In the current labor market, businesses are finding it increasingly difficult to not only find strong talent, but retain talented key employees. Non-Qualified Deferred Compensation plans (NQDC) have recently been getting a second look by many employers as a means to accomplish that difficult task.
There are a variety of ways employers can set NQDC plans up, but let’s first discuss what a NQDC plan is.
A NQDC plan is essentially a promise to pay a key or executive employee a future benefit. To be considered “non-qualified” and not fall under the regulation of either Employee Retirement and Income Security Act (ERISA) or the Internal Revenue Code (IRC) for qualified plans such as 401k, the plan must follow specific guidelines found under section 409A and 83 of the IRC.
NQDC plans can be very attractive to both employers and employees, but it does come with some considerations which are summarized below:
Advantages to the employer:
Employers find the use of NQDC plans as an effective way to attract and retain key employees (executives and highly compensated). Instead of the plan being solely funded by the employee, the employer may choose to promise a future benefit (subject to forfeiture) provided certain criteria are met by the key employee. One common criteria often used by the employer is length of time with the company. For example, an employer might agree to pay a key employee a predetermined amount in the future, provided the key employee stays with the company for 10 years.
Disadvantages to the employer:
One of the most common disadvantages to the employer remains their inability to deduct dollars set aside on behalf of the key employee. Because these plans are unfunded promises to pay an amount in the future, many companies feel compelled to set money aside to avoid being unprepared for what could be a substantial payout. If the employer does decide to fund an investment account, the earnings would be taxed to the employer. For this reason, employers will often incorporate the use of life insurance to fund the future benefit. Growth in a life insurance policy is tax deferred and it’s possible that if properly funded, the future payment could come out on a tax free basis using a “loan provision” allowed in many permanent insurance policies. In addition, because the policy is owned by the company, if the key executive dies, the death benefit proceeds are paid to the company and can be used to cover costs associated with the death of the key employee. The disadvantage to using life insurance is potential lack of growth and costs associated with a life insurance policy. The key employee might also have problems with insurability and the costs might outweigh the benefits.
Advantages to the employee:
NQDC plans can be set up as a way for a highly compensated individual to defer their own income. This may be attractive to the key employee because the amount deferred is considered to be tax deferred. Future distributions from the NQDC plan can be aligned with an event such as retirement or college funding. Perhaps the main attraction to the key employee is the dollars an employer may also choose to commit to the NQDC plan on their behalf. This can give the key employee a sense of commitment and loyalty from the company that they are appreciated and valued.
In addition NQDC plans are attractive for highly compensated employees because they are free from the contribution limits, participation requirements, and nondiscrimination restrictions that apply to qualified plans such as 401(k) plans.
Disadvantage to the employee:
One of the primary concerns for the key employee is that the NQDC plan is considered an unfunded/unsecured promise to pay a future benefit. Any formal funding of the plan on behalf of the key employee may also be subject to the creditors of the company. In other words, the promise to pay at a future date is dependent upon the solvency of the company. This could even be true of dollars the employee personally chooses to defer from their own compensation. Additionally, any amount the employee chooses to defer must be determined prior to their compensation being earned (IRC 409A). This forward planning could potentially cause timing problems if, for example, a child does not attend school in the same sequence as the dollars are scheduled to be paid out.
There are some additional concerns for the employee related to dollars being used to fund their future benefit. As mentioned earlier, the dollars being used to fund the future benefit of the key employee are subject to the creditors of the company should bankruptcy occur. In addition, there isn’t anything that could stop the company from using the dollars should the company come under financial stress. To reduce employee concerns, employers have been encouraged to create a trust often referred to as a Rabbi Trust. In this case, dollars used to fund the key employee’s future benefit will be deposited into the Rabbi Trust with the caveat that proceeds can only be used for the sole benefit of those covered under the NQDC program. Keep in mind that this method still does not entirely protect the assets from the claims of creditors.
In summary, NQDC plans can be useful tools for employers to reward and retain key people but require proper planning and consideration. Key employees appreciate these “carve-out” plans because they are able to defer their personal compensation for later use, or are incented to stay with the company for a stated period of time in return for a future benefit. The flexible creativity and design for both employer and employee make NQDC plans something to consider today for a company to differentiate themselves in the competitive job market.
Clint Bauch, CFP®, ChFC®
Hausmann-Johnson Bauch Financial LLC
700 Regent St.
Madison, WI 53715
*Investment Advisor Representative
Hausmann-Johnson Bauch Financial, LLC.
A Registered Investment Advisor