3 Ways to Turn Deferred Compensation into an Incentive Plan

Last week I talked about why deferred compensation (DC) is still a viable plan for the right organizations. Some of those companies are interested in a plan that serves as more than a means for employees to defer income and save taxes.  They want it to have a performance component associated with it. So this week, I'll discuss how to turn a plan into a means of creating greater focus on the results the company wants its top performers to achieve.

Deferred compensation can be used as an incentive plan and not just a tax saving tool.

In those situations where an organization want to achieve a performance objective with its deferral plan, we recommend businesses take a more strategic approach by tying it to an incentive.  Done correctly, this allows the company to give employees a tax-advantaged means of saving while meeting the company's objective of driving higher performance and productivity. Any pay plan should fit into a larger rewards construct where individual compensation components complement each other in creating alignment between company goals, roles and pay. Plans that allow employees to defer income should be no different.

With that in mind, there are three common approaches to making these plans more incentive-based:

  • Company Match--Through this approach, a company agrees to match the contributions of the participant to the plan up to a percentage or dollar cap.  Although a match doesn't have to be incentive-based it is commonly tied to a pre-determined performance requirement. The results that have to be achieved for the match to be made may be linked to the company, a department or team, or individual performance. Typically, company matches are made annually while employee deferrals are made through regular payroll deductions.
  • Company Contribution--This type of arrangement is similar to a company match except that the money contributed to the plan is not tied to the employee contribution. As a result, it's not limited by the level of the employee's participation.  An employer's contribution could, in theory, be more than that of the participant.  However, the performance criteria for earning the company's deposit follows the same principles as those outlined in the company match description. Where this approach also differs is that the contribution made by the organization may go into a company stock or phantom stock account as opposed to being allocated among the investments the participant has selected.
  • Strategic Deferred Comp--This kind of plan is used when the company wants to create both a recruiting and retention incentive for top talent.  The plan is fully funded by the company on the basis of performance criteria such as that already outlined.  Although employee contributions may be allowed as well, they are not required.  These kind of programs are also not usually "all or nothing" in nature.  In other words, a range of contribution is made based on the level of performance that is achieved.  It is also possible to have no contributions in some years. Strategic deferral plans will quite commonly make the contribution to a stock or phantom stock account, tying the long-term value of contributions to the performance of the company. 

In any of these three arrangements, there is typically a vesting schedule for any money contributed by the company. This is obviously to ensure that a participant stay a designated period of time to reap the full benefit of the plan. This ties key people to the business.  The performance requirement additionally focuses their attention on the achievement of results that are critical to the growth of the enterprise--creating better alignment between owners and key talent.

Compensation should help create a unified financial vision for growing the business.

The overall purpose of an organization's compensation strategy is to build a more unified financial vision for growing the business.  As a result, each component of pay needs to work in coordination with others to create that effect.  As a result, any of the approaches discussed here should not be considered "in a vaccum."  Companies that are most effective at engineering a successful employee value proposition build a Total Compensation Structure where all pieces of the overall pay plan are laid out by salary grade or tier. This ensures that decisions regarding pay are always made in a broader context. This prevents an organization that provides one of the types of plans discussed here to avoid over commitment to short or long-term value sharing outside of the deferral arrangement.

In the end, DC plans such as those discussed here can be a valuable way of helping a company achieve the following:

  • Attract and retain key talent.
  • Create greater focus on the results the company wants to achieve.
  • Tie compensation more clearly to performance.
  • Combine one of the company's retirement plans with the long-term success of the company.
  • Make some or all of the deferrals "self-financing"--the company's contribution is only made if sufficient value is created.

By any measure, those outcomes make such plans an effective tool.

A Checklist for Building World-Class Compensation


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