More companies are offering deferred-compensation programs for high-earning executives, and participation in the plans is increasing. Among the Fortune 500 companies, 422 now have such plans, estimates Robert Barbetti, head of compensation advisory for J.P. Morgan Private Bank, a unit of JPMorgan Chase that offers services for high-net-worth individuals.
The biggest reason for the burgeoning interest is recent tax increases. Under the deal agreed to by Congress to avert the “fiscal cliff,” the top marginal tax rate for those earning more than $400,000 a year ($450,000 for couples) was raised to 39.6 percent.
The top tax rates have also been increased in states where many corporations are based. California’s top marginal rate rose 3 percentage points last year, to 13.3 percent, while smaller increases were enacted in Massachusetts and Maryland (to 6.25 percent and 5.75 percent, respectively). Other key corporate bastions with high rates include New York (a combined 12.7 percent for the state and New York City) and New Jersey (8.97 percent). Rates are also high in Hawaii (11 percent), Oregon (9.9 percent) and Washington D.C. (8.95 percent).
Plan-sponsoring companies are responsible for paying federal and state taxes on any gains within the plans. That benefits plan participants, although many finance chiefs, always good soldiers, are uncomfortable with it. “Most CFOs cringe at the thought of the company having that tax liability,” says Barbetti.
That’s why they support their companies in structuring the plans to be as tax-efficient as possible. For example, hedge funds are notoriously inefficient with respect to tax, and few deferred-compensation programs permit investments in them. On the other hand, some plans are funded with company-owned life insurance (COLI) or some other type of private placement universal variable life insurance product. That gets the company off the hook for plan taxes, just as individuals don’t have to pay taxes on life insurance policies as their value increases.
A “funded” deferred compensation plan allocates specific assets, like a COLI, to ensure that the promised amounts will be paid. An “unfunded” plan is supported by the general assets of the company. But the up-front costs for setting up a COLI are such that far more companies have unfunded plans, in which participants usually invest their deferred compensation in the same kinds of mutual funds that are typically found in 401(k) plans.
Barbetti says he counsels many CFOs on whether and how to defer compensation. “You’d be surprised,” he says, when asked why financial experts need such help. One current, typical client is making about $2 million a year in salary and bonus but has not yet taken advantage of his company’s deferred-compensation program. “You know what he told me? He doesn’t have time to think about it!”
Even CFOs, he says, may be scared off by the fact that deferral elections are irrevocable. That is, once an election is made, it cannot be altered so as to accelerate its schedule for distributing the funds to the participant. “If people don’t have time to think about it, rather than make an irrevocable election they often choose not to make one at all,” Barbetti says.
But a deferral may well be in a participant’s best financial interests, not only because of the tax advantages but also as supplemental retirement income. “The reduction and elimination of [pension plans and cash-balance retirement plans] have been very instrumental in the increase in deferrals,” says Barbetti.
Barbetti says five key variables are generally in play when weighing whether, how much and for how long to defer, as well as how to take distributions of the deferred compensation. Prioritized, they are:
1. The creditworthiness of the company. Even if the plan is funded, it will be an unsecured creditor of the company should it go bankrupt. “If you work for an airline, do you want to defer? No. Airlines are in bankruptcy situations all the time,” Barbetti says. But there is usually at least some risk at almost any company. “Who would have thought Lehman Brothers would go bankrupt? A lot of people made deferral elections there.”
2. The participant’s liquidity needs. Are you going to be sending three kids to college or buying a second vacation home before taking distributions of your deferred compensation?
3. Potential investment return. This directly relates to the length of the deferral. Because of the tax advantages of keeping money in the deferred-compensation plan, the participant would have to get higher returns outside the plan in order get the same income. But with a deferral of only, say, two years, pretax compounding will have little effect. Barbetti recommends that all deferrals be at least five to seven years.
4. Where you will live. If you earned the deferred income in a high-tax state, you can save a bundle by deferring it until retirement and moving to a low-tax or no-tax state, like Florida, Texas, Washington or Wyoming.
5. The investment options available within the plan. Most but not all plans have good ones, Barbetti says.