In the lexicon of four letter words that continue to create consternation, Risk is one that we face on a daily basis. Oftentimes, we do not even consider the risks we take in our lives. While we will not be discussing risk in our home life, we will discuss risk in our business life. Indeed, it is very difficult to separate personal risk from business risk, but often the risk decisions we make in our business life trickle into our personal life. The reverse is equally true. There is and always will be a risk-reward continuum that governs all of us as we plan and execute our daily decisions.
In this publication, we will discuss risk from both the corporate as well as the executive’s perspective. This will include the risk the executive takes when enrolling in a company’s nonqualified deferred compensation program, more specifically claims of creditors, as well as the care an employer should take in plan design. According to the old adage, “reward is a byproduct of risk”, but we do not completely agree with this statement. Yes, risk is an element of reward, but within our industry the more operative words are “controlled risk.” We feel the risk associated with nonqualified plans is largely controlled by the plan design and the informal funding decisions made by the employer. It is also controlled, to some degree, by the fact that these nonqualified plans are only available to the highly compensated executives within an organization who should have a better sense of the financial health of their organization.
Since we are not registered investment advisors, we feel that it would be inappropriate to discuss investment risk, per se, other than to encourage anyone enrolling in a nonqualified deferred compensation plan to seek the necessary professional investment advice based upon the investment offerings within their nonqualified plan. We will focus our comments on creditor risk and plan design, which we feel are more specific to risk and can do the most to mitigate the risk associated with implementing, administering and participating in a nonqualified plan.
Claims of Creditor Risk
Within the guidelines set under §409A, it is clearly understood that while there can be protection from Change of Heart or Change of Control, there is no protection from the claims of creditors resulting from a bankruptcy of the participating employer. While the employer that is sponsoring this nonqualified plan can take many actions with drafting of the appropriate language within the plan design, there is no way to shelter the risk of bankruptcy as long as the assets set aside within the nonqualified plan continue to belong to the participating employer. The participating executive would become a general creditor subject to the same guidelines as the other general creditors of the company.
It is this same element of risk, which is more clearly defined as a substantial risk of forfeiture, that allows the participating executive under the nonqualified regulations to defer their income on a tax deferred basis until the distribution is made. Once that distribution is made, the element of bankruptcy concern is erased and the income relating to that distribution becomes ordinary income to the executive and is taxed accordingly.
When first meeting with a client to discuss the development of their nonqualified plan, we spend a great deal of time discussing what the employer/client would like to accomplish and why they feel a nonqualified plan is critical to their executive benefit program. We feel it is important for the client to express their concerns so we can have a clear understanding of their goals. It is not uncommon for those in a leadership role within the organization to speak in general terms about wanting to implement a deferred comp plan, when in reality, they need an employer sponsored supplemental retirement plan, a phantom stock plan, performance unit plan or some other variation of a nonqualified plan solution.
Once we have ascertained the client’s goals, we begin to focus on the elements that will do the most to mitigate risk as well as offer a solution that the participant will see as a true benefit.
Unlike the risks with a qualified plan, such as a 401(k) plan, the risks within a nonqualified plan extend to corporate bankruptcy. It is not uncommon for participants to be unaware that the assets within a nonqualified plan, which are those assets set aside by the participant, are subject to creditors of their employer if a bankruptcy would occur. Therefore, if the company defaults, there is no assurance the deferred compensation would ever be paid to the participant. This differs from qualified plans where assets are protected from a company’s creditors.
So, how can plan design help to mitigate the concern of bankruptcy? Plan design is what drives the nonqualified plan. Nonqualified plan designs must adhere to the guidelines set by Congress within IRC §409A, which was introduced as part of the American Jobs Creation Act of 2004. As stated earlier, these plans are designed to support the retirement and financial planning needs of the top executives of a company. The term, “Top-Hat” is sometimes used to define these plans since only the top 10% or so are eligible. While there is no formal definition for top hat, it has been our experience that maintaining eligibility below a 10% of the company’s employee population is prudent. From a salary perspective, the minimum threshold for eligibility should be at least the highly–compensated threshold of $115,000 in 2012.1 Often times, it is a facts and circumstances issue that is driven by the company’s own profile. Knowing the challenges of bankruptcy, Congress set these eligibility limitations on nonqualified plans. Congress assumed the top-hat executives of a company should have a good understanding of the financial health of their company as well as be able to influence the plan design and thus better understand that threat of bankruptcy.
In addition to the top-hat consideration mentioned above, we counsel the employer on plan designs that can mitigate the financial risk of corporate bankruptcy while allowing the executive to accumulate assets that he/she can use to supplemental retirement or use toward expenses such as college tuition, second home or other financial needs. To aid in this process, we have developed an extensive plan development checklist, which we use with all of our clients. Throughout this process, we emphasize the need for a flexible plan design that conforms to IRC §409A while being sensitive to the changing economic environment.
There needs to be a balance of benefits and risk. If executives feel the plan does not offer the desired supplemental benefits then the company may not achieve their desired retention or attraction goals. While risk can be mitigated by a flexible plan design, it cannot be eliminated. It can only be controlled.
Planning for a nonqualified executive compensation plan requires a deliberate and carefully devised game plan. Limitations of qualified plans present many challenges to highly compensated executives, most of which can be addressed with nonqualified plans. A properly designed nonqualified plan—whether an NQDC plan or a SERP—can offer most of the financial planning tools that executives may need. Nonqualified plans easily complement qualified plans to serve as comprehensive financial planning vehicles.
Executives who are afforded nonqualified plan solutions are in a much better position to prepare for their retirement. In contrast, executives who do not have nonqualified plans must rely on other methods to save for retirement. These other methods may not be as effective in the retirement planning process and may cause executives to lose certain benefits such as tax deferral, employer match and the choice of investment options.
As a greater percentage of the American population moves towards retirement, nonqualified plans may become more valuable for retirement planning. Retirement planning opportunities under traditional qualified plans continue to be limited, especially for highly compensated executives. Implementing nonqualified plans help empower executives to plan and to save for retirement.
Nolan Financial has designed and implemented nonqualified plans for all types of organizations, including for-profit and non-profit. If you have any questions or interest in regards to designing, funding or administering a nonqualified plan, please contact:
Michael E. Nolan
President and CEO
Email – firstname.lastname@example.org
William A. Craig
S.V.P. Business Development
Email – email@example.com
Registered associates of Nolan Financial are registered representatives of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker/dealer. Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. LFA/Sagemark Consulting, 8219 Leesburg Pike, #200 Vienna, VA 22182Lincoln Financial Advisors does not offer legal or tax advice. CRN 201205-2067696
Any discussion pertaining to taxes in this communication (including attachments) may be part of a promotion or marketing effort. As provided for in government regulations, advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.