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2010 Nonqualified Deferred Compensation Plans Fact Sheet
A nonqualified deferred compensation (NQDC) plan is a company’s unsecured promise to pay a future cash or stock benefit to a plan participant. Contributions to NQDC plans provide highly compensated executives with tax-deferred growth free of current tax and without annual limits, thus accelerating retirement savings for executives limited by 401(k) plans.
Background NQDCs emerged as an antidote to the imposition of caps on government-sponsored retirement savings plans. High-income earners were not permitted to contribute to tax-deferred retirement savings the same proportional amounts as lower-income earners. Nonqualified means that companies are not subject to ERISA regulations as in qualified plans.
Plan Eligibility Employee Retirement Income Security Act (ERISA) rules restrict highly compensated executives from contributing any more than $16,500 into the company’s 401(k) as of 2010 and $22,000 if over 50 years old. NQDC plans can be offered to only those persons the company deems eligible. ERISA clearly states that the plan must be intended for a “select group of highly compensated and/or management employees.” Eligibility is commonly defined as employees who earn in excess of $100,000 annually. Department of Labor guidelines do not state a specific definition. It is advisable to stay within this limitation and only for up to 10 percent of the total employee population.
Plan Advantages NQDC plans offer an effective strategy to attract, retain and reward top talent by offering the ability to: • • • • • • •
Defer more pre-tax compensation than possible in a 401(k) Reduce current income tax liability Choose a variety of tax-advantaged investment options Gain higher equivalent rates of return compared to after-tax earnings Take penalty-free scheduled distributions while employed, if properly structured Receive lump sum or installment distributions upon termination or retirement Elect payout timing and/or method by deferral year
Useful Statistics • 95 percent of the Fortune 1000 companies offer NQDC plans1 • Companies in the small business sector now offer NQDC plans • Two-thirds of Americans between 54 -63 years of age have not saved enough for retirement2 1 2
Clark Consulting Executive Benefits: A Survey of Trends 2007 McKinsey Global Institute
Design Factors
Funding Concerns
Best practices design offers these plan features to participants who are able to:
Companies informally fund NQDC plans. Deferral amounts are recorded as a liability on corporate balance sheet, and go into a corporate general account; they cannot be set aside to guarantee the plan’s future obligations. Compared to qualified retirement plans, nonqualified plans must be unfunded. If a plan sponsor becomes insolvent, deferrals become part of company assets, subject to the claims of creditors—a risk to the participant.
• Defer up to 80% of salary, 100% of bonus compensation • (80% based on withholding requirement to cover FICA, medical insurance, and other withholdings) • Vest 100% on employee’s deferrals immediately • Withdraw monies while still employed without penalties • Choose many benchmark investments (growth, fixed income, 401(k) company stock) • Select different annual payout schedules for every year of deferrals
Formal funding, required in 401(k) plans, occurs when companies set investment aside, outside the reach of general creditors. Companies cannot touch these earmarks. If insolvency occurs, creditors cannot make claims against the investment.
Administration Aspects Best practices in plan administration are defined, in part, by the following quality standards: • • • • • • • • •
Highly secure and independently audited systems Coordination of informal funding requirements Disclosure of plan liabilities and related assets for financial reporting Accessibility of online enrollment, daily valuation of account balances Detailed record-keeping with production of benefit statements Preparation of clear and consistent plan communication materials Daily valuation and Internet access to participant account balances Toll-free service center to assist with questions regarding the plan Preparation of customized administration manual and Annual Report Card summary
To offset the liabilities in informally funded NQDCs, companies invest part or all of participant deferrals to ensure those funds are available when payout is required. To hedge risk, companies invest in mutual funds, Corporate-Owned Life Insurance (COLI) or Variable Universal Life (VUL) Insurance contracts, which they own and are the named beneficiaries.
Security Issues Most companies secure and protect plan investments with an irrevocable Rabbi Trust, which prohibits use of those assets for any other reason than to pay benefits in the nonqualified plan. Assets are protected against corporate change of control, management’s change of heart or changes in the financial condition of the company, short of bankruptcy.
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