Meeting the Needs of Businesses
Although there are certainly some businesses that provide employee benefits because they feel their employees are entitled to them, there are many more businesses that install employee benefits because they feel they must do so in order to compete for talented employees. While these latter firms may be giants, this feeling, i.e. that particular benefits must be provided in order to compete, is highly characteristic of closely held corporations and other business forms in which the owners take an active part in the day-to-day management of the business. It is to these businesses that nonqualified plans are most attractive.
The needs of businesses that are met through nonqualified plans generally fall into the following categories:
The ability to attract key talent
The ability to retain identified key executives
The ability to reward high-impact achievers, and
The need to maximize the beneficial impact of allocated employee benefit expenditures
Let's look at just what each of these needs involves.
Attracting Key Talent
It is not unusual in many industries for a few extremely talented individuals to gain industry-wide recognition for their talents and ability to produce meaningful business results. Although these individuals may be CEOs, it is more likely that they hold other senior management or professional positions. Attracting them to fill key spots in the organization can be very challenging, especially if the organization's pockets are not as deep as those in other industry firms.
Let's consider a real-life -- if hypothetical -- example. IBM, because of its enormous capitalization and outstanding reputation, probably wouldn't have much difficulty luring a talented executive away from a much smaller competitor if it chose to do so. It would be able to sweeten the pot until the executive agreed to join it. One of the incentives that it could offer is a special salary continuation plan that pays the executive an income at retirement in addition to the organization's pension and profit sharing plans. Regardless of the final offer that it made to the executive, IBM's likelihood of success is high.
Turn the example around, however, and we can begin to see more clearly the importance of nonqualified plans. Suppose Dot.Coms `R Us, a small high tech company, is trying to lure an IBM executive away from Big Blue. Not unlike many start-up companies, Dot.Coms `R Us offers enormous potential if it is successful. What it doesn't usually offer are the following:
Fringe benefits similar to those of a large company, and
The principal reason for its more modest fringe benefits is economic. In a word, the cost for such benefits for all employees may be substantial. However, by using a nonqualified plan, Dot.Coms `R Us could tailor-make a fringe benefit plan solely for the executive that it is trying to attract. Furthermore, it can shield those benefits from its creditors. (This protection from creditors will adversely affect the tax treatment of the plan, but it will guarantee that the benefits are available if the employer were to fail.) While the availability of a nonqualified plan won't guarantee that Dot.Coms `R Us will attract the executive, it can help to make up for the benefits he or she would give up by leaving the industry giant.
Retaining Key Executives
Just as these nonqualified plans can be used to help attract key talent from other firms in the industry, they can also be employed to help ensure that the key executive is motivated to remain with his or her present employer. Although any special benefit provided to a key executive may be sufficient to retain him or her, one nonqualified plan -- a salary continuation plan -- performs this function so well that it is often referred to as the "golden handcuffs."
One of the important nonqualified plans -- the one that we will examine in chapter 2 -- is called generically a nonqualified deferred compensation plan. In fact, a nonqualified deferred compensation plan may involve an actual deferral of income by the executive (a true deferred compensation plan) or not (a salary continuation plan).
Normally, a firm that is interested in ensuring that a key executive remain with the company will install a salary continuation plan for him or her. Under the terms of this plan, the executive may receive a continuation of some portion of salary for 10, 15 or more years beyond retirement along with any regular pension benefit. However, if the executive were to leave the firm's employ before retirement, he or she would forfeit all of the salary continuation benefits.
Consider the impact that this kind of a plan might have on a key executive. Suppose that Jim Clark is an executive at Dot.Coms `R Us and he is earning $200,000 annually. He has a salary continuation plan under which Dot.Coms `R Us will pay him 50 percent of his salary for 10 years if he stays with the firm until retirement. If he leaves the firm before that time, he will lose all of those benefits. Even if Jim never received another increase in salary, his salary continuation plan will pay him a total of $1 million in the 10 years after he retires. If he leaves Dot.Coms `R Us before retirement, the entire $1 million is lost to him. At the very least, Jim will think long and hard about what he would lose before he left to work for someone else.
Rewarding High-Impact Achievers
Current income is the primary method of rewarding executives in Western society. Although the employer must pay the high-impact executive a salary that he or she considers appropriate for the job being performed, current income has certain limitations.
Current income's first limitation is its diminishing ability to motivate. If the executive is currently earning $80,000, an additional $50,000 in salary may be quite motivating. It is likely that the executive will both grateful and highly motivated -- at least for a period of time. However, if the executive is already earning $500,000, an additional $50,000 in salary is considerably less motivating. Furthermore, the motivation level of even our first executive who is now earning $130,000 will probably wane before too long, particularly if the employee's next raise is less than $50,000.
The second limitation of current income is caused by our progressive income tax structure. The top federal income tax rate is 35 percent. All but 9 states levy a tax on earned income, and their top bracket, on average, is about 7 percent. These two income taxes produce a composite marginal income tax bracket of about 40 percent (remember, the state tax is a deduction against federal income). As a result, a $20,000 raise to an executive in the top income tax bracket amounts to only about $12,000; $8,000 is lost in income taxes. That additional income must also be invested and, at an 8 percent annual taxable return, will net about 4.8 percent after taxes.
Consider how much better the executive would fare if his or her employer took the $20,000 raise and deferred it in a nonqualified deferred compensation plan. The entire $20,000 would be invested by the employer (rather than $12,000 after taxes), and the earnings on the investment would not be taxed to the executive until the funds were received.
Maximizing the Impact of Employee Benefit Expenditures
Everybody wants to get more "bang" for his buck. That sentiment applies to the money spent for employee benefits just as surely as it applies to other things. The question, of course, is how to get that increased impact.
A true story may illustrate. Some years ago a major eastern mutual life insurance company sought ways to provide increased motivation to its field force -- not an uncommon objective. One strategy followed another, and each was introduced with more fanfare than its predecessor. Unfortunately, none of these strategies produced the desired result -- that is until a sales campaign was mounted that offered agents an opportunity to win a green blazer bearing a distinctive crest. The results were gratifying as one agent after another met the qualifying sales benchmark.
The competition for these green blazers was intense. One of its more interesting aspects was the identity of those agents that qualified. For virtually all of the winners, the economic value of the blazer was insignificant. These were people in the top 1 percent of earners and could easily afford to purchase the blazer if it were available. Furthermore, the highly visible crest on the pocket meant that the blazer was probably inappropriate for use at many social occasions. What the blazer did, however, was to set these individuals apart from their colleagues; by virtue of being awarded the blazer, they became a select group. Nonqualified plans offer the same kind of setting apart and may provide similar motivation to achieve.
Identifying a key executive and establishing a nonqualified plan for him or her makes a statement about the executive's value to the firm. Although other employees would probably be unaware of the nonqualified plan, the message is not lost on the executive. The selectivity offered by nonqualified plans generally enables the employer to gain maximum motivational impact from its benefit dollars.