Executive Deferred Compensation: A Time Tested Tool That Attracts and Retains Key Executive Talent

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The return of CEO compensation to pre-2008 levels triggers a renewed interest in a properly designed Non-Qualified Deferred Compensation Plan.

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A plan design that does not reflect management plan objectives is an ineffective plan

American Benefit Corporation’s Jim Herlihy has just released a new article citing the importance of Executive Deferred Compensation Plans to both the executive and the corporation. On April 10, 2011, the New York Times reported that executive pay, particularly the CEO pay, had returned to the pre-2008 levels before the financial crisis. It was further reported that with the economy improving, executives are considering job changes and once again they are taking telephone calls from “headhunters”.

A Non-Qualified Deferred Compensation Plan can be an excellent tool to both assist the corporate executive in sheltering his income from taxes and the corporation in retaining key executive talent, provided it is properly designed to achieve these two very important objectives.

The provisions of the deferred compensation plan will determine its effectiveness as an attraction and retention tool. We have found that the plan with the most distribution options and the greatest flexibility is most successful at attracting participants. 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.

Plan eligibility requirements will define the group of executives who are eligible to participate. The smaller the eligible group the more prestigious it is to be part of the plan. 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, or a percentage of pay.

Plan distribution options define the form and timing of a payout. Payouts may occur at one or more of the following events: Retirement, Termination, Death, Scheduled In-Service (pre-retirement), Hardship, and Plan Termination.

Contributions to Non-Qualified Deferral Plans (NQDP’s) are typically made in three forms: Employee Contributions, Employer Matching Contributions, and Employer Discretionary Contributions. A plan without an employer contribution of some amount is not an effective attraction or retention tool.

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.

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 matching and 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 vesting schedules are: 1) Full and Immediate Vesting – All account balances vest immediately, 2) 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, and 3) Cliff Vesting – Full vesting occurs after a specified number of years, with no partial vesting at all.

A very effective retention strategy is 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. With class year vesting the executive is never 100% vested in his corporate contribution until retirement.

Finally, a non-qualified plan is exempt from ERISA and can be quite flexible as long as it complies with IRC 409(A).

About Us -
At American Benefit Corporation, we design, fund and manage executive non-qualified benefit plans for highly compensated corporate executives who wish to reduce current income taxes and form personal capital on a tax efficient basis. Established more than 30 years ago, we serve the unique needs of executives in numerous corporations with their personal capital formation objectives.

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