DEFERRED COMPENSATION ARRANGEMENTS
Each deferred compensation plan — regardless of how it is structured — has three important elements:
a promise to pay certain benefits;
forfeitability of promised benefits; and
a method to pay the promised benefits.
A Promise to Pay
The first deferred compensation plan element is a promise that the employer pays a stated benefit to the employee. The benefit may be expressed in a defined benefit or a defined contribution manner. The executive may be promised an amount of retirement income for a fixed period of time — a defined benefit plan approach, which is often used in SERPs. Alternatively, the executive may be promised a retirement income based on what a cash fund will purchase at a given age — a defined contribution plan approach, frequently used in "top hat" and excess benefit plans.
Many plans also offer a preretirement death benefit — often called a survivor benefit — if the participant dies while in the service of the employer. Disability benefits can also be provided under the plan. The specific package of benefits is governed by the provisions of the deferred compensation plan document.
Falcon Corporation's deferred compensation plan provides the following for one of its key executives:
a retirement benefit equal to 60 percent of the employee's final salary for 10 years after retirement;
a disability benefit equal to 60 percent of the employee's salary at the onset of disability, payable during the employee's disability but not beyond age 65; and
a survivor benefit equal to 60 percent of the employee's salary at the time of his or her death payable for a period of 10 years.
Retirement and other benefits may be expressed as a defined benefit or based on defined contributions.
Most "top hat" plans follow the defined contribution model — the amount of income that is deferred and its investment gain are credited to an account set up for the executive. The executive's eventual "top hat" benefit is based on aggregate amount of all contributions and earnings accumulated over the life of the plan. (In some cases, the employer will also contribute to the top hat plan, usually as a bonus for meeting some prearranged goal, e.g, reaching a sales or profit objective. If the executive fails to live up to the terms of the plan — for example, retires early — he or she will typically forfeit any employer contributions to the plan. The retirement benefits will be based solely on his or her personal deferrals.)
On the other hand, salary continuation plans (SERPs) are typically structured as defined benefit plans. The actual level of future plan benefits is spelled out, or "defined", in the plan documents — usually as a percentage of final salary or as a flat dollar amount.
Percentage of Final Salary
In the example above, the retirement benefit is 60% of the executive's final year of salary. An executive earning $150,000 annually could expect a retirement, disability and survivor benefits equal to $90,000 per year for the designated period — assuming his or her salary remained at the $150,000 level. It is not unusual for a plan to provide retirement benefits equal to one-half of the executive's final salary for a period of 10 years — but each plan is unique, benefits can be more or less than 50 percent of salary and may be for a period that is longer or shorter than 10 years, and benefits may be larger or payable longer for one key executive than for another.
The percentage of final salary approach has the additional benefit of automatically adjusting the executive's benefits with changes in earned income during his or her working years. This is an important, considering that the benefit package may have been negotiated 10, 15 or more years before the executive's retirement.
Couching deferred compensation benefits in percentage of final salary terms is certainly not the only method being used. Despite their inflation-induced shortcomings, deferred compensation plans whose benefits are stated in dollar, rather than percentage, terms continue to enjoy popularity.
From the employer's perspective, a deferred compensation benefit that is a specific dollar amount has two distinct benefits when compared to the percentage of final salary approach:
administrative simplicity-the funding does not require adjustment as the executive's salary changes; and
a definitely determined benefit-there is no uncertainty about the final cost of the benefits.
Forfeitability of Benefits
The second element of a deferred compensation plan is a wall or barrier that exists between the promised benefits and a cash fund. To enjoy the income tax deferral that is an integral part of the deferred compensation plan, the wall or barrier should not be breached in plan design. To maintain the important tax advantages of deferred compensation plans, there should never be any connection between the promised benefits and the accumulating fund.
Deferred amounts under a nonqualified deferred compensation plan are merely an employer's promise to pay the employee sometime in the future — they could simply "evaporate". To defer income taxes, these amounts must remain subject to the claims of the employer's creditors in the event of insolvency (i.e., they must be unsecured). This means that an employer's promise to pay may become an empty promise if the employer becomes insolvent. What happens if the employer that has promised deferred compensation benefits is bought out by another company that chooses not to honor the plan commitment or declares bankruptcy? Quite simply, the deferred compensation participant becomes an unsecured creditor of the employer. To overcome this concern regarding the insecurity of promised deferred compensation benefits, two important trusts have been developed: the rabbi trust and the secular trust.
Rabbi Trusts: Some Security and Deferred Taxes
The rabbi trust derived its name from a trust created in a nonqualified retirement plan under which a rabbi was a participant. The rabbi was concerned that future decision makers in his congregation might not be as kindly disposed to providing for his retirement as the current leaders. To provide additional security, the rabbi arranged for the plan assets to be placed into a trust with conditions that they could only be used for his retirement.
However, to avoid the current income taxation on those assets, the trust document left the assets available to the claims of the employer's general creditors.
Similar trust arrangements have been upheld by the Internal Revenue Service and offer a planning alternative that is appropriate in some circumstances (i.e., if the employee is comfortable about the long-term financial health of the employer but concerned about the employer's willingness to make the promised benefit payments).
Secular Trusts: Greater Security but No Tax Deferral
A growing trend of mergers and acquisitions, as well as bankruptcies, in recent years has spawned another trust known as a secular trust. Secular trusts provide the protection afforded by a rabbi trust (protection against the employer's unwillingness to make promised payments) plus protection against the risk that the employer will declare bankruptcy or become insolvent and be unable to make payments. In a secular trust, the funding assets are segregated or "earmarked" for the executive's exclusive benefit. As a result, all contributions to a secular trust are currently income taxable to the executive.
Unlike the taxation of the trust corpus of a rabbi trust, all contributions to a secular trust are currently income taxable to the executive. This income taxation occurs because the opportunity for forfeiture of assets is sufficiently reduced by trust provisions to create current income to the executive.
The secular trust is perceived by some executives to be of value if it is expected that the income tax rate will increase dramatically in the future or if it is likely that the existing corporation will be merged or sold to unfriendly future owners.
In theory, a nonqualified plan could stop there. Benefits could be paid from the future earnings of the firm or from any of several investment options. The question the employer normally needs to answer is, "What is the least expensive way to provide the promised benefits?" And, as the discussion about rabbi and secular trust implies, there is usually something of value being held by the employer to meet the "unsecured promise" of the deferred compensation agreement. When there is something more than a simple promise, the plan is said to be "informally funded". (Full "funding" would occur if specific assets were set aside for the executive's eventual use — but that would negate the tax deferred nature of the plan — as is the case with secular trust.)
Paying the Benefit
The third element of the deferred compensation plan is its source of funding. The funds needed to pay the promised benefits can be provided on a pay-as-you-go basis — a purely unfunded plan. Obviously, it would require a great deal of trust from a key executive to accept a simple promise of future benefits. Companies can set aside reserves, invest them in stocks, bonds or mutual funds, and pay benefits from those investments. As long as the reserves are not specifically set aside for the employee's use, this type of informal funding would be acceptable and preserve the tax deferred nature of the plan. If the employee is insurable, life insurance is the most financially attractive way to insure that the cash will be available when it is needed. Permanent life insurance policies build cash values that can be accessed to help the employer pay retirement benefits, the cash value growth avoids current income taxation, and the permanent nature of the policy means that death benefits will be available to the employer to enable it to recover costs whether the executive lives for many years after retirement or dies shortly after the policy's inception.
Important Role for Insurance
Generally, insurance is the least expensive way for the employer to create a fund to pay promised preretirement and post-retirement benefits. In addition, it is the only financial vehicle that enables the employer to recover its costs to provide the benefits — a factor that can be attractive to many deferred compensation plan sponsors. Life insurance is normally purchased to fund both the survivor and retirement needs, while disability income insurance can meet the obligation the deferred compensation plan's disability provision creates (These benefits are often funded through an individual disability income policy that is conditionally renewable, the condition being the executive's continued employment with the firm.)
Cash Value Policies Preferred
In the insured deferred compensation plan, the internal rate of return in a permanent life insurance policy's death benefit may be greater than can be obtained through stocks, bonds or mutual funds. In addition, the employer often use life insurance policy cash values at the time of the plan participant's retirement to fund the retirement benefit in whole or in part.
However, life insurance does not fund the plan in the usual sense; instead, it is often referred to as "informal funding." The distinction between funding in the usual sense and the informal funding that often is by life insurance provides is important. The critical factor in this distinction is that no connection exists between the amount of insurance on the participants and their contribution in a deferred compensation plan, or between the contributions made for them by the employer in a salary continuation plan.
Although employers may be able to fulfill their obligations under a deferred compensation plan without purchasing a life insurance policy, the employer who "funds the plan" with life insurance satisfies several objectives: funds will be available to meet its pre-retirement death benefit liability, funds will be available to help provide retirement benefits and the employer may be able to recover its costs. A plan funded with life insurance also provides a sense of security to the executive who is more assured of his employer's ability to meet its commitments under the plan.
Key Features of a Deferred Comp Agreement
We will turn our attention now to a discussion of the main provisions of a typical deferred compensation agreement. A general knowledge of the content of these agreements will enable you to be of service to your prospects and clients. Just as importantly, it will help give you any needed confidence to effectively pursue prospects in this lucrative market.
Although there are other provisions in a deferred compensation agreement, generally the most important provisions relate to the:
income to which the agreement applies;
unfunded nature of the plan;
source of retirement and other benefits; and
conditions that must be met to receive a benefit.
Source of Income
The important point from the perspective of deferred compensation is that once income is received (actual or constructive receipt), nonqualified income deferral possibilities cease. So, for the individual to defer his or her compensation under a deferred compensation plan, the agreement must apply only to income that is unearned at the time of the signing of the agreement. Only future income, not past income, may be subject to the deferred compensation agreement. As mentioned earlier, "top hat" plans are funded by deferrals of an executive's current income (and possibly additional contributions from the employer), while SERPs are funded exclusively by the employer.
The employer's agreement with the employee is a mere promise to pay an income benefit in the future. The employee has no right to any asset of the employer nor any right to income benefits prior to the events specified in the deferred compensation agreement that trigger the payment of income.
Those triggering events are generally:
The unvested nature of the plan applies even if the employer has purchased insurance policies or other assets to help meet its obligation to the employee. In the insured deferred compensation plan, plan participants are insured, but they do not have any interest in the life insurance policies. Under the insured deferred compensation plan:
the corporation owns the policies;
the corporation pays the premiums; and
the corporation is the beneficiary.
Employer Retains Rights
All payments made to the employee, the employee's spouse or family must flow from the employer. If the employer owns any insurance on the employee's life, none of the incidents of ownership should be transferred to the employee — not even at the employee's retirement — nor should the spouse or other family member be named beneficiary of the policy.
If the employer were to name the employee's spouse as the life insurance policy beneficiary or transfer some or all of the rights to the policy to the employee so that payments would be made from the life insurance policy, there would be adverse income tax results. Specifically, the premium the employer paid for the life insurance policy the employee owned generally would be considered current income to the employee.
Payments May Be Subject to Conditions
Conditions may or may not be a part of the agreement. These are clauses that condition the payment of the benefits upon the employee either doing something or not doing one or more acts, such as:
refraining from competing with the employer after retirement;
not attempting to assign the deferred benefits; or
remaining with the employer until retirement age and acting in an advisory capacity afterwards.
In years past, deferred compensation programs had to contain some limiting conditions, in order to avoid a finding of constructive receipt of income. Changes in the tax code have eliminated the requirement for conditions in a deferred compensation plan, but there are still good business reasons for inclusion of certain conditions.
An employer may be hesitant to enter into an agreement whereby the employee could terminate employment, receive the deferred compensation, and then immediately use the funds to finance himself or herself in competition with the employer. If the employer is concerned about possible employee actions that might be detrimental to the employer, the deferred compensation agreement should be drafted to include a provision that all benefits are lost if the employee were to violate certain agreed-upon conditions.
Sample Deferred Compensation Agreement Conditions Provision
CONDITIONS - The provisions of paragraph 3 [providing benefits] are conditional upon the continued employment of the employee by the Company (including periods of total disability described in paragraph 1 and subject to the provisions of paragraph 5 hereof) until the 15th day of June, 2020, or his death, whichever is sooner, and upon the further condition that, during the period that retirement payments are made, the Employee shall not engage in business activities that are in competition with the Company without first obtaining written consent of the Company.