USES OF DEFERRED COMPENSATION
Deferred compensation programs can serve a variety of purposes:
Substitute for a Formal Pension Plan:
The employer has complete freedom of action in the selection of the employees (including owner-employees) to participate in a deferred compensation plan. Because no government approval is required, the plan can be — and almost always is — discriminatory. Further, it can be tailored to fit the funds available and may be continued or terminated at will. Also, possible adverse reaction from other employees that are not included in the plan is avoided as they never need know of its existence.
Supplement a Qualified Pension Plan
Regulations affecting pension and profit-sharing plans operate to limit benefits that can be paid to the executive class of employees.
Further, the executive may have been employed by the organization late in life and may be either ineligible for the formal plan, or because of service requirements, eligible for only a reduced pension. The deferred compensation plan overcomes this qualified plan problem by supplementing the benefits that are provided by the pension or profit-sharing plan.
Supplement a Qualified Profit-Sharing Plan
In some qualified plans, when the profit-sharing contributions are projected to retirement, it is evident that an adequate benefit will not be provided for the key employee. In many qualified plans, the key employee entered the plan late in life so that the plan will not develop benefits for the person commensurate with those projected for the firm's younger employees. The deferred compensation plan overcomes this profit-sharing plan problem by providing additional benefits that supplement inadequate profit-sharing benefits.
Aid in Recruiting New Key Executives
In many cases, deferred compensation can give the new key employees a greater fringe benefit program than they left behind at their previous employer.
Retain Valuable Key Personnel
An important employee can be deterred from leaving his or her present employment if leaving means the loss of substantial deferred compensation benefits. Because of this ability to retain deferred compensation participants, a deferred compensation plan is often referred to as "golden handcuffs."
Retain Key Employees to Run the Business for the Family
Deferred compensation plans may figure importantly in business succession planning. When business owners desire to see their families continue to own and operate a family business, deferred compensation can be employed to hold the key people and keep the business alive, until the owners' minor or inexperienced children can assume the management of the business.
Make Executive Compensation More Meaningful
Because of the graduated tax structure, much of a pay raise or bonus to a key executive may be taken by taxes. Deferral of such a raise or bonus to a future date-until after retirement, for example — may allow the executive to keep far more after taxes because a retiree may be in a lower tax bracket.
Substitute for Stock or an Ownership Interest
Owners of closely held businesses are reluctant to grant ownership interest in the business — especially if it means losing effective control of the firm. Key employees may view minority ownership in a close corporation of having little value because of its lack of marketability. Deferred compensation for key employees is often preferred to a minority stock interest in many close corporations, especially if few or no dividends are paid.
A note about Deferred Compensation for Public Employees: "Section 457 Plans"
State and local government employees are also permitted to establish nonqualified deferred compensation plans similar in certain ways to plans for employees in the private sector. These plans are often referred to simply as Section 457 Plans. Many regulations — similar to those for qualified retirement plans — govern these governmental-sector plans and do not apply to deferred compensation plans for non-governmental organizations. For that reason, this course will not address deferred compensation plans for public employees.