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Breathe New Life Into Nonqualified Deferred Compensation PlansWilliam L. MacDonald
Unless you are Tiger Woods or another member of the PGA tour, you cannot avoid new legislation on deferred compensation plans (i.e., IRC §409A). Fortunately for Tiger and other PGA professionals, PGA lobbyists had the foresight to realize that the Tour’s plan would be subject to §409A. Congress obligingly included a very small provision that was largely overlooked in the scores of articles addressing Section §409A. An obscure qualification exempts a deferred compensation or arrangement if 1) it was in existence on May 1, 2004 (the Tour’s plan was established in 1983), 2) it covers only “non-employees” who render services to a tax-exempt entity (the PGA Tour is tax-exempt, and its member-players are actually independent contractors), and 3) it is “established or maintained by an organization incorporated on July 2, 1974.” And guess which organization was incorporated on July 2, 1974? That’s right, the PGA Tour—so, for the rest of us, “Hello §409A.”
Among the requirements for a nonqualified plan is that it be designed “primarily for a select group of highly compensated and/or management personnel,” and that the organization file a letter with the Department of Labor (DOL) within 120 days of adopting such a plan. The letter requires the sponsor to state how many full-time employees it has, and how many will be eligible for the plan. By tracking public information available from the DOL, businesses have seen a major decline in both the number of plans and participants since 2004.+
According to a 2007 survey by Clark Consulting, 95% of the Fortune 1000 have nonqualified deferred compensation plans. The survey also states most plans were adopted between 1986 through 1999 (Chart II). As we compare this data to the history of the top marginal income and capital gains tax rate, the key motivator for the adoption of so many plans during this period seems to be tax savings (Chart III). Even though the top marginal rate dropped from 70% to 50% in the mid-80s, individuals were still paying a top rate of 50% on the Federal side (plus state, city, etc.). Once the rate dropped to 35%, the decline in new deferrals seemed to kick in slightly; however, the real slow down has come about since 2006, perhaps due to more §409A restrictions.
Perceived Loss of FlexibilityAlthough the drop in the Federal tax rate had an impact on the decline in new plans, other factors also came into play. According to Clark’s Survey, by 2001 86% of Fortune 1000 companies had deferred compensation plans already in place—a major increase over the previous 20 years. The increase from 2001 to 2007 was only 9%, an indication that companies had already provided deferred arrangements. The American Jobs Creation Act of 2004, which was passed by Congress and signed into law in October 2004, put a lot of uncertainty into these arrangements as transition rules were considered. It wasn’t until late 2007 that businesses got clear direction, and now they must modify their current arrangements to comply. Many organizations chose to “grandfather” their existing plans and start new plans going forward, while others froze or terminated plans. With the adoption of §409A and final regulations, businesses now have clear rules to abide by. There is more flexibility short-term in these arrangements than before and certain traps to be avoided. The balance of this article will discuss “wealth accumulation” going forward, and take a lesson from the past in order to safeguard the future.
§409A Gives You an Opportunity to Change Your Strategy Before December 31, 2008Yes, §409A is going to give you one more chance. You may have already made previous elections to defer and receive benefit payments in the future. However, under the new regulations, and the extension of transition rules through 12/31/08, you will be able to make one final change, even if that change results in an acceleration of payments. Participants may change payment elections (both as to time and form) without resulting in an impermissible subsequent deferral on acceleration. This relief provision only applies to §409A-compliant plans. As an example, let’s imagine that in 2007 you elected to defer your bonus until retirement, which is expected to be 15 years from now. You also elected to take payments over a 10-year period. Before the end of 2008, you will have an opportunity to change your election (either time or form). You may want to elect a shorter time frame, as you can always at a later time; since §409A provides new rules for re-deferral. You must make the election to re-defer a previous election one year prior to distribution and the re-deferral must be for at least 5 years. Re-deferral is discussed in more detail later in the article.
New Concerns with §409A RulesPrior to §409A, best practice plan design gave executives a lot of control over their account balances. Even though their accounts contained tax-deferred money and the executives were considered unsecured general creditors of their employer, they had recourse to a special 10% haircut provision that allowed them full access to their money at a cost of 10% at any time for any reason. That provision is not allowed under §409A. Executives also had the ability to wait until retirement to determine how payments would be received; new rules have eliminated that flexibility. Not having these provisions may result in less money being deferred and accumulated over many years for retirement. The new rules require us to think in a much different way and design plans in accordance with the current environment. Retirement may be your objective, but with the ability to re-defer there is no real advantage in deferring for the long-term with your initial election.
Designing Plan Features for New Economic TimesExecutives in this decade are much different than those who deferred compensation in the 80s and 90s. Back then, they relied more on their stock options and other equity plans to create their wealth. Having their cash portion taxed at 50% motivated them to tax-defer it, as under the old rules of deferred compensation they still had substantial control as discussed earlier. Most deferred compensation plans were designed with short-term distribution options, giving the participant an opportunity to defer compensation for short periods of time for expenditures such as a child’s education or perhaps a life-long goal of buying a boat, vacation home, etc. Plan administrators in the past used a “class year” approach to accomplish this, mainly due to system constraints. These “class year plans” have created unlimited numbers of accounts, payment dates, and forms of payment making administration more complex than it needs to be. Best practice plans today use a “bucket” approach to simplify the class year approach, and make the process more intuitive to the executive’s savings needs. This “bucket” approach cannot only simplify your plan, but allow more flexibility.
§409A will allow you to re-defer any of your payments for a minimum of 5 years, as long as the participant elected to re-defer one year before the original distribution was scheduled. No limit is placed on the number of re-deferrals. Another best practice feature is to allow a “partial lump sum” at retirement, so executives can reduce their creditor exposure during your retirement years. Remember, these account balances are subject to the claims of the employer’s creditors. Electing a partial lump sum allows an executive to take a little money off the table. Taking advantage of the short-term opportunity to defer, and the ability to re-defer, many executives are using a “cascading” approach by spreading their elections into five buckets (Chart V) and redeferring each opportunity. With this election, you’re only a few years away from starting a five-year payout; however, you can keep cascading as long as your objectives and concerns are met.
Additionally, on the distribution side, using the cascading approach, you could defer a portion of your pre-tax amounts into an after-tax Roth-type option (Chart VI). As illustrated in Chart III, tax rates may be at their all-time lowest rate. So if you think rates will be higher in later years, the use of this feature could diversify some of your income into a non-taxable payout, not subject to the company’s creditors. The Executive Roth PlanSM (ERP) allows executives to diversify their distributions, having a portion in a fully secured non-taxable account (Chart VI). Remember, as we discussed above, in 2008 you will have a one-time option under §409A to change previous elections. So after thinking through the risks of future tax rate increases and of being an unsecured creditor, you may wish to move some of your money into the Executive Roth PlanSM. For those concerned with the large balances appearing in their proxy, this is also a good way to reduce them.
The Executive Roth PlanSM feature is not subject to §409A; therefore, there is no need to elect a distribution date. This account belongs to you and is not subject to creditors, and all payments, including interest earned, are non-taxable. The ERP, through a special tax restoration feature, restores your taxes so you continue to grow your account balance on the pre-tax amount (i.e., $50,000 distributed to ERP, $20,000 taxes paid, net deposit of $30,000, $20,000 taxes restored, and balance equals $50,000).
Selecting the Best Investment ManagersOver the years, a variety of funding vehicles have been used to informally fund nonqualified plans. According to the Clark Survey, 72% use corporate-owned life insurance (COLI), with mutual funds at 37%. Many companies use a combination. One of the most overlooked areas is the selection of the investments. Not only do you need the right asset classes, but you need to identify top-performing investment managers and have a system for monitoring them. If your company is funding your plan with COLI, make sure you’re not paying unnecessary manager fees that are a result of additional charges by the insurance company to fund management fees. As an example, you may be paying 30 bps for an S&P Index when the alternative is 14 bps. Best practice plans start first with building the investment menu and selecting managers (Chart VII). Then, if COLI is used by the company, they place their selected managers into the COLI product. This could make a major difference to your account balances and to the overall cost to the company.
Having the right investment menu and best in class managers is one thing, but who has the time and experience to manage their account properly? A rising trend is to use risk- based model portfolio construction. Few nonqualified plan administrators can offer this best practice feature. When offered to participants, over 60% utilized the model portfolio construction. Advantages include:
Review Benefit Security Post §409AIn most cases, companies that informally fund nonqualified plans also place their assets in irrevocable trusts referred to as “Rabbi Trusts.” (The Rabbi Trust received its unusual moniker because the case leading to its legal creation was brought by a Rabbi.) These trusts protect participants from all contingencies, short of bankruptcy. Rabbi Trusts will protect the participant’s assets (account balance) against:
As stated earlier, perfect protection against bankruptcy has not existed until now. Given the limitations under §409A, many plans will be designing after-tax features like the Executive Roth PlanSM where a participant can start to diversify their holdings not only to mitigate future tax risk, but also to put certain assets outside the reach of the company’s general creditors. Executive Roth Tax Restoration Feature versus Traditional Deferred CompensationWith a traditional deferred compensation plan, the executive is permitted to save money on a pre-tax basis. In exchange, however, the plan sponsor defers a current tax deduction to a future date when the compensation is paid to the executive. In effect, the plan sponsor provides the executive with an interest-free loan. The executive is then able to invest the “loan” in any of the plan’s investment options as discussed above.
Upon distribution, as illustrated in Chart IX, the deferred compensation is paid to the executive. The executive effectively pays the “loan” off with interest by paying taxes on the distribution at ordinary income rates at that time. The company finally receives its tax deduction when the compensation is paid to the executive. Conceptually, the company has provided an interest-free loan to the executive. The cost of the loan to the company is the after-tax cost of capital applied to the cumulative loan balance over the time frame of the arrangement. Let’s take a look at some real numbers with a traditional deferred compensation arrangement: If a 45-year-old defers $40,000 of his or her compensation until age 65, the company loses its tax deduction until then. Therefore, they are out $16,000 per year (assuming a 40% tax rate) for 20 years, or on a net present value basis at 4.80%, equaling $212,556. With that in mind, let’s see how the Executive Roth PlanSM compares. First, let’s consider a little background. The Executive Roth PlanSM was created in response to the concerns about traditional deferred compensation plans. The ERP is an after-tax nonqualified plan organizations are offering to update and/or replace existing deferred compensation plans. Chart X will give you a conceptual overview of the two alternatives.
From the participant’s standpoint, the ERP is a flexible supplemental benefits program specifically designed for highly compensated executives and professionals. To achieve its tax advantages, the ERP is powered by an institutionally-priced variable universal life insurance contract not available to individuals. The policy has 100% cash value in year one and no surrender charges. It is a self-directed, tax-advantaged savings vehicle that provides:
In addition, the ERP is portable, protected from the firm’s and participant’s creditors, and provides a significant life insurance benefit. The “Tax Restoration Feature” of the Executive Roth PlanSM puts the participant’s wealth accumulation on par with tax-deferred plans, without the limitations discussed above. One of the disadvantages of an after-tax plan is the loss of the investment principal each year due to taxes (on contributions, not earnings). At the participant’s discretion, after-tax contributions to the ERP can be supplemented by a tax restoration account internal to the insurance contract used to fund the ERP. This account is funded through an internal contract loan. The loan charge has a long-term debt rate (LIBOR plus 1.5% capped at the Moody’s Seasoned Corporate Bond rate). Policy loans are automatically deployed in the participant-directed investment accounts (e.g., equity funds). The loan is a non-recourse loan with no required pre-payment, except through policy proceeds at surrender or death. There is no pre-payment penalty. Chart XI outlines how this feature works.
SummaryAs you rethink your wealth accumulation strategy under the new rules of §409A, consider the limitations of traditional deferred compensation plans and focus on diversifying your distributions to mitigate risk. True diversification would have varying distribution sources with varying tax treatment, as illustrated in Chart XII.
An increase in the top rate from 35% to 50% would reduce your distribution assumptions by roughly 25% per year in your taxable accounts. Thus, a portion of the investments should be in a non-taxable bucket designed to provide a hedge against higher tax rates in the future; plus these dollars would be safe from your employer’s creditors. Traditional tax-deferred compensation will still be a part of your wealth accumulation strategy. However, as discussed above, you may want to take advantage of the short-term flexibility in plan design to rethink your current distribution elections, perhaps shortening the deferral period, or triggering distributions that can be deployed into an Executive Roth PlanSM.
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