Imagine if your company could offer its top employees a 401(k) plan that has no annual contribution limits; has no discrimination testing; allows them to take distributions at any time before retirement with no tax penalty for pre-age 59 ½ distributions; allows separate contribution amounts from salary, bonus and commissions; allows each of these “accounts” to be measured by different benchmark portfolios; allows each account to have different distribution dates and methods; permits re-deferrals of planned distributions if objectives change; and provides a menu of benchmark investment choices with more options and more risk categories than a typical 401(k). How many would want to enroll in this plan?
Well, it is possible to provide just such a plan through IRC Section 409A deferred compensation plans.
Most regular C corporations, particularly those that are publicly-traded, offer to their executives and highly-compensated employees some form of deferred compensation arrangement. Often, however, these programs simply take the form of mandated deferred bonus programs or SERP-like retirement plans. While these may provide some benefit to the participants, they merely scrape the surface of the possibilities afforded to this top group of employees by a true, customized, nonqualified deferred compensation plan.
A properly-designed deferral plan is exempt from ERISA and its many restrictions, limitations and onerous requirements. As long as the plan only admits as participants those employees who are management or highly-compensated and does not formally fund the plan, the possibilities are endless for a myriad of corporate and individual objectives. Following are just a few ideas for maximizing the potential benefits of a DCP for both the employees and the corporation.
Many companies have problems with the discrimination rules attendant to 401(k) plans, along with the required testing and frequent year-end refunds to those who over-deferred into the plan. A deferred compensation plan can alleviate this burden by making the management and highly-compensated employees ineligible for the company’s 401(k) plan. 401(k) rules permit a company to discriminate AGAINST the highly-compensated, so it can simply make it not available to them. In its place it could offer them a nonqualified plan with all the benefits and advantages described above. The same (but not reduced by the discrimination rules) company match can be incorporated into the DCP.
Another potential use for these plans is to change the way a company pays incentive bonuses to newly-hired executives or employees. Not infrequently a company might pay a new CEO, CFO or other important hire a substantial signing bonus, only to see that CEO depart after a year or two with this bonus. A company could pay this bonus into a deferral account with a vesting schedule attached, helping to ensure that this executive would remain long enough to fulfill corporate goals. In addition to protecting the company, this arrangement would be beneficial to the employee as well by allowing him or her to receive this large sum on a tax-deferred basis, and to accumulate earnings, directed by him or her, also on a tax-deferred basis. Vesting schedules for deferral accounts are also not subject to 401(k) requirements, and can be virtually anything the company desires.
Annual performance bonuses are by their very nature uncertain, making it difficult for a participant in a deferred compensation plan to make an election to defer a portion of the bonus more than a year in advance. Many people earmark a certain portion of their annual bonus for current needs, especially for large fixed expenses such as a wedding or college tuition. If a given year’s bonus amount is small, a deferral of any amount might pose difficulties for the participant. To solve that, the plan could provide a two-tier election option for bonus deferrals. The participant would elect to defer an amount of bonus equal to “_____% of the first $_________ of bonus and _____% of any bonus in excess of $________.” He or she could thus set a floor below which no bonus would be deferred, yet allow the luxury of deferring a large amount in a banner year.
A deferred compensation plan might also want to offer its participants a more comprehensive selection of investment benchmarks than are commonly available in 401(k) plans. Since a 401(k) is available to all full-time employees, most of whom are not experienced investors, the menu of investment choices must be relatively conservative and limited to the larger, less-volatile funds. However, in a DCP, all the participants must be highly paid and therefore generally have significantly greater investment experience and expertise than the general employee population. It often makes sense, then, to include in this plan opportunities to select additional choices that may involve higher risk or volatility, but also have the potential for more sophisticated financial choices. This can greatly enhance the attractiveness of this plan for highly paid employees.
Deferral plans can also be used for any number of specific purposes or for specific individuals, such as individual bonus awards, project completions, industry achievements, or promotions. A company can discriminate freely among the eligible participants.
The high degree of flexibility offered by a nonqualified deferred compensation plan provides an unparalleled opportunity for a corporation to enhance its ability to attract, retain and reward valued employees. It is important, therefore, for it to analyze its needs and objectives prior to implementing a plan. Working with a qualified advisor to assist in the design of a customized plan is essential to achieving maximum participation and effectiveness of the plan.
I’ll leave you with one final thought. A nonqualified deferred compensation plan is virtually the only benefit a company can provide for its top employees at little or no cost to the company, and one that is highly valued by these employees. The question then becomes not “Why should we implement a deferred compensation plan?”, but rather “Why wouldn’t we implement such a plan?”
For further information, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
