit rates, distribution options, and benefit security. Then, analyze the financial impact of the benefits plan on the corporation, taking into account the effect on other employer provided benefits. Be sure to view your data from the perspective of cash flow, profit and loss impact, and the balance sheet.

Step 3. Benefit Security Issues
The important security aspects of your benefit plan can be best addressed by determining the level of plan protection necessary. This level should match the potential risk of a change in control of management or ownership; a change of heart by management; or an impending bankruptcy. Then, carefully analyze the wide range of security vehicles available, such as the Rabbi Trust, secured trust, or split-dollar insurance.

Step 4. Funding Analysis
The best way to undertake your funding analysis is to analyze a variety of funding approaches from the perspective of tax-free investments and taxable investments. Then, look at the cost-efficiency of each approach by concentrating on a range of investment rates of return; your company’s current tax bracket; and discount rates. Finally, give careful consideration to the financial impact of your funding analysis.

Step 5. Develop and Process Recommendations
Now that you have determined plan objectives, worked on preliminary plan design, and identified the types of security and funding vehicles that are appropriate for your company, it is time to develop specific recommendations. First, prepare a final report outlining your recommendations. Then, prepare a Board of Directors overview and presentation. Once you have secured Board approval, the next area to investigate is your own capability to administer the plan.

Step 6. Implementation
One of the toughest decisions surrounding a plan is determining when to implement. Once you have established the right time, you are ready to do some of the more basic work of plan building. The key actions that require your attention are as follows:

• Create specimen documents
• Prepare and provide enrollment materials:
  • Executive Summary
  • Question and Answer Section
  • Directions for Enrollment
  • Election Forms
  • Beneficiary Designation
  • Spousal Consent
  • Notice of Non-Participation
  • Plan Document
  • Sample Benefits Statements

Finally, plan to conduct enrollment meetings, either on-site, by teleconference, or with personal phone calls.

Step 7. Administration
Sound administration and precise record keeping are critical for successful plan design and implementation. First, establish account teams, comprised of an account manager, a benefit analyst and a financial analyst. From that point, create or gather the following documentation:

• Participant benefit statement
• Investment changes
• Company financial information
• Participant questions
• Any plan changes
• Account history

In your team evaluation, focus on areas of non-compliance and Best Practices to ensure good results. Also review documentation and processes to take advantage of any administrative efficiency available to you; determine what type of customization may be required; and note any possible updates or amendments that may be needed. Then, meticulously monitor legislative and regulatory issues that could eventually affect the plan.

Third-Party Outsourcing
Before you implement your nonqualified plan, determine whether you want to administer the plan yourself or outsource its administration to a third party. There are many points to consider when making this decision. Three areas to keep in mind when evaluating the need for outsourcing are economics, complexity, and your department’s visibility with the corporation. Consider outsourcing if you discover:

• You have fewer personnel to manage and keep records on your plan
• Plan participation has increased
• Your company is going through a merger or acquisition
• Your current vendor does not deliver the service required
• Your plan is changing from a fixed to variable interest rate

Many corporations have found that it is more efficient and cost-effective to outsource plan administration to an expert third-party benefits consultant. Customarily, in-house administration of benefits plans is time-consuming and expensive. The decision to outsource plan administration to a vendor can be difficult to make, but easy to implement.

DEVICES FOR PLAN SECURITY AND PROTECTION

There are several security devices that can reduce a participant's risk in an unfunded, nonqualified plan. We advise our clients to perform a risk/rewards analysis to determine which type of plan benefit security devices is right for their employees. When you eventually draft a trust agreement, be sure to consult competent counsel and use the model language provided by the IRS. Some of the appropriate devices to secure the nonqualified benefit include:

Rabbi Trust
A Rabbi Trust sets aside or segregates 'unfunded' assets, which may be used to satisfy the employer's obligations to employees under one or more nonqualified plans. Similar to an escrow account, it is an irrevocable trust established for the benefit of the participant by an employer. The trust simply creates a liquid fund to pay the nonqualified benefits as they become due. A Rabbi Trust may also be set up as a revocable trust and can be written to automatically “spring” by some predetermined event. This means that the trust will be funded, or will become an irrevocable trust, if certain triggering events occur, such as a change in control, a Board resolution, a favorable private letter ruling, a decline in the corporation’s credit-worthiness, or other events that are beyond the control of the executive or corporation.

The primary purpose of a Rabbi Trust is to provide and protect nonqualified plan assets. In essence, it functions as a security device, guaranteeing that funds will be available when promised. For income tax purposes, the company is the owner of the trust assets and will, therefore, pay taxes on the trust’s earnings.

"Haircut" Provision
Another type of security device is a popular “hair-cut” provision that permits “withdrawal at any time,” enabling participants to access their account balances whenever they wish. The withdrawal is subject to a monetary penalty that can average between 5 and 15 percent, with a 10 percent penalty being most common.

Secular Trust
Unlike a Rabbi Trust, the secular trust is an irrevocable trust in which employer contributions are outside the reach of the employer and his creditors, as assets cannot revert to the employer. But, there is a trade-off. Plan participants must forgo tax deferrals in exchange for the security. One way to avoid adverse tax consequences is for the employer to direct the cash contribution to the employee, who then contributes this cash to his or her own grantor trust. The trust is then considered an employee-grantor trust with no separate taxation.

Rabbicular Trusts
A Rabbicular Trust? is a hybrid of a rabbi and a secular trust that offers “springing” provisions beyond the control of executives but holds contributions against a contingent liability. If a triggering event occurs, assets are transferred to a secured trust, and executives are taxed at that time. There is a question as to whether this type of arrangement will protect the assets from the general creditors of the corporation in the event of insolvency. The bankruptcy look-back provision is 90 days prior to the date of filing and one year for officers and directors.

Non-Sectarian Trusts
Also known as a vesting trust, the non-sectarian trust is taxed as a separate entity and is designed to pay amounts only if certain triggering events occur. If the events do not occur, the trust repays the employer, and the executive is paid directly by the employer from general assets. The IRS deems this type of arrangement equivalent to a funded arrangement, and, therefore, it is taxable.

Secured Trust
In response to situations where corporate insolvency occurs, CBC-CRG developed a proprietary type of trust, called a secured trust. The goal of the secured trust is to provide bankruptcy protection, alongside the benefits of a Rabbi Trust. Bankruptcy protection is accomplished by combining the deferred compensation plan with a second plan/trust that provides a benefit to an employee only upon change in control or bankruptcy. If a change in control or bankruptcy does not occur before the employee leaves the company’s employment, the employee forfeits the additional benefit, and the company becomes a contingent beneficiary of the trust.

In effect, this trust provides the employee with a fund that approximates his or her deferred compensation benefits in a lump sum payment. This payment is outside the reach of creditors at retirement, when the employee most needs those benefits. The secured trust can be a strong confidence-builder and may assist your company in retaining its most valuable employees.

Surety Bonds/Indemnity Insurance
Another way to provide benefit security is through surety bonds or executive indemnity insurance, a contract/policy from a liability carrier that insures payments of the executive’s benefits if the employer becomes insolvent or bankrupt. Bonding arrangements, however, are expensive and have inherent limitations. As a result, they are rarely offered.

Insurers typically underwrite only the largest and most financially sound companies, leaving the closely held business market without coverage. The insurer also requires corporations with NQDC plans to disclose their annual financial statements, credit reports, short-term and long-term debt, as well as other information. What’s more, the insurers typically retain the right to cancel the policy on an annual basis.

Concerning taxation, the IRS has made it clear that the executive and not the employer must pay all premiums on the surety bond or indemnity insurance policy. This action is the only way to avoid having the plan characterized as a secured plan, which would invoke the economic benefit tax doctrine. In effect, it is the employee who insures against the benefit risks of non-payment by the employer. Be aware that the IRS is concerned that a nonqualified plan, using a Rabbi Trust that holds indemnity insurance, may be considered funded for ERISA purposes.

APPROPRIATE FUNDING VEHICLES

It is important to recognize that proper funding of your plan ensures lower costs, which is dependent upon the nature of your funding analysis and financial assumptions. The best place to begin your analysis is to select a number of financial assumptions to be used in the evaluation of funding vehicles.

Corporate Tax Bracket
If a company is currently in an alternative minimum tax position, the projected analysis must include an assumption of when the company will return to a full tax position. State and local taxes must also be included in these projections.

Cost of Capital
When preparing your financial analysis, you may select from the corporation’s borrowing rate, cost of capital, return on equity, return on assets, or weighted cost of capital.

Assets Evaluated
If a full evaluation is to be completed, you must determine which company assets you will evaluate. Choices may include managed portfolio, company stock, tax-free bonds and corporate-owned life insurance.

Rate of Return on Select Assets
Each asset will have varying rates of return, depending on the risk associated with investment. If you purchase a managed portfolio with a large equity holding, for example, you could receive a higher return as compared to a tax-exempt bond.

Funding Options
Once you have generated a thorough review of your company’s finances, you can then choose the most appropriate funding vehicle for your plan. They are as follows:

Mutual Funds. Recent trends suggest companies may be moving away from mutual funds as a stand-alone funding device because of the tax liability created by growth in plan earnings. For example, if an executive defers $100,000 into a NQDC plan funded by shares in a mutual fund, earning a 10 percent rate of return, the company would then have to book a liability of $110,000. The covered employee would have to pay tax on their 10 percent gain, which results in a net addition to their NQDC account of only $106,000. The longer such a plan is in force, the greater the disparity between assets and liabilities, and the participant's tax exposure will grow over time. As a result, many firms using mutual funds to underpin their NQDC plans are revisiting their funding strategies. We expect this trend to continue.

Pay-as-You-Go Financing. Using this method, a company will pay nonqualified benefits from the company’s cash flow when executives terminate their employment or retire. In effect, the company is reinvesting executive deferrals under the plan back into the company to be used, typically, as operating capital. The company is able to do this because it is not using the deferrals or setting aside company funds in a specific investment vehicle. Companies are attracted to the pay-as-you-go method, as it does not require extensive financial analysis. It’s important, however, that you determine the corporate rate of return on equity and ascertain that this rate is competitive with alternative investment options. Pay-as-you-go works well when the amount of the nonqualified benefit liability is not significant.

Sinking Fund Method/Managed Portfolio/Mutual Funds. You can fund your nonqualified liability with traditional investment choices, such as a managed portfolio. In this case, the company projects the benefits to be paid to an executive at retirement, and, each year, the company sets aside a calculated amount into an internal segregated sinking fund from which benefits will be paid. The company may use stocks, bonds, mutual funds or any other types of investment to realize an expected return on the fund. Unfortunately, the income attributable to such funds, including a dividend on a stock or mutual fund, will be taxable to the corporation. In that spirit, taxable and tax-exempt bonds are worth consideration. Companies are also investing in their own stock to finance nonqualified deferred compensation obligations. Simply make a contribution to a Rabbi Trust, which then uses the money to purchase company stock on the open market.

401(k) Mirror. Companies with a 401(k) plan often want to supplement it with a NQDC plan. As 401(k) participants can select their own investment options for contribution, they can also make their own choices in the mirror plan. While these choices may be taxable to the corporation, costs can be shouldered by the company or passed onto participants.

Corporate/Trust-Owned Life Insurance (COLI/TOLI). The tax advantages associated with life insurance make it highly attractive for financing nonqualified plans. Cash values accumulate on a tax-deferred basis, and death benefits are income tax free. Equally positive, cash value withdrawals by the employer’s company are also income tax free. The process of comparing types of COLI products is time-consuming at best. We recommend that you consult your insurance advisor or a third-party benefits consultant for assistance.

Cost-Recovery Method. In this scenario, the company purchases a policy on the life of each executive participating in the nonqualified plan. When the executive retires or terminates employment, the company pays benefits from the company’s cash flow. The company holds the policy, as owner and beneficiary, until the eventual death of the executive and realizes a tax-free death benefit designed to fully recover costs associated with the NQDC plan. Typically, the amount of the death benefit will sufficiently cover the after-tax cost of the benefits paid, the insurance premiums paid on the policy, and the cost-of-money factor.

Cash-Value Method. Although the cost-recovery method produces the best results when held until death, there are shorter-term results that are beneficial. The cash-value method finances benefits by using cash funding from the policy to provide monies owed to the retired executive without surrendering the policy. The company can pay benefits due under the NQDC plan directly from its cash flow. To restore this cash flow with the after-tax cost of paid-out benefits, you may make withdrawals or loans from the policy equal to the after-tax benefit cost, which accumulates on a tax-deferred basis. Another way to use the cash-value method is to distribute the policy to the executive at retirement as payment of benefits under the NQDC plan. He or she either keeps the policy for its tax-favored death benefit or accesses the cash value as a source of supplement retirement income.

Split-Dollar Life Insurance Funding. The company agrees to share in the purchase of a policy on the life of the executive. The company will pay most or all of the premiums and retain an interest in the policy equal to the cumulative premium payments. Thus, the company has an interest, evidenced by a collateral assignment, in the cash value and death benefit. The executive owns the policy so any excess death benefit or cash value belongs to them.

IN SUMMARY

Shifting tax laws, market forces and other unique economic factors have all resulted in the rapid evolution of executive benefits programs over the past few years. When first planning to implement any type of deferral benefits plan, it is essential that you seek the counsel of experienced professionals to assist with the tax and legal aspects of your plan, whatever its eventual parameters. We also advise companies with existing NQDC plans to revisit objectives and overall design to determine if they reflect the latest trends and thinking and adjust their plans accordingly. If your company has yet to adopt such plans, it is easy to avoid most of the economic, legislative and regulatory pitfalls unwittingly created by earlier plan designs. The process can begin by simply studying and incorporating the best in current plan design practices.

At RCG, we see all types of benefits plans in our consulting work. Unfortunately, a lot of these plans simply don’t succeed, or don’t meet the needs of either the company or its top executives. Often, the plans that do not measure up to Best Practices were not well thought out in the first place. As a result, we encourage you to plan ahead and constantly improve. From the outset, try to create an environment that supports continuous plan improvement by instituting a few guidelines:

• Develop a sound strategy that supports your overall corporate objectives
• Design a comprehensive and cost-effective benefits plan from the outset
• Always do sound financial modeling in preparing any analyses
• Coordinate with other corporate benefits programs
• Use technology to enhance, not impede programs
• Anticipate and resolve problems quickly
• Set up an early warning system to track economic cycles
• Continuously monitor plan relevance by adjusting for changes in the organizational culture

As companies improve their ability to attract senior talent to lead and manage, everyone benefits. Corporate vision and values are heightened. Business performance and longevity are enhanced. That’s why your work as a human resources practitioner contributes significantly to the vitality and future of your company. With the appropriate knowledge and the right guidelines, you and your company can meet the recruit-retain-reward challenge through well-planned, high-quality deferral benefits plans.

Return to Table of Contents