It is important to understand that deferred compensation plans come in varying sizes and styles, each designed to meet the needs of both the employer and the employee.
For the employer, the deferred compensation arrangement assists in attracting and retaining key employees. Also deferred compensation programs can be designed to allow employers to recover the cost of the benefits.
For the employee, the deferred compensation arrangement enables him or her to receive additional compensation at retirement and avoid current income taxes on the amount of compensation that is deferred. So, in the right situation, deferred compensation can be attractive to both the employer and employee. The package of employee benefits in a deferred compensation plan might include:
retirement benefits for the plan participant;
disability benefits for the plan participant; and
survivor benefits in the event of the employee's death
There are many ways the benefit package can be structured and funded. The primary advantage of a nonqualified plan is that it can be custom-tailored to fit the employer and key employee's unique circumstances. Benefits can be expressed as a percentage of income or as a fixed-dollar amount. The benefits can be secured by assets in a trust or not; the plan can be funded, unfunded or "informally funded" — depending on the objectives of the employer and employee.
Funding the Eventual Liability
Regardless of whether the deferred compensation plan contains a formula based on the executive's final salary or simply recites a fixed benefit, the judicious employer will immediately put in place the informal funding that will enable it to meet the employer liability that the plan imposes.
Any number of financial vehicles may be used by the employer to provide an asset reserve against the deferred compensation liability, including bonds, stocks and mutual funds. As we will examine in the material to follow the most effective and efficient informal funding vehicle involves insurance, both life insurance and disability income insurance on the life of the plan participant.
Life and disability insurance provide an effective means of assuring that funds will be available in the future to pay the benefits promised by these plans. The promotion and sale of deferred compensation programs is, therefore, a natural activity for the insurance professional. Although the nonqualified deferred compensation plans discussed in this course represent sophisticated sales, the basic concepts are relatively simple.
Is Salary Deferred or Not?
Executives who leave the employment of an employer who has established a deferred compensation plan — a plan under which the key employee actually defers his or her compensation — generally receive their total deferrals with modest accumulated interest, such as interest at the prevailing savings account rate. This interest rate is typically much lower than would apply if the executive had remained with the employer until retirement. Thus, there is a substantial financial incentive under the plan for a participating executive to stay with the company until normal retirement.
It is customary for salary continuation plans (SERPs) — which are not typically funded with employee deferrals — to pay no benefit at all to the executive who leaves the firm before the specified retirement date. Any funds the executive loses are retained by the company.
Despite the "golden handcuffs" aspect of deferred compensation, a covered key executive will sometimes leave the employer's service before retirement. If the executive leaves the company before the retirement date specified in the plan document, the plan may provide either for:
no distribution whatever, or
a partial distribution according to a predetermined schedule.