How to Use Nonqualified Deferred Compensation

The attorney drafting the nonqualified deferred compensation plan must first identify who is in control of the decision-making process—the employer or the employee. The employer has three main objectives:

  • attracting new employees
  • retaining highly productive key employees
  • providing incentives for superior performance.

Employer Objectives

If the attorney’s mission is to maximize employer objectives, the plan should contain a vesting (forfeitability) schedule or other forfeiture of benefits provision desired by the employer. For example, many employer-controlled plans remain unvested for a number of years and then have only graduated vesting. ERISA’s vesting requirements do not apply to a properly designed nonqualified deferred compensation plan. Planners, particularly the attorneys who draft nonqualified plans, should keep in mind that, regardless of whether an employee’s benefits are subject to forfeiture, the plan must never give the employee any right in the assets that the employer may have purchased to meet its obligations under the plan. Even if plan benefits are fully vested, there should be no adverse income tax implications to the covered employee, as long as: (1) the employer’s promise to pay benefits is unsecured; and (2) the agreement is signed before the employee earns the income.

The individual drafting a nonqualified deferred compensation plan should consider the following:

  • Confining eligibility to certain key executives or technical or sales personnel
  • Making plan eligibility either part of a predetermined company policy or adopting the plan for specific individuals as the need arises
  • Including performance incentives (e.g., basing benefits or contributions on salary increases, profits, sales goals, the value of employer stock, or upon the satisfactory achievement of specified objectives)
  • Including clauses that trigger a forfeiture of benefits for termination of employment or for undesirable conduct

Delaying vesting

Establishing a two-tier interest rate on participant deferrals or employer contributions toward financing the benefit of a given employee (e.g., the plan could credit dollars at a lower rate of return if the employee retired or terminated employment prior to a given date, and at a higher rate if the employee stayed and met other employer conditions)

Paying benefits only upon the same terms and conditions as in the employer’s qualified plan

Employee Objectives

Where an employee is the more powerful force in the bargaining process, his objectives are typically the following:

Additional forms of compensation, the income tax on which is deferred as long as possible, so that money otherwise paid in taxes may continue to work for the employee for many years (this compounding of dollars otherwise paid in taxes is a major benefit of a nonqualified deferred compensation plan)

Benefit certainty

Immediate vesting of all benefits, without forfeiture provisions.

If the mission of the attorney who is drafting the nonqualified deferred compensation plan is meeting the employee’s objectives, he should consider the following drafting points:

The inclusion of performance incentives (e.g., basing benefits or contributions on salary increases, profits, sales goals, the value of employer stock, or upon the satisfactory achievement of specified objectives)

The elimination of any clauses that trigger a forfeiture of benefits for termination of employment or for undesirable conduct

Immediate 100 percent vesting

In addition, where the employee has a strong influence, planners should consider requiring the plan to pay benefits in the event of disability. Typically, such benefits should begin immediately upon disability. In addition, the definition of disability should be less stringent than the normal total and permanent disability required for Social Security payments. Possible disputes about disability status can be minimized by shifting the determination of disability to an insurance company or a physician chosen jointly by the employer and the employee.

Example. The Uncanny Corporation promises Jo-Ann Egly, a key executive, that, in return for her continued services until age sixty, she will receive (in addition to her normal salary and other fringe and qualified pension or profit-sharing benefits) $100,000 a year for ten years, beginning at her retirement. Should she die prior to retirement, her children will be paid that amount, beginning at her death.

Like almost all nonqualified deferred compensation plans, the Uncanny Corporation’s plan provides both lifetime retirement and at death payments. If the covered employee retires, the employer pays the promised annual payments from corporate surplus. The employer holds the life insurance policy until the employee’s death, thus realizing income tax-free proceeds that will help the employer’s business recover its costs, and in some cases, may even result in a net gain–even after figuring the time value of the employer’s premium dollars. Insurance agents refer to this as cost recovery deferred compensation.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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