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The Executive Roth PlanSM:Updating Defined Benefit SERPsWilliam L. MacDonald Kenneth A. Kirk
Companies have a short window of time to analyze their nonqualified plans and react to changes in §409A before the end of the year. 1IRS notice 2006-79 provides that a plan may be amended to provide for new payment elections on or before December 31, 2007, with respect to both time and form of payment and such elections will not be treated as a change in the time and form of payment or as an acceleration of payment. Many companies are finding the Executive Roth PlanSM an attractive update to their SERP plans. To comply with Code Section §409A, a company that wants to convert its existing SERP into an Executive Roth PlanSM would need to amend the SERP by December 31, 2007 to provide for the distribution of accrued benefits beginning on a fixed date in 2008. Typically, nonqualified retirement benefits provide more than 50% of an executive’s retirement income. With competition fierce for attracting and retaining a quality executive team, and stringent new proxy reporting requirements, a well-designed nonqualified plan has never been more important. Executives look to their employers to offer nonqualified plans that provide security, tax efficiency, portability, and self-directed investments. Companies must balance those requirements with their responsibility to stockholders and the new governance/reporting requirements. This article provides perspective on the current situation based on the evolution of nonqualified plans, and introduces an innovative new plan, the Executive Roth PlanSM, which many companies are utilizing to attract key talent, respond to the new benefit environment, and enhance shareholder value. This article also explains why it is essential to reevaluate your corporate plans and make desired updates before year-end.
Why Now Is the Time to Reevaluate Your PlanIn April of this year, the U.S. Treasury and IRS issued final regulations for §409A which affect nonqualified plans. The changes to §409A create new restrictions on nonqualified arrangements and imposes stricter reporting and disclosure guidelines. The new rules reduce the flexibility, security and appeal of many nonqualified arrangements. Although these restrictions were effective for all plans beginning January 1, 2005, IRS Notice 2006-79 provides for transitional relief until December 31, 2007, giving companies a window of opportunity to amend plans and alter existing elections. Before the end of the year, the transition period permits companies to reevaluate plans and make necessary changes to meet the objectives of executives and the company. Many employers are reassessing the benefits of maintaining older SERP designs versus the advantages of restructuring plans into new options such as the Executive Roth PlanSM.
The Evolution of Nonqualified Retirement PlansOver the past 20 years, restrictions on contributions and benefits from qualified retirement plans (i.e., pension, 401(k), and profit sharing plans) prompted many companies to implement nonqualified retirement plans. Commonly, the plans were designed to help highly compensated executives receive the same benefit percentage from qualified and nonqualified plans as other employees would receive from qualified plans alone. Today, nonqualified retirement plans are a common benefit for many executives who earn more than $125,000 annually. The following chart provides a comparison of highly compensated executives with those earning less than $125,000.
Defined benefit (DB) pension plans became a staple of corporate retirement delivery. However, DB plans (and DB SERPs) began to lose favor due to the popularity of 401(k) plans. In addition, the pension-funding crisis (2002-03), plan volatility, and the financial strain of the DB approach also led companies to rethink the DB plan. Consequently, many qualified DB plans were updated to cash balance and/or modified to Deferred Compensation approaches. On the nonqualified side, many defined benefit SERPs are still in place and have not been redesigned to meet the new objectives of plan participants, §409A, or new alternatives available in the market.
The New Regulatory and Tax Environment: The Current Tax EnvironmentThe original premise of nonqualified plans was to not only restore benefits and contributions, but also to defer taxation until retirement when tax rates would presumably be lower. However, today’s current low income tax rates expose many executives to an over-concentration of tax rate deferral risk. The graph below shows that combined marginal income and capital gains tax rates are at the lowest point in over 60 years. Many believe that it is safe to assume that tax rates will increase, with at least one tax increase scheduled for 2010, and even higher rates likely on the horizon.
As a result of our current low income tax rate environment, many companies and executives do not want to defer compensation into traditional plans. There has been a dramatic drop off of deferred compensation contributions over the last several years, and many are looking to redesign/replace their plans with new plans designed to optimize the low tax rates.
Recent Regulatory ActionsDuring the 1990’s, nonqualified plans began to attract IRS/Congressional attention as the plans evolved to broader participation, provided significantly increased benefits, and became substantially funded. Nonqualified (NQ) plans escaped current taxation as long as participants were exposed to a substantial risk of forfeiture3, were not secure from corporate insolvency, and participants did not possess too much control over the deferrals, receipt, and/or informal funding of the benefits. However, the NQ market became very sophisticated, and progressively transferred greater control/security to executives through:
In addition to the progressively increasing control and security executives enjoyed, Enron, WorldCom, and perceived executive compensation abuses attracted greater visibility to NQ retirement plans. As a result, Congress and the IRS have recently tightened nonqualified plan regulations, and intensified corporate governance was extended to NQ plans. In response, new regulations and legislation affecting NQ plans have been either made or proposed.
In January 2008, the Senate Finance Committee will begin markup of the Small Business and Work Opportunity Act. One proposed provision extends the §162(m) cap on proxy officer compensation deductions to retired officers (once a proxy officer, always a proxy officer). The new provision would cap the deduction on all post-retirement compensation including SERPs, deferred compensation, etc., for all proxy-covered officers. These new regulations have reduced the advantages of many existing nonqualified plans including DB SERPS:
Corporate Reactions to the New EnvironmentCompanies are reacting to these new regulatory constraints by:
The Executive Roth PlanSMThe qualified Roth 401(k) was introduced in January 2006. Just a little more than a year after its implementation, the Roth 401(k) has now become a viable, permanent fixture in the retirement planning toolkit. Many employers have adopted the Roth 401(k) to work in concert with their 401(k) plan. The Roth 401(k) option provides participants the flexibility of using after-tax income to save for retirement, which allows them to make non-taxable distributions. However, contributions are restricted and many executives are limited on what they can contribute. The Executive Roth PlanSM is an after-tax arrangement that companies are utilizing to modify and update existing defined benefit SERPs. For example, it can be structured based on performance goals14 or continued employment to a specified age for eligibility. From the company’s perspective, the Executive Roth PlanSM:
From the executive’s perspective, the Executive Roth PlanSM:
Comparison of Executive Roth PlanSM and DB SERPThe best way to evaluate the Executive Roth PlanSM is to look at an example. The following tables provide a comparison of a Corporate Pay-As-You-Go Defined Benefit SERP and the Executive Roth PlanSM. Table IV provides a set of assumptions about our executive, age 53, who will retire in 12 years at age 65.
Table V looks at the executive perspective. Assuming tax rates stay the same (40%), the executive has comparable after-tax income (Column 3 vs. Column 7). With the Executive Roth PlanSM, the executive still has excess cash value (assuming 7% investment return) and a non-taxable life insurance benefit (Column 9).
Now, putting on the corporate hat (Table VI), we look at the net present value cash flow (Column 3 vs. Column 6). The Executive Roth PlanSM is $400,000 less expensive, based on a 6% gross discount rate (3.6% net). Next we look at the corporation’s P&L impact (Table VII). The current SERP has a $4.3 million cost (Column 5) vs. the Executive Roth PlanSM $2.1 million cost (Column 10).
In Summary§409A rules reduce the flexibility, security, and appeal of many existing plans. The Executive Roth PlanSM is not subject to these new restrictions, but must be implemented prior to December 31, 2007 to take advantage of the transition period. Because of this short transition timeline, we are finding many companies currently reevaluating their plans. To comply with §409A, a company only needs to amend their plans, allowing such distributions, prior to December 31, 2007. Funding and implementation of the plan can take place in 2008.
NOTES 1.IRS and Treasury Department has provided transition relief under Code Sec. §409A until December 31, 2007. top
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