Deferred Compensation on the Uptick
Will recent changes to federal tax laws encourage more high-earning executives to participate in non-qualified voluntary deferred compensation plans?
By Andrew R. McIlvaine
Executives and other high earners are now in Washington's crosshairs as the federal government searches for additional revenue to stanch its budget deficits. In addition to the higher income-tax rates for individuals making more than $400,000 ($450,000 for married couples filing jointly) agreed to by Congress earlier this year as part of the deal to avert the "fiscal cliff," high earners will also be faced with Medicare surcharges on earnings above $200,000 ($250,000 for joint filers) and higher capital-gains taxes for those in the new top bracket of 39.6 percent (20 percent, versus 15 percent for all other brackets).
Even more taxes could be on the horizon for high earners, says Janet DenUyl, a partner at Mercer's executive compensation advisory in New York. President Obama has proposed capping tax deductions for individuals making $200,000 or more per year ($250,000 for couples) at 28 percent.
"Every time you have a tax-reform proposal, there's always the risk that they're going to limit tax-deferral opportunities for high-income people," she says.
These bigger tax bites are sparking renewed interest in VDC plans, says DenUyl. VDC plans are typically offered by companies to executives as a way for them to save additional pre-tax pay beyond what they can save in defined-contribution plans and other retirement programs. The plans can be an effective retention tool for high earners, she says.
Higher tax rates may not be the only incentive pushing more executives toward VDC plans, says DenUyl. The decline in traditional defined-benefit pension plans means more executives (like most employees) are relying on less-generous DC plans as a cornerstone of their retirement. However, the limits on what high-earning employees can contribute to these plans means that for executives hoping to have income replacement of 70 percent to 80 percent during retirement, other options are necessary, she says.
"If you're aiming for that level of income replacement, you need to be saving at least 25 percent of your income on a pre-tax basis," she says. Particularly for executives with pre-retirement incomes of $400,000 or more, tax-deferred options such as VDCs can be very helpful in achieving this level of savings, she adds.
Approximately 80 percent of Fortune 500 companies currently offer such plans to their executives, says DenUyl.
Don Lindner, executive compensation leader at Scottsdale, Ariz.-based WorldatWork, oversaw VDC plans during his years in senior HR management at several large companies. He agrees that recent tax changes are making the plans more attractive to executives.
"We are seeing more interest in these plans, and I think we'll continue to," he says. "Companies that don't offer these plans are going to start thinking about offering them, while the ones that already offer them are probably going to make them a more prominent part of their executive-compensation strategy."
VDC plans are hardly risk-free, of course. In order to be considered "non-qualified" by the Internal Revenue Service (as opposed to qualified plans such as 401(k)s), they must be unsecured and unfunded, says Lindner. This means that, should their employer go bankrupt, executives with money tied up in these plans will find themselves at the back of long lines of creditors, including employees seeking payment of their regular wages. This is precisely what happened at many companies following the 2008 financial crisis, says Alan Nadel, a principal in the compensation consulting practice at Buck Consultants in New York.
"When you sign up for these plans, you're essentially taking your company's word that the money will be there when you ask for it," he says. "These plans provide no assurance or security for the employee other than serving as a cash-accumulation vehicle."
Interest in the plans had declined in the wake of Section 409A of the Internal Revenue Code, which was enacted in 2004 as part of the American Jobs Creation Act to "return these plans to their original intent," says Lindner.
"Prior to Section 409A, companies had been getting very creative with these plans, allowing executives to take their money whenever they wanted in return for taking a 10-percent haircut," says Lindner. Section 409A forbids companies from allowing this, thus making the plans much less flexible than they had been, he says.
Lindner describes Section 409A as "one of the most onerous, complex pieces of regulation we've seen in forever." The penalties for failing to comply with the rule can be severe, he adds.
In the last few years, however, as the economy has improved and companies have gained a better understanding of Section 409A, VDC plans are regaining their popularity, says Lindner.
"With tax rates going up, if you can defer when you're at a high tax rate and get your money when you're at a lower rate, it makes these plans quite appealing," he says.
Companies need to be straightforward when explaining the plans to executives, says Lindner.
"Be very transparent and do not try to downplay the potential risks," he says. "Executives have to make decisions based on the risks. That said, I think they're a great tool for companies because they provide an additional option for executives in planning for their futures, whether it's saving for retirement or paying for their kids' college tuition."
Although companies aren't required to actually set aside money to fund the plans, Nadel recommends that they do to ensure the necessary money is available when the executives ask for it. "It's easy to make promises, but another thing to actually cough up the cash," he says.
Some companies use a so-called "rabbi trust" to fund their VDC plans, says Nadel. Money deferred by plan participants is placed in the trust and can't be accessed by the employer, thus giving the participants an additional level of security, he says. However, even rabbi trusts aren't protected from creditors should a company go bankrupt, he cautions.
Companies have a great deal of flexibility in structuring their VDC plans, says Nadel. Some offer annual incentives to encourage participation, while others design them to mirror DC plans, with regular company matches, he says.
Most companies haven't looked closely at their VDC plans since 2009, which was the deadline for all companies offering such plans to be in compliance with Section 409A, says DenUyl.
"Since then, there have been a lot of advances in website technologies to allow for a much more robust plan that's still Section 409A-compliant," she says.