Should You Have a Deferred Compensation Plan?

Over the years, deferred compensation plans have experienced varying degrees of popularity in corporate America. They rose to prominence in the 70s with many major companies providing some form of this benefit to their executives. As companies started moving away from defined benefit and defined contribution plans and towards 401(k) plans in the 90s, deferral plan arrangements became a solution to offset the "reverse discrimination" those plans imposed against highly compensated executives. Then we hit the 2000s when Enron prompted 409A--and many organizations wondered if deferred compensation would even survive.  

So where are we now? Is such a plan still a viable pay strategy to employ? If so, how do you determine if your business should have one? 

Deferred compensation helps complete a competitive value proposition for the right company.
As it relates to that second question, the answer is an emphatic yes--for the right situation. I'll deal with the related third question in a minute, but let's talk about why I assert deferred compensation is still so viable.

Most of the fears surrounding non-qualified plans occurred when 409A regs hadn't been fully fleshed out. Organizations didn't want to get caught providing a benefit that would ultimately be disqualified by some technicality that triggered penalties for the business, the participants or both.  However, that fleshing out has occurred and now organizations entering into these agreements have better guidelines than ever before about how to avoid pitfalls and danger areas.  There's no question you need a good consultant and knowledgeable attorney to help you navigate the development of a "clean" plan, but all of that is available.

The most popular use of these plans has been to provide a means for highly compensated employees to defer income and save taxes. Because of the restrictions associated with qualified plans, people earning large incomes have few means of saving and investing on a tax favorable basis.  In a highly competitive environment for premier talent, your business will need a value proposition that both rewards and facilitates. By "rewards," I mean top producers will expect to see a relationship between the value they create and how they are paid. "Facilitates" implies they will then look to the organization to enable a means of protecting their income from diminishment through means only a business can provide.

Another application of this kind of benefit is strategic deferred compensation.  In those arrangements, company instead of employee dollars are contributed to the plan (although an employee deferral component can be added also).  Organizations use this approach when they want to build a long-term benefit for key contributors in the business based on their performance. This is either done as the primary means of funding the benefit or as an additional contribution in employee deferral plans.

This is not to suggest that a deferral plan of any type is a panacea or not without disadvantages. Such plans are still a "non-qualified." As such, assets are not secured as they are in the qualified arena and participants rely upon the financial stability of the company to ensure payouts. Also, tax deductions for amounts contributed to a plan are deferred until benefits are paid out. That said, once payments are made, the full amount of the distribution (deferrals plus accumulated interest or investment return) are deductible. 

So What Organizations Should have a Plan?

Companies that favor this type of benefit typically fit the following profile (although not all these criteria must apply for a plan to be a viable consideration):

  • They are financially stable and that stability is anticipated to continue. 
  • They have highly compensated employees who could benefit from the ability to defer income and are restricted by the guidelines associated with their 401(k) plan.
  • They want to incent higher performance and can use the plan for that purpose (company contributions based on the achievement of certain results).
  • They have a enough potential participants to make the installation and maintenance of a plan "worth it."
  • They need to a competitive value proposition to attract and retain premier talent.
  • They can comfortably absorb the cash flow implications of a plan.
Premier talent seek a value proposition that many public companies offer.

Companies that want to ensure their plan is successful typically incorporate features that will make the plan attractive as an accumulation opportunity and that will minimize risks to participants as much as is feasible. This might include some or all of the following:

  • A range of investment options (similar to those offered in their 401(k) plan).
  • A Rabbi Trust to ensure plan assets are segregated (only available for deferral payments) in the event of corporate takeover or business sale. (This does not protect them from creditors in the event of bankruptcy however.)
  • An "informal" funding strategy to ensure assets are available to pay plan benefits at the time of distribution.
  • A committee that meets regularly to make decisions about investment offerings, plan agreement stipulations, plan promotion and communication, etc.
  • A commitment to plan communication and promotion particularly during open enrollment periods.
  • Clear and effective plan introduction, communication and enrollment materials.
  • Top down support of the plan from company leadership.
  • A documented agreement that ensures the plan meets all of the statutory requirements under 409A and ERISA.
  • An ongoing strategy for plan administration, statutory oversight, plan accounting and results measurement (is the plan achieving what the company wants it to achieve?).

If your company meets the criteria of one who would benefit from this kind of program, and you can commit to ensuring the plan is well run (as just itemized), then you are probably a good candidate for a deferred compensation plan. 

A Checklist for Building World-Class Compensation

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