Plan Design Factors for Consideration When Implementing a Non-Qualified Deferred Compensation Plan
- Designing a Plan
- Who Should Participate
- Distribution Options
- Vesting Alternatives
- Securing Non-qualified Deferral Plan Benefits
Designing a Plan
Designing a Non-Qualified Deferral Plan can be as simple or as complex as you wish to make it. Although no two plans are exactly the same, they all share a similar framework and usually include the following provisions:
- Eligibility requirements will define the group of executives who are eligible to participate.
- The deferral election determines the amount of compensation to be withheld from the participant's paycheck. It could be defined as a:
- Flat dollar amount
- Combination of the above
- The deferral commitment duration is the period during which compensation is withheld. Different options to consider might be:
- One year (participants re-enroll annually - most popular option)
- Evergreen (the commitment continues until stopped or changed during an enrollment period)
- Multiple year units predetermined by the plan (usually associated with underlying funding assumptions)
- Sometimes an employer contribution in the form of:
- Match (percentage formula similar to 401(k))
- Discretionary contribution (a percentage or flat amount - may be used to supplement limits on qualified plan benefits)
- Distribution options define the form and timing of a payout. Payouts may occur at one or more of the following events:
- Scheduled in-service (pre-retirement)
- Plan termination
Who Should Participate?
Originally, Non-Qualified Deferred Plans (NQDP's) were designed for high-level executives in a particular company, such as:
- Presidents and chief executive officers
- Executive and senior vice presidents
- Vice presidents
- Members of the board of directors
- Highly compensated sales people
Over the past few years, companies have become more aggressive in offering NQDP plans to middle management, since:
- An increased number of executives are being affected by the limitations of qualified plans.
- Executives are in high demand in competitive industries, and a NQDP plan is an excellent tool for attracting and/or retaining key executives.
The selection of the appropriate group to participate in the plan is critical to qualifying for the top hat exemption, and thereby bypasses the complex restrictions and limitations ERISA imposes. If the exemption is violated, the plan would be subject to a great many of the provisions of ERISA that are applicable to qualified plans, without the benefit of tax-deductible contributions.
A top hat plan is "unfunded" and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management composed of highly compensated employees.
Here are some guidelines for selecting the participants:
- In general, the plan should limit participation to a small group of highly paid executives, relative to the total employee population, usually not more than 15% of all employees. In addition, an employee, to be considered management, should have definitive management responsibilities and duties.
- Plan participants should be key employees, and should be designated as key employees by the company - usually by the board of directors.
A Non-Qualified Deferral Plan (NQDP) plan document will generally define the time and form of payment of benefits for each event (this is a Rev. Proc. 92-65 requirement). The most common events that trigger a distribution are the following:
- In-Service (pre-retirement) Withdrawal
- Financial Hardship
IRC Section 409(a) provides that distributions are allowed only upon separation from service, death, disability, a specified time or pursuant to a fixed schedule, or the occurrence of an unforeseeable financial emergency. In addition, any "key employee" of a publicly held company would be required to wait 6 months for the commencement of any payment triggered by separation from service or death.
Most plans offer a variety of options in order to provide the participant with retirement planning flexibility. The typical options are:
- Lump sum
- Periodic payments (annual, quarterly, monthly) over 5 to 20 years
Death, Disability, and Termination
These events usually have plan provisions that result in a lump sum payout in order to avoid maintaining a liability on the books for a participant who is no longer employed. However, plans may also apply vesting provisions allowing participants to be considered eligible for retirement under the plan, and therefore eligible for delayed and/or annual distributions in lieu of an immediate lump sum.
Most plans offer the participant the right to make a series of withdrawals in annual installments while still an active employee. The most common use of this option is the withdrawal of funds for college and education needs. Typically, a plan will allow four or five annual installments, beginning at some point in the future. To avoid constructive receipt issues, this election must be made at the time of enrollment.
Multiple education accounts may be implemented at the plan level, allowing a participant to select a different beginning date for payment for each dependent.
Most plans allow only a lump sum payment for financial hardship. Financial hardship is defined by Rev. Proc. 92-65 as an unforeseeable emergency that is caused by an event beyond the control of the participant or beneficiary and that would result in severe financial hardship to the individual if early withdrawal were not permitted. The plan must further provide that any early withdrawal approved by the employer is limited to the amount necessary to meet the emergency.
Revising Distribution Options
Most plans have restrictions on the ability of participants to change their distribution elections. IRC Section 409(a) allows a "second election" to delay or change the form of a payout provided that the "second election" is made at least 12 months prior to the scheduled payout date of the election, and results in an additional deferral of at least five years (except in the case of death, disability, or unforeseeable emergency).
Contributions to Non-Qualified Deferral Plans (NQDP's) are typically made in three forms:
- Employee Contributions
- Employer Matching Contributions
- Employer Discretionary Contributions
Many plans allow the deferral of various forms of compensation. The majority of plans will permit executives to defer a portion of their base salary. A large number of plans will also permit executives to defer a portion of their bonus. A typical plan will generally allow for the deferral of 50% of base compensation and 100% of bonus compensation.
Basically, a NQDP may be designed to accept any compensation source. Some of the more common sources of deferrable compensation are:
- Base Salaries
- Directors Fees
- Sales Commissions
The plan sponsor will choose the minimum and maximum deferral amounts permitted.
Minimums and maximums are usually expressed as a percentage of compensation source, possibly combined with a flat dollar amount. For example, a typical plan may be set up as follows:
Min/Max Dollar Amount
Employer Matching Contributions
Similar to a 401(k) plan, a NQDP often provides a matching contribution by the employer. The matching contribution may take on a variety of forms but typically the match is based on a percentage of the employee's deferral, up to a maximum dollar limit.
A typical matching formula would be a match of 50% of the employee's deferral (50 cents on the dollar) on deferrals up to some percentage of compensation. Plans that are designed as executive retention tools tend to have a higher corporate match, which are subject to a vesting schedule.
Matching contributions are most often made when the participant makes contributions. However, there are plans that credit the match at the end of the plan year as a further incentive for the retention of key employees; a year-end match would normally be credited only to participants who are still employed by the company on the last day of the plan year. Matches can be totally discretionary in amount and to whom they are given.
Vesting gives the participant a non-forfeitable right to his or her account balances derived from employer contributions over a certain period of time. Commonly used to retain key employees, vesting requirements are often imposed on employer matching contribution account balances.
Employer Discretionary Contributions
Discretionary contributions are employer contributions that are unrelated to employee contributions. They are analogous to contributions made by an employer to a qualified profit sharing plan, where the employer may or may not make a contribution each year.
The discretionary contribution is not dependent on the magnitude of the employee's deferral, but is most often based on a percentage of the employee's compensation (e.g., each participant will receive a contribution of 10% of compensation, irrespective of their deferrals).
Similar to matching contributions, discretionary contributions can be made throughout the year, or processed at the end of the plan year.
Vesting gives the participant a non-forfeitable right to his or her account balances derived from employer contributions over a certain period of time. Commonly used to retain key employees, vesting requirements are often imposed on employer discretionary contribution account balances.
Vesting requirements are often imposed on employer contributions and associated account balances in a Non-Qualified Deferral Plan (NQDP). Vesting requirements are a commonly used strategy to retain key employees. Vesting gives the participant a non-forfeitable right to his account balances derived from employer contributions over a certain period of time. The period of time for full vesting (i.e. the time at which a participant may leave the employ of the company with the right to 100% of his account balances) may vary from 100% vesting immediately, to a percentage of the account balance vesting each year.
Common patterns (schedules) of vesting include:
- Full and Immediate Vesting - All account balances vest immediately.
- Graded Vesting - A percentage of the account balance vests each year. An example of a graded vesting schedule would be 20% per year for 5 years.
- Cliff Vesting - Full vesting occurs after a specified number of years, with no partial vesting at all.
Class Year Vesting
Class Year Vesting, in essence, treats each calendar year of deferral as a separate entity.
Class year vesting results in each calendar year's deferrals vesting separately, according to the vesting schedule selected. For example, assume that a graded vesting schedule of 20% per year was applied on a class year basis. Then the following would occur:
- Year 2000 deferral account balances would be 20% vested in year 2000, 40% vested in year 2001, 60% in year 2002, etc.
- year 2001 deferral account balances would be 20% vested in year2001, 40% vested in year 2002, etc.
Choosing an Appropriate Vesting Schedule
A sponsor may choose any vesting schedule. There are no statutory requirements for a NQDP.
Here are some practical considerations:
- Full and immediate vesting is obviously the choice that will achieve the most satisfaction with plan participants. However, it will also accelerate the corporate liability growth. It is also the simplest form of vesting to use when considering the new FICA and FUTA withholding rules. The new rules require FICA withholding on the portion of the employer account balance that vests each year. Once taxed for FICA purposes, any future growth on that portion of the balance escapes future FICA tax. Any graded vesting schedule will require a complex record keeping system to keep track of what portions have already been taxed.
- Cliff vesting provides the slowest growth rate of corporate liability, but results in a spike at the end of the cliff period. It also simplifies the calculation of FICA/FUTA taxes as stated above.
- The major benefit of class year vesting is the minimization of the rate of corporate liability growth. For any given schedule other than full and immediate vesting, class year vesting will increase liabilities at a slower rate than the same schedule utilized without the class year option.
Securing Non-Qualified Deferral Plan Benefits
Non-Qualified plans typically provide the majority of an executive's retirement income. However desirable these plans may be, there is still a risk factor - the very nature of these plans requires that the promise of payment be an unsecured obligation. This risk factor is a major consideration for most executives.
There are basically two scenarios which might cause a sponsor not to pay the benefits: a change of heart, and the inability to pay due to financial considerations, such as bankruptcy.
To help alleviate executives' concerns, the plan sponsor may establish a trust as a vehicle to accumulate assets to support the payment of benefit obligations under the plan. The trust receives contributions, makes investments, and makes distributions according to the terms of the plan.
One form of trust, a Rabbi Trust, protects plan participants from being denied payment due to a change in management or a hostile takeover. Another form of trust, a Secular Trust, will further secure the benefits for the participant, but could result in some undesirable tax consequences.