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| Sales Insight - September, 2008 |
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Imagine that a client – a 42-year-old manager of
a privately held company – calls you, concerned and seeking advice. He says:
“I’ve been offered an opportunity to participate in my company’s non-qualified
deferred compensation (NQDC) plan. It’s quite an honor.”
You ask why he is concerned.
He says: “Participating in NQDC gives me the
opportunity to defer salary and bonuses rather than taking taxable cash. But my
tax bracket isn’t very high yet, and I could use more liquidity, especially
since my children are moving toward college age. Mainly, I’m concerned how safe
my money will be in the plan. I can’t access my NQDC money until I leave the
company, die or retire. Although the plan is funded with corporate-owned life
insurance (COLI), the policy belongs to the company, not me. I would be a
general unsecured creditor of my employer. If the company becomes insolvent, I’m
worried what would happen to my money.”
You tell him you will look into it, and here’s
what you find: His company has been expanding rapidly with borrowed money. It is
a secretive private company with financial statements that are closely guarded
and not accessible to most executives. The company operates in a competitive
industry with vulnerability to the economic cycle. Its owners want to recruit
and retain executive talent, but they aren’t willing to pay salaries comparable
to competitors’.
Why is this information valuable? NQDC has become
one of the hottest products of the life insurance industry, and agents are
aggressively promoting its benefits to companies of all types and sizes.
However, for reasons detailed in this article, NQDC is not suitable for some
types of companies or executives, especially when compared to alternative
benefits or savings/investing programs. Even in companies with a valid need for
NQDC, executives should carefully consider the pros and cons of participation
with professional help.
Some life insurance companies are omitting part
of the NQDC story. Your ability to fill the gaps will make you a more valuable
advisor, and this article can help.
A Brief Review of NQDC
NQDC represents an agreement between an employer and its executives under which
the executives agree to defer compensation until a future date, mainly to delay
payment of current federal income tax. By meeting a few basic “top-hat”
requirements, the employer can adopt the plan without the obligations or
restrictions of ERISA and selectively decide which executives participate.
NQDC plans may be unfunded or “informally funded,” but in either case, the
employee may not derive economic advantages from plan assets until benefits are
paid out. The failure to comply with this provision will result in having
compensation immediately included in the participants’ gross income for federal
income tax purposes. Under the Section 409A requirements of 2004 tax law, if the
IRS determines that deferred compensation should be included in gross income, it
may levy on the plan participant an additional 20% excise tax, plus interest.
In today’s market, most NQDC plans are funded with corporate-owned life
insurance (COLI), and variable COLI is claiming a growing share of the market.
Variable COLI offers each executive a menu of investment options, similar to a
401(k) plan, along with the opportunity to participate in equity-like returns
with tax-deferral.
COLI also offers tax-deferral advantages for corporations because the inside
build-up of cash value is not currently taxable. Because participants in NQDC
tend to be relatively healthy, upscale, and white-collar, COLI can offer more
streamlined underwriting and better pricing than individual life insurance
contracts. In some cases, more than 100% of first-year premium is credited to
cash value.
Filling the Gaps
The life insurance industry is doing a good job making the case for NQDC plans
funded by COLI. However, key points in the story aren’t always addressed. When
you are aware of these gaps, you will become a more objective advisor in helping
companies and executives evaluate these plans. They include the following:
- Personal liquidity –
Some corporate executives are deferring money into NQDC before
they have achieved adequate personal liquidity. Under the 409A
regulations, plan assets have become less liquid and
distributions can’t normally be accessed or accelerated except
for death, disability, or unforeseeable emergencies.
Otherwise, distributions are allowed at separation from
service, change in company ownership or control, a specified
future age or date, or subject to a domestic relations court
order.
Planning note: An executive who needs money to make
college tuition payments probably will not be able to tap NQDC
money because college costs are foreseeable and non-emergency.
Some executives have been forced to resign from their
companies to gain access to the liquidity they need for
important financial needs.
- Lending to the employer
– In today’s market, as traditional bank financing has dried
up, many small companies are paying interest rates of 10%+ for
financing. As a general unsecured creditor of the company, the
NQDC participant probably will earn less than a 10% return on
plan assets. In bankruptcy proceedings, courts can erase or
greatly diminish the value of claims by all unsecured
creditors, including NQDC participants. According to the U.S.
Economic Census, the average U.S. start-up company lasts about
12 years before going out of business. Therefore, many
companies will not outlast the lock-up provisions of their
NQDC plans.
- Lack of diversification
– Executives who already have a large part of their net worth
tied up in their own company may be poor candidates for NQDC.
If employers fail, they may not have enough diversification to
weather the storm. In public companies, most executives who
already own substantial employer stock or options would not
consider it a great idea to buy the company’s bonds. Yet, as
NQDC participants, they stand with (or even behind)
bondholders in line to be repaid.
- The cost of COLI –
Although COLI offers better insurance costs than individual
life insurance, it isn’t cheap. Each executive’s NQDC account
typically mirrors the growth of policy cash value less
insurance contract costs. In variable COLI, this can be
roughly equity market returns less 2-3% per year. When equity
markets were achieving 10% average gains per year from
1975-2000, executives could grow NQDC accounts by 7-8%
annually. But over the last seven years, the S&P 500 Index has
averaged a total return of just 2.5% per year, leaving an
average variable COLI NQDC account about flat after expenses.
It’s small compensation for the risk of being an unsecured
creditor during a period of economic uncertainty and credit
market distress.
- Tax cost and complexity
– The life insurance industry often touts the attractive tax
benefits of NQDC without mentioning tax drawbacks. First, the
IRS requires FICA and FUTA (federal unemployment) taxes to be
assessed on deferred amounts at the time they become vested –
which usually means in the same year they are deferred.
Secondly, several states have adopted “source tax” rules
designed to tax any compensation earned in-state. To make sure
they receive their share of income tax, these states limit the
maximum tax deferral period to 10 years. Due to complexities
and lack of consistency among states, NQDC practitioners say
it is difficult to obtain clear and accurate information on
state income tax rules.
Planning note: In 2008, the employee’s portion of FICA
tax is 7.65% on the first $102,000 of gross earnings and then
1.45% on any additional earnings. (6.2% is the capped Social
Security portion and 1.45% is the uncapped Medicare portion.)
However, Barack Obama has proposed removing the cap on the
Social Security portion above a specified level of gross
earnings. Such a change, if enacted, could increase the tax
impact on NQDC participants, who must meet payroll tax and any
state source tax obligations by pulling cash out-of-pocket.
- Administrative complexity
– The life insurance industry is touting simplified
“turnkey administrative packages” for the NQDC market, even
though it’s difficult to cookie-cutter plan administration in
this market. For example, companies that sponsor both
qualified and NQDC plans must make sure that their documents
and communications do not link NQDC eligibility with an
executive’s agreement not to participate in the qualified
plan. Companies must make sure that the NQDC plan has been
formally adopted by the Board of Directors and that
participants have no ability to gain economic benefit from
plan assets, such as using those assets directly or indirectly
as collateral for personal loans. The IRS urges its auditors
to “determine whether the company (sponsoring the NQDC plan)
has paid a benefits consulting firm for the executive’s wealth
management,” presumably to establish whether the company is
commingling current and deferred benefits for top executives.
Planning note: It’s important for NQDC participants to
realize that even if the company is clearly responsible for
administration errors, participants will bear most of the tax
cost, including any excise taxes and interest assessed by the
IRS.
- The drift of income tax
policy – For executives, NQDC will work most effectively
if federal income tax rates are lower in the future than they
are today. Of course, it’s impossible to know whether federal
income tax rates go move higher or lower. But growing federal
deficits and populist sentiment favoring higher taxes on the
wealthy (e.g.,, the “Obama plan) should be considered. Some
executives take NQDC payouts in a lump-sum, either because the
plan mandates it or they no longer wish to be an unsecured
creditor after leaving work. Lump-sum payouts can push
executives into a higher federal tax bracket – e.g., from 28%
to 33%.
Planning note: It may not make much sense for
“executives-on-the-rise” to participate in NQDC because future
increases in compensation may push them into higher tax
brackets, even if federal income tax rates stay constant. The
higher the executive’s tax bracket is now, the more sense NQDC
makes.
- Miscommunication – The
NQDC story isn’t quick or easy to tell, and it’s possible for
executives to hear a story not supported by facts. For
example, Rabbi Trusts are touted as a proven way to protect
NQDC funding. However, Rabbi Trusts have value in protecting
assets against a change in company ownership/control – not
against insolvency or bankruptcy.
The tougher 2004 rules on NQDC plans were prompted by abuses
at Enron, where more than 100 top executives received
accelerated distributions totaling more than $50 million just
before the firm collapsed. In the post-Enron era, when IRS
auditors are examining the fine print of NQDC plans in great
detail, experienced practitioners say there is no reliable way
to protect plan assets against a company’s insolvency without
subjecting compensation to inclusion in the participant’s
taxable income. Because bankruptcy judges can “claw back” NQDC
plan distributions made up to 12 months prior a bankruptcy
filing, executives are not “off the hook” until a full year
after distributions are made.
- Transparency – NQDC
participants in private companies can be even lower on the
creditor chain than some secured creditors. For example, a
bank that loans money to a company on an unsecured basis
usually has access to a full set of financial statements, and
it can write a loan agreement containing specific terms and
covenants. Plan participants working for private companies may
not have this leverage or transparency. Even if an NQDC plan
is funded with COLI, it is possible that the plan could pledge
the policy or borrow its cash value, especially if the company
needs cash in a pinch. The more highly leveraged a private
company’s balance sheet is and the less visibility it gives
plan participants into financial statements, the less
attractive NQDC may be.
- Economic cycle
vulnerability – Executives with strong loyalty to their
employers may not be aware how vulnerable the company is to
changes in the market environment or economic cycle. To gain
objectivity, it’s usually a good idea for an executive to
order a Dun & Bradstreet credit report on the employer before
deciding to participate in NQDC. The report can illuminate the
company’s current financial and competitive position,
creditors, and other key data.
Planning note: NQDC should supplement competitive
executive pay packages. When companies offer NQDC in lieu of
competitive salaries, they are asking executives to finance
part of their own compensation, and this can be a warning sign
of vulnerability.
- More attractive
alternatives – The life insurance industry’s prima facie
case for NQDC is the fact that highly paid executives may have
limited ability to participate in their company’s 401(k) plan
due to nondiscrimination requirements and top-heavy rules. But
that was before the Pension Protection Act of 2006 created a
streamlined new “safe harbor” for 401(k) plans that adopt
Qualified Automatic Contribution Arrangements (QACAs). You can
read about it here:
http://www.freeerisa.com/insightnew/200611si.asp
Plans that adopt QACA guidelines and agree to
make a non-elective contribution of 3% for each non-highly compensated employee
(or an annual employee matching contribution) are no longer subject to
non-discrimination tests or top-heavy rules. For companies with fewer than 100
employees, SIMPLEs offer relief from discrimination tests and top-heavy rules.
For 2008, a corporate executive age 50+ is
eligible to defer $20,500 into a 401(k) and also participate in employer
contributions up to a total of $46,000 in annual plan additions, assuming the
plan has adopted a QACA. The argument that top executives are handicapped in
their ability to plan for retirement with 401(k)s is no longer as compelling.
Also, in many companies with younger executive
teams, Executive Bonus Plans funded by life insurance may be more appropriate
benefits than NQDC plans. In these plans, executives can own the life-insurance
policies, tap cash values for personal liquidity, and rely on the death benefit
for family protection – without the complexities of NQDC administration or the
risk of company insolvency. (The drawback is that executive bonus plan premiums
are paid by the executive with after-tax dollars.)
In Summary – Know When NQDC Works
When you are able to fill gaps in the NQDC story, you will be in better position
to recommend participation to executives when it is suitable. For example, NQDC
works best when: 1) the participant is in a high tax bracket and has already
built personal liquidity; 2) the participant has a well diversified portfolio
not over-concentrated in employer securities; 3) the company has a strong
balance sheet not over-leveraged; 4) the company gives participants transparency
into its financial statements; and 5) all plan details are carefully reviewed by
a competent third-party administrator. It also helps when the employer is
supplementing the participant’s own plan deferrals with company contributions
through a “401(k) mirror” or Supplemental Executive Retirement Plan (SERP)
design.
Suppose you are prospecting to install NQDC plans at the company level, and you
encounter a company where all of the above requirements are met. In that case,
you can be more confident that the plan will become valuable for the company and
its executives and profitable for you. The NQDC plan sale at the company level
opens doors to providing personal insurance and investment services to
executives and building strong long-term relationships with them. However, the
plan can only be a winner for insurance companies and agents if its benefits
trickle down and materialize for all participants, many years from now.
By filling the information gaps for NQDC participants, you also will become more
effective at qualifying companies that are the best prospects for these plans
and making sure they keep working on a continuing basis.
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