Deferred Compensation Plans
Non qualified deferred compensation plans (DCPs) are designed to provide supplemental retirement benefits for a select group of key employees, officers, directors, and independent contractors. They assist in establishing an incentive to remain with the company and may be designed to contribute to the company's growth and profitability. There are basically two types of deferred compensation plans:
- A defined benefit plan, where the future retirement benefit is calculated in advance of retirement and the future benefit is informally "funded" based on the projected benefits. The most common type of plan is referred to as a Supplemental Executive Retirement Plan (SERP)
- A defined contribution plan, where the benefits are based on employee and/or employer contributions plus any future increases or decreases in value based on the participant's underlying investment choices. These types of plans are commonly referred to as Deferral Plans and 401(k) "Mirror" plans.
DCPs are typically used in both public and privately held companies where the owners would like to:
- Encourage executives to build wealth through tax favored savings vehicles
- Motivate and reward executives for long-term employment and productivity
Typical objectives for a deferred compensation plan include:
- Offset the effects of discrimination testing under qualified retirement plans
- Provide "excess benefits" for participants involved in traditional defined benefit plans
- Give executives an opportunity to reduce taxes and build long-term wealth
- Legally discriminatory
- More design flexibility than qualified retirement plans
- Unlimited participant contributions (pre-tax)
- Corporate contributions can create a retention "hook"
- Ability to motivate executives through a performance based company contribution
- Employee/employer contributions, plus growth, are tax-deductible when paid
- Employee deferrals and corporate contributions are not tax deductible until paid
- "Top Hat" rules apply to eligibility in an employer/employee relationship
- Participants are general creditors and subject to a substantial risk of forfeiture
In an employer/employee relationship, eligibility must be limited to a select group of management or highly compensated employees (plus independent contractors). Unfortunately, the exact interpretation of a "select group" remains ambiguous. Therefore, plan designers must understand the requirements, evaluate the potential eligible group, and consult with the client and counsel to make a good faith determination of the group of persons who will be eligible for the plan. With that in mind, the following factors should be considered when deciding on eligibility:
- Percentage of workforce
- Ownership interest
- Each participant's compensation vis-a-vis their fellow employees
- Executive or management responsibilities
- Combined compensation of participants
- Ability to affect or substantially influence the design of the plan
Independent of ERISA regulations, the company would want to focus eligibility on individuals who:
- Have the means to save additional dollars
- Are receiving "refunds" back from the 401(k) plan
- Are in a relatively high marginal tax bracket
Risk of Forfeiture
DCPs must remain "unfunded" for ERISA purposes. Company's may choose to "informally fund" future benefits with corporate owned life insurance (COLI), mutual funds, fixed interest investments, or any other financial instrument. Nonetheless, participants must not be provided with any rights to plan assets. Since the plan must remain "unfunded" for ERISA purposes, the participant's in the plan are general creditors and subject to a substantial risk of forfeiture. Consequently, in the event of a bankruptcy, the plan's assets would be subject to the company's creditors.
The type of plan design will dictate the type of contributions made to a DCP. For example, a SERP would be funded 100% by company contributions, unlike in a true deferral plan where the participant's deferrals are used as the source of contributions. In addition, many times plans will be designed so that both the company and the employee contribute. Typical forms of contributions include:
- Participant deferrals
- Company match as a percentage of deferrals
- Fixed company contribution
- Profit sharing contribution
- Production/incentive contribution
- Phantom stock
- Company stock
Vesting and Award Payment
Company contributions to a DCP may vest over any time period desired by company management. Most commonly, they vest over a 3-5 year period. Unusually long vesting periods may cause participants to minimize their perception of the expected value of the future award.
The company may also reserve the right to accelerate the vesting schedule based on performance, age, years of service, etc. Some companies will have different vesting schedules for different classes of employees. Generally, vesting is accelerated in the event of death or permanent disability.
DCPs are typically financed (informally "funded") in one of the three ways: (1) self-funded (2) investments (3) Corporate Owned Life Insurance (COLI).
Self-funding occurs when the company chooses not to "earmark" specific assets for future benefit payments, but rather pay the benefits out of future cash flow. Although DCPs do not reqiure an employer to maintain an asset reserve for future benefits, many times there are good reasons for doing so, particularly with a closely held business where managing future cash flow obligations may be a concern.
If a company feels they can realistically earn a greater rate of return on their corporate assets versus what the DCP earns over time, then self-funding makes a lot of sense. However, since future benefit payments are paid in cash, the company would need to make sure they have enough liquidity to pay future benefits. Since a deferral from an employee is in essence a "loan," it is financially prudent for them to attempt to match their future obligations with comparable or superior investment returns. In addition, many participants in DCPs are hesitant to defer any of their own monies into a plan where the business doesn't "earmark" specific assets for future distributions. Nevertheless, self-funding is still a viable financing method for DCPs under the right circumstances.
Investments could include almost any asset (stocks, bonds, certificate of deposits, mutual funds, etc). However, unless an asset is intself tax exempt or tax deferred, the income (interest, dividends) or gains earned by an employer in connection with a DCP would be taxable to the company. The clear disadvantage of using such an asset is the potential tax cost the company will incur on the earnings. Participants' accounts grow on a tax-deferred basis, but the employer is taxed on the investment income on the asset. Consequently, the employer's asset reserve and the plan's liability can become negatively mismatched over time.
Corporate Owned Life Insurance (COLI)
COLI is a common asset used as a reserve for DCPs. The primary advantage is the tax-deferred growth of policy cash values. As long as the policies aren't surrendered, the sponsoring company may access cash values without recognizing any gains (for tax purposes). At the same time, benefit payments made to participants are tax deductible to the firm. If structured properly, the COLI financing arrangement can also keep pace with the plan's liabilities over time. Lastly, the policy death benefits can proved the company the opportunity to recover the costs of the program.
The primary disadvantages of COLI are the up-front costs and ongoing mortality charges that ultimately affect the cash values within the COLI arrangement. In addition, COLI cash value increases and death benefits are treated as preference items for purposes of the corporate Alternative Minimum Tax (AMT).
Currently, mutual funds and COLI are the most common ways to finance DCPs. Typically mutual funds are more attractive in the near-term, while COLI will look better over a longer period of time (6-7 years or longer). This is due to the tax-deferred growth in the COLI compensating for the insurance related charges. In addition, mutual funds do not provide the employer the opportunity to recover plan costs.
Consequently, a thorough understanding of the employer's objectives, financial considerations, number of participants, age of participants, size of deferrals, etc., is necessary in order to make the correct financing decision.
The crediting rate within a DCP is established by the employer. It may be tied to a hypothetical index or interest rate, or it may mirror the performance of specific investments (mutual funds, stocks, etc). In either instance, it is important that participants not be given any access to the actual underlying investments or the plan may be deemed "funded" for ERISA purposes. With that in mind, most DCP participants earn interest/growth on their account balances in one of several ways:
- Fixed interest rate to be determined by the company/plan committee each year
- Fixed interest rate tied to a pre-determined index (Prime rate, Moody's etc.)
- Phantom stock value
- "Hypothetical" investments
- Tie benefits directly to a corporate asset (cash value, mutual fund, etc.)
Many times, companies will use a combination of some or all of these approaches.
Accounting and Tax Treatment
- The deferred compensation value, plus any appreciation, is treated as a compensation expense.
- The deferred compensation plan value is accrued as a liability on the company's balance sheet, offset by a deferred tax asset.
- Employee - No tax when deferred. Taxed at ordinary tax rates when actually paid to employee. Tax withholding is required. FICA taxes payable in year of deferral.
- Company - Receives a tax deduction when paid to employee equal to the employee payment.