Nonqualified deferred compensation plans are increasingly popular, as they help companies to cost-effectively retain and attract quality executives while also helping provide executives with sufficient retirement savings. Here are 10 important things to know about these plans.

  1. Plan Prevalence

The target for these plans has broadened. Nonqualified deferred compensation plans (DCPs) were once regarded only as a tax tool for senior management. As pension plans have increasingly given way to 401(k) plans, participants now understand that preparing for retirement is their responsibility. But rules limit 401(k) contributions to $18,000 per year ($24,000 if you are over 50). Studies show that for middle managers and up, these limits impede adequate retirement planning.

  1. The DCP Can Defer Taxes on Equity Awards

The ongoing shift from stock options to restricted stock awards has eliminated executives’ ability to time the taxation on their equity awards. As restricted stock units are taxed upon vesting, companies should consider allowing for the deferral of equity awards. This may also make it easier for executives to meet stock ownership guidelines.

  1. The Proxy Advisory Services Get It

Unless you are crediting the plan with some unattainable guaranteed rate or company contribution that is not justifiable, do not expect any heat with regard to “say on pay.” In general, these plans are so common that they are widely accepted by proxy advisory services and most compensation committee chairs.

  1. Risk Management

Section 409A of the tax code deals with DCPs and is far-reaching and punitive. For example, a violation of 409A — generally either distributions that shouldn’t have been made or those that weren’t made that should have been — triggers tax, penalties, and an additional 20% excise penalty levied on the participant. Look at your administrative services agreement. If your provider has indemnification against 409A penalties, have a conversation. Your administrative partner should have skin in the game.

  1. Plan Funding

Participants are unsecured creditors when they have a plan balance. While you cannot protect against the risk of insolvency, a rabbi trust can give you options. Should the company choose to terminate the plan, assets are readily available to do so. Segregating assets on the balance sheet is a prudent practice followed by the vast majority of plan sponsors.

  1. Your DCP Could Be an Expensive Loan

Participant deferrals create a balance sheet liability, because the company in essence is borrowing money from the participant. Additionally, most companies allow executives to index the deferral to a market investment such as a stock or bond fund. Of course, in your role as a CFO it is unlikely that you would borrow money from any source and let the interest rate be set monthly based on equity returns. So, informally funding a plan (see point 5 above), when done properly, creates asset and liability parity that ensures that the plan participant is taking the risk, not your company.

  1. Change in Control

Pay attention to the provisions in your document outlining the result of a change in control. Many documents call for a termination of the plan. This may or may not be optimal. Many companies utilize a “double trigger” upon a change in control. If the company changes hands and an employee terminates within, say, 18 months, the double trigger is executed and the participant is paid his or her balance.

  1. Communication Is Key

Non-qualified plans are valuable, tools but they are not always widely understood. Make sure your company communicates the advantages of a plan (flexibility, tax-deferral, etc.) but also make sure that participants understand the risks. As CFO, you have a unique perspective on the benefit-security risk at your company. Consider helping out HR and offering to be part of the education meeting to inform executives of the advantages of plan participation. At the very least, be sure that your executives understand the need to save, whether in the DCP or not. Americans are generally under-prepared for retirement.

  1. Contemporary Plans Are Flexible

Many plan sponsors do not realize that the rules allow participants to set up multiple accounts within the DCP. For example, an account could be established to save for retirement and additional accounts (so called in-service accounts) could be established for other life events like children’s educations. Modern deferred compensation administration systems accommodate this feature quite easily, and participants love it.

  1. A Company Contribution Is a Great Idea

Consider a non-qualified 401(k) match subject to the IRS limits. Executives with higher incomes are limited in their qualified 401(k) match due to the covered compensation limits in IRS regulations. Matches are non-dilutive to your equity, simple to understand, and highly valued by participants.

Deferred compensation plans are widespread and growing. With some attention to plan design features and plan funding considerations, a plan can dramatically increase the likelihood that your company’s managers will reach their retirement goals.

Rich DeVita and Scott Holton are senior consultants and serve on the executive committee of The Todd Organization, a nationwide leader in the design, financing, and administration of executive benefits.

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