Nonqualified Deferred Compensation Plan (NQDCP): Reform and Your Alternatives

By William L. MacDonald
Chairman, President & Chief Executive Officer
Retirement Capital Group, Inc.

Overview of NQDCP Reform

As part of heightened scrutiny of executive compensation and benefit practices following the Enron and WorldCom bankruptcies, Congressional Tax Committees have developed reforms that, after final passage, will require changes to existing nonqualified deferred compensation and supplemental retirement plans.

Two similar proposals have advanced in the House and Senate and are parts of these Bills:

• H.R. 2896, the American Jobs Creation Act, which was approved by the House Ways and Means Committee in October 2003.
• S. 1637, the JOBS Act, which includes the Senate Finance Committee's changes to executive nonqualified benefit plans.

As the House and Senate provisions are similar (both raise revenue and have bi-partisan support) their enactment is likely this year. Major provisions within the bills include:

• Distribution restrictions
        - Elimination of in-service distributions ("haircut withdrawals")
        - Prohibition on elections to accelerate benefit payments
        - Limits on changes in the time of, or form of, a scheduled payment
        - Tighter definitions of distributable events, such as disability and change            of control
• Prohibition on use of offshore trusts to hold executive plan assets
• Prohibition on use of financial triggers to earmark assets to pay executive    benefits
• Reporting of deferred amounts on W-2 Forms

Additional provisions within the Senate Bill as of March 2004 include: the prohibition on the deferral of gains from exercising stock options; the restriction of available investment options (requires parity with 401k plan options); the prohibition of payments to a company's top five executives within one year of change in control; an additional 10% tax penalty on tax liabilities for non-compliance; and, a requirement that only one election to defer a payment be allowed by plan.

If plans fail to comply with the new rules, participants would be required to include past deferrals in income, pay taxes and interest, and, under the Senate Bill, pay a 10% penalty.

NQDCP Plan Design

The single most important plan design decision concerns the crediting rate, as identified in the plan documents, and investment options available to participants. The pending legislation limits available design options and will require changes to existing plans.

RCG Best Practices	New Legislation	Suggested Action
Wide selection of investment choices (i.e. mutual funds, hedge funds, high rate of fixed interest - Moody's Bond Rate plus, 10-year Treasury plus) Self-directed brokerage accounts Deferral of stock option gains	Investment options are limited to those available under the employer's qualified plan with the fewest options. No hedge funds, no self-directed brokerage options, or above-market rates allowed Preclusion of deferral of stock option and restricted stock gain	Plan Sponsor should evaluate current investment selection and mirror selection with qualified plan Eliminate all choices not available to rank and file employees

Investment diversity and the ability and frequency to reallocate investment options among a variety of funds vary widely across Deferred Compensation Plans (DCP). Thirty-seven percent (37%) mirror the returns of a particular stock index or the investment options in the 401(k)/savings plan, up from thirty-one (31%) in 2002.

Source: Clark Consulting 2003

A new concept is to use a Stable Value (SV) feature within your plan’s investment options. The SV feature removes the account balance and performance volatility of an actively-managed separate-account investment option.

Illustration of Stable Value Portfolio

The company can fund their DCP with SV inside of COLI (corporate owned life insurance). The policy’s cash value investment is accounted for at the cash surrender value. Income will accrue steadily and the participant is guaranteed a positive return, absent default of securities. Upon a surrender election, a company will receive the stabilized portfolio value, regardless of market conditions.

Legislative Impact

The legislation will most likely leave nonqualified plan eligibility requirements untouched as there is no compelling reason or public outcry to make plans more or less inclusive. The new rules may, however, impact plan deferral limits on bonuses and options. NQDCP participants can defer options in 2004 though this feature will most likely be eliminated in the final legislation. Also, new rules will mandate corporations to follow bonus deferral rules (i.e., defer bonus before earnings period).

The participant’s ability to access their accumulated assets in a nonqualified plan is based on the occurrence of any one of the following life events: death, disability, termination of employment, retirement, or financial hardship. Both bills attempt to redefine financial hardship as:

• A severe financial hardship of the participant or beneficiary resulting from an illness or accident of the participant, beneficiary, or dependent.
• Loss of the participant’s or beneficiary’s property due to casualty.
• Other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the participant’s control causing loss of participant’s or beneficiary’s property.

The trend over the past several years in a typical NQDCP plan design has been to allow more flexible distribution options to plan participants. Most of today’s plans allow a lump-sum distribution over a certain period of time. Under both bills, the lump sum or installment option must be selected and specified under the plan at the time of deferral / enrollment. The source tax benefit is also a distribution option permissible under the new guidelines, though it is an often overlooked benefit. Source tax law prohibits states from imposing a tax on the retirement income of non-residents, regardless of when the retirement income was earned, as long as it is distributed after termination of employment.

A new concept that RCG is exploring through the best practices design would allow the participant, prior to retirement, to convert their account balance into an option constructed to track the investments held in the NQDCP. The option could then be transferred to a third party (beneficiary) as a non-taxable event.

The legislation will also impact a typical NQDCP in-service distribution feature. Under the new requirements, the plan would not allow any payment election or re-election to be delayed less than five years. This means that any short-term distribution, whether is was needed to fund college education or to provide capital for the exercising of stock options, is not permitted until five years after the deferral is made.

Today’s best-practices design allows a participant to change their retirement distribution election up to one year prior to retirement, even to accelerate it. For example, a participant may initially elect a 15 year installment distribution option. One year prior to retirement, the participant may change his election to a lump sum distribution. Under the new guidelines – no acceleration of distributions would be allowed (except under limited circumstances governed by the IRS). (Note: This restriction may warrant a company to re-state its NQDCP in 2004, allowing the executive to make one final election.) Also impacted by changes in acceptable distribution option, key employees of publicly-traded companies may not receive separation distributions less than six months after the date of separation.

The most prevalent assets used to informally fund a typical NQDCP today are mutual funds and corporate owned life insurance (COLI) policies. Neither the House nor the Senate Bill impacts the use of COLI as a plan funding option. The bills do propose new rules outlining how COLI should be purchased.

Another plan funding option that is new to the marketplace involves a hedge portfolio that tracks the performance of an underlying investment. The hedge typically costs a company an annual management fee of LIBOR (London Inter-Bank Offered Rate) plus 100 basis points and would save a company’s cash flow.

A new concept, the Pooled Benefits Trust^SM (PBT®), is a plan funding tool that allows a company to monetize the plan’s value, potentially improving the company’s cash flow and earnings. The PBT® “pools” the death benefits of a company’s executives (i.e., a group of 50 to 100 executives is added to a larger pool of 3,000 to 5,000 executives) to realize a percentage of death benefits from the greater pool.

Once a company decides to fund their NQDCP, the next step is the securitization of the funding to protect plan benefits. Funded Rabbi Trusts are the most common vehicle used to provide protection in the event of change in control, financial instability, or the refusal on the part of the company to pay. Domestic Rabbi Trusts will be allowed under then new guidelines -- only Rabbi Trusts housed offshore, in foreign jurisdictions, will be impacted.

Both bills are in support of eliminating the commonly accepted practice of allowing a NQDCP participant to request a distribution at any time – though they incur a 10% penalty, or haircut, assessed at payout. Retirees may escape the restrictions on these unplanned distributions.

Life After Reform

All indicators point to changes in many aspects of NQDCP Plan Design. Until the final bill is presented to Congress for a final vote, we will not know the exact details of the legislation. The House and Senate continue to move closer to agreeing on the specifics. A few recent developments have the narrowed the differences:

• House and Senate Tax Committees generally agree on the scope of nonqualified reforms.
• The recent Senate Bill, S. 1637 is based on the House language, with several additional provisions.

The reforms will raise nearly $1 billion per year in the first two years after enactment, and over $4 billion over a ten year period. From a revenue raising standpoint, these reforms are not controversial, and when Congress finds revenue sources, they usually tap them, especially in today’s economic and political environment.

Congress is highly polarized now as we enter the election period, and the Senate Democrats have the votes to block Senate action (it takes 60 votes to stop unrelated amendments to legislation, and the Democrats are trying to get votes on minimum wage, overtime and various hot button issues that Republicans don’t want to vote on). As a result, the Senate is currently gridlocked preventing a final vote on the NQDCP reform legislation. The Senate and House are in recess until April 19th.

RCG’s approach is to assist companies in the audit and redesign of their nonqualified benefit plan, helping companies properly fund and secure their participant’s benefits. To find out more visit www.retirementcapital.com, or contact RCG at info@retirementcapital.com.