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Consolidated Benefit Statement 401(k) and Nonqualified Deferred CompensationEase of administration may increase company cost and lose sight of your key executives' needs.By
William L. MacDonald As the war for talent continues through this decade, attracting and retaining key people who can make a difference in your organization continues to be a challenge. Although it may not be politically correct to say in some circles, your key executives and managers are the key to victory. Nonqualified to Discriminate In order to attract, retain, and reward key executives and managers, for years the Fortune 1000 have provided a benefit that allows highly-compensated individuals to accumulate wealth on a tax-deferred basis. These plans, referred to as nonqualified deferred compensation plans offer a potential win-win scenario for companies, participants, and shareholders, and are available to companies of all sizes. As mentioned above, these plans are "nonqualified" plans, meaning they are not subject to ERISA and IRS regulations governing qualified plans, such as the 401(k). Because of their nonqualified status, deferred compensation plans offer advantages that cannot be overstated and should not be overlooked. 1. Discriminate - Nonqualified deferred compensation plans allow you to discriminate. What the plan provides to one, need not be offered to another. 2. Discretionary - Companies may decide to make contributions to the plan, or they may not. Contribute one year and not the next. Impose "golden handcuffs" or "glue in the seat" to get people to stick around or offer immediate vesting to create a powerful recruiting tool. 3. Flexibility - Companies can structure deferred compensation to meet their individual situations and objectives. 4. Cost - The cost of providing a deferred compensation plan benefit, depending on how you choose to structure it, is extremely low by any standard. Few executive benefits cost so little yet provide so much. Designing the Plan Before beginning the design process, consider the objectives for the plan. All nonqualified deferred compensation plans aid in the areas of recruiting, retaining, and rewarding key employees. However, the plans can be structured to emphasize one of these areas over another (Chart I).
Coordinate Nonqualified with 401(k) Many assume that 401(k) providers are well-positioned to help companies design their deferred compensation plans to work in concert with the company's 401(k) plan. More often than not, this isn’t the case. Most companies who adopt this strategy are simply looking for administration simplicity, but as we will see later it could be costly. Nonqualified plans operate under a whole new set of regulations (409A) than qualified plans, and plan designs contain multiple moving parts. No standard design exists as it does with a 401(k). Remember, nonqualified plans are designed for your senior management group who will see as much as 90% of their total retirement savings come from nonqualified plans. The truth of the matter is, they drive different cars and have different needs than what the 401(k) was designed to provide. You even compensate them differently putting a high percentage of their compensation at risk through incentive plans. Not only are they looking for more flexibility because these assets are not secure like the 401(k), and their financial advisors want them in different asset classes and managers normally not found in 401(k) plans. Given how critical these plans are for executives, it is crucial that the right provider is selected to properly implement and oversee the plan for your company. We are dealing with your most important asset - your key people. Treating the Nonqualified Plan as if it Were a 401(k) is a Big Mistake As discussed above, putting the nonqualified plan in the 401(k) box can be a problem for a number of reasons. First, some of the major design components of nonqualified plans are taken away: namely flexibility and asset selection. Benefit managers need an expert provider who can interact with a company's top executives and help to communicate the added flexibility and options associated with their plan (not just a "call center", where representatives are not required to be experts in any particular client's plan). Second, from a participant's standpoint, these plans are less secure than 401(k) plans. As opposed to "qualified" retirement savings plans, nonqualified plans must be "unfunded". This means that the money deferred by a participant goes into the company's general account and cannot be set aside to guarantee the plan's future obligations. Should a company sponsoring such a plan become insolvent, the amounts deferred are considered part of the company's assets and are therefore subject to the claims of creditors. (In a 401(k)/qualified plan, this is not the case.) Many firms "informally" fund the plans by setting assets aside in a Rabbi Trust (Chart II). This feature is what gives the nonqualified plan its tax deferred status. The thinking is that since the participant is placing money into a plan that he or she may never receive or benefit from, the amounts contributed are considered to be tax-deferred until such time as the participant actually receives the cash from the plan. With this risk, working with a real specialist who understands funding/securitization alternatives because he can help design the plan to minimize risks is extremely important. Finally, when these plans are informally funded by 401(k) providers, they tend to use mutual funds since this is the asset used in the company's 401(k) plan. The major difference here can cost the company substantial dollars. When the company funds its 401(k) (which is required by law) assets are set aside in a tax-exempt trust, and held until distributed to the participant, usually at retirement. The company simply makes the contribution to the trust and takes a current tax deduction with no future liability on its balance sheet. With the nonqualified plan, it's not so simple. A separation wall exists between assets and liabilities (Chart III). First, the executive elects to defer compensation, and the company holds the cash and accrues a liability on its balance sheet. Next, the executive elects to defer such money in an investment fund (mutual fund) offered by the plan. The return of the fund (hypothetically, let’s say 8%) is also accrued to the deferred compensation liability. Separately, on the other side of the wall (Chart III), the company has decided to take the money deferred, and purchase an asset (e.g. mutual fund) to hedge its liability. The asset, even if held in a Rabbi Trust is held on the company’s balance sheet. If this asset is a mutual fund, under FAS 115, the company must report all realized gains, even if the fund is not sold. With many managed funds, the manager may have a higher turnover in the portfolio. In addition, most well designed plans allow participants to move their money from fund to fund, generating additional gains.
According to a recent Lipper Inc. study, last year investors paid an estimated $15.2 billion in taxes to the U.S. government, a 58% increase from 2004 from such gains. Lipper Inc. stated that much of the rise is due to a dwindling of tax carry-forward losses that mutual funds amassed during the bear market of 2000-2002. "Those losses can only be carried forward eight years, and already are beginning to be used up", said Tom Roseen, a senior research analyst at Lipper.* Taxes on mutual funds take the biggest bite out of a fund's performance more than management fees on a fund's load, which is the cost paid when investing in a mutual fund. This is the asset companies are looking for to hedge their deferred compensation liabilities, and with this factor, a mismatch is put between assets and liabilities (Chart IV). *According to Tom Roseen in the April 2006 issue of Weekly Review by HIG.
According to the Lipper study, during the past 10 years investors in taxable mutual funds have seen taxes reduce performance by an average 1.6 percentage points in equity funds and 2.4 percent points in fixed-income funds. This equates to a cumulative loss of up to 20% and 45%, respectively. This is why most tax-paying companies hedge (informally fund) their deferred compensation liabilities with corporate owned life insurance (COLI). Gains that result from investments inside of an insurance contract (same offered to participants in the plan), owned by the corporation and held until maturity accrue tax-free to the company. Costs are associated with purchasing a COLI contract and a portion of those costs provide a death benefit. The executive participating in the plan becomes the insured; the beneficiary is the company (or Rabbi Trust) that owns the policy. Over the life of the plan the costs of insurance, assuming overall positive investment returns, are significantly less than they would have been if the company was taxed on investment gains in a mutual fund (Chart V).
Summary Working with a firm experienced in designing these funding strategies is very important, as it could save the company millions of dollars over the life of the plan. Our experience shows that most 401(k) providers lack the funding experience and administrative services outside of mutual funds. If it’s important to have that single benefit statement, find that firm that can provide top resources in both 401(k) and nonqualified plans. Nonqualified deferred compensation plans are continuing to be an
important part of an executive’s wealth accumulation - for
many it’s the largest part of their retirement savings. Since
they are such an important element of your key executive’s
package, choosing the right consulting firm with the appropriate
level of expertise is more critical than ever. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or its contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/materials(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. Retirement Capital Group, Inc. (RCG) neither acts as legal counsel, tax advisor nor provides accounting services. Recommendations should be reviewed with appropriate tax advisor or counsel. This report contains proprietary and confidential information belonging to RCG (www.retirementcapital.com). Acceptance of this report constitutes acknowledgement of the confidential nature of the information contained within. |
