Best practices for nonqualified deferred compensation
Kirk Wolf, CFA
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I am, in fact, a native of the great state of Alaska. And I won’t spend too much time talking about it because I notice we have some people who are here from Texas. Is there anybody here from Ketchikan, Alaska? Nope. Anyone? Has anyone ever heard of Ketchikan? Awesome. So you went on a cruise. You went through Ketchikan? Ketchikan is a little coastal community in southeast Alaska with about 8,500 permanent residents. When I was growing up, there were a couple of thousand less than that. It was a great place to grow up. I loved it dearly. I still have family up in Alaska. But 27 years ago, I met a staggeringly beautiful, strawberry blonde–haired lady, and she did not want to live in Alaska. So I find myself in southern California. And it’s been wonderful.
I have three kids, a daughter who just graduated from college, one who is starting her sophomore year in college, and a son who is a senior in high school. And that’s going to be relevant as we go through the discussion about deferred compensation. I’ll touch on that in just a second.
I’m going to talk about specific communication issues with deferred compensation. But the title of it is “Best Practices in Deferred Compensation 2018,” which is great. It’s a wonderful title.
What I’m going to do, though, from a practical standpoint is kind of start with a high-level overview of what nonqualified deferred compensation plans are and the environment in which we exist today that makes them attractive. We’ll talk about some specifics in terms of how they’re designed and, more importantly, how you as an advisor can use this information to generate business for you and to solve problems for your clients, whether those are clients on an individual level or clients on a corporate level.
Then we’ll talk about some of the specificity in terms of the plan design, and that’s where we get into the best practice about how companies are using them to meet the needs of both the corporation and the key employees of an organization.
And finally, we’ll get into some of the pros and cons of the plans and things that you want to be watching out for. Throughout that time period and in the presentation, I have three or four slides that have three little circles on them. And in those three circles, there are questions. Some of those questions are going to be relevant to you; some of them aren’t. But when we see those circle slides, that will be an opportunity for you to ask questions about what I’ve covered up to that point rather than raising your hand in the middle of the discussion. And then at the very end, if we move things along smartly, we’ll be able to have some Q and A time.
I was struck when I first saw the photo up on the screen. [visual] Yeah, who is that guy? And it dawned on me that maybe I might want to have a more recent photo taken, and then, of course, I thought, No, why would I do that? I have more hair there, and I like that. But it hit me how quickly time passes. That picture was taken just 10 years ago. Now, have any of you ever asked or said to yourself, Man, time flies. And it seems like it’s accelerating, doesn’t it? The older we get, the faster it goes.
Now, there are a couple of things that I’ll mention because they’re relevant to our discussion. The first one is from just a mathematical perspective. When you’re 5, time drags, and it takes forever to get through the day. If you’re in preschool or whatever, it takes forever. That’s because each year when you’re 5 is 20 percent of your life, it’s a massive function of your life. It’s a huge component of it. When you get a little bit older, 50, now it’s 2 percent of your life. And so as a percentage of life experience each year, it is a much smaller component of that. And because of that, time as we get older seems to go much faster.
There’s another side of the equation, and this is where it’s really relevant to all of us. There’s a group of researchers out of the University of California, Santa Barbara, UCSB, and it’s a wonderful school. My middle daughter attends there. It’s right on the coast. It’s beautiful. If I had known it existed when I was going to college, I wouldn’t have gone to Pullman, Washington; I would have gone to UC Santa Barbara. But the researchers there came up and started looking at this whole concept, the psychological concept of time and how it seems to accelerate. And what they found by interviewing people is that when they would talk to individuals, and they would ask them to talk about their lives, most of their experiences, the more meaningful things, were when they were younger. They were talking about their childhood. The most vivid memories come out of your childhood. And I think that’s probably consistent for most of us in the room.
Then they said, “Well, let’s not talk about your childhood; let’s talk about recent things.” And as people would talk about the recent—the last couple, three, four, or five years—they would focus on vacations. That’s kind of how we would define our lives. And what the researchers found they called a “holiday paradox.” It’s that when you’re younger, it’s meaningful because everything is new. It’s a new experience. It’s a new thing that you’re doing. You’re learning how to ride a bike. You’re learning how to spell. You’re learning how to read. You’re learning how to climb a tree. It’s all new. And so it imprints on your brain; it’s really significant.
Then, as we get a little bit older, things become a little bit more rote. I suspect a number of you, when you drive to work, take the same route every day. If you go to church, you sit in the same seat or the same pew. We do things because it just becomes natural. And what happens, and this is what the researchers found, is that when we’re doing things that we’ve always done the way that we’ve always done them, time really just disappears because nothing significant happens. And what they found is that if you want to add value, if you want each year past age 10 to be meaningful, you’ve got to add something, which is why people remember their vacations because they’re going someplace new or doing something new.
As a graduation present, my wife and I took our eldest daughter to Hawaii, and we went skydiving, which is awesome. If you have the opportunity, please do so. Just remember, as you’re freefalling, make sure to clear your ears. I still can’t hear out of my right ear. It’s just terrible. The point being is that as we age, if we want to have more life in our years as opposed to having more years in our life, we have to do new things. We have to try new things and have new experiences. And that counts during our working years, and it also counts during retirement. The reason all of this matters is that doing new things and trying new things costs money. So if you’re going to do that as a retiree, you need to have sufficient savings, and that’s part of what we’re going to talk about today too.
But we’ll talk about the environment. We’ll talk about the basics of deferred compensation. And by the way, just so we’re on the same page with regard to this, I’m going to say, “non-qual.” I’m going to say, “nonqualified deferred compensation.” I’m going to say, “NQ.” And I might say something else. It’s all the same thing: nonqualified deferred compensation plans.
The plans that I’m going to talk about, interestingly enough, are governed under Section 409(a) of the Internal Revenue Code. Now, you say to me, “Kirk, why does that even matter?” Because 409(a) governs nonqualified plans of all shapes and sizes whether it’s just an individual split-dollar arrangement that an employer has with key employees or up to a 5,000-employee deferral plan. It all gets covered under Section 409(a) of the Internal Revenue Code, which coincidentally enough, a little sense of irony in our lives, what room are we in today? 409A. I saw that, and I thought, Wow, I couldn’t have planned that any better. Fantastic. So if you remember nothing else about the presentation, remember 409(a). Those are the governing rules behind these types of plans. So we’ll talk about that a little bit.
Then we’re going to focus on the No. 3 bullet (primary uses) and the No. 5 bullet (sales opportunities). [visual] We’re going to spend a little bit more time on those things because that’s where it’s relevant. We’ll talk about how the plans get used, how you can use this plan, and something to think about. A nonqualified plan is a solution in search of a problem, and it’s a problem that an employer and/or the key employees have.
So let’s take a look at the environment right now. What’s happening today? We have historically low unemployment. It’s fantastic. It’s a very good thing. It means people are working. We also have almost historically low underemployment. And underemployment is kind of an interesting term. Underemployment just means that the CFO isn’t working at H&R Block as an accountant; the CFO is doing a CFO job. When we have higher unemployment, people have to take whatever is available to them, so it’s an interesting position that employers and employees find themselves in. So we’ll talk about it from two different perspectives.
As an employer, when I’m looking at the marketplace right now, I can find a lot of rank-and-file employees. But finding the top talent, the people who are going to drive the bus and make my corporation successful, whether it’s a small business of 50 to 100 employees or a mega Fortune 200 firm, it doesn’t really matter. Finding the people, the top talent, that’s the challenge. And there’s a war on talent right now. You add to that from a demographic perspective, what’s the largest cohort group that we have right now? It’s the baby boomers, right? There are a zillion of them. Who identifies as a baby boomer? See, I got a bunch of them here.
Then, the next group coming after that are the Gen Xers. Millennials in the back, keep your hands down. Of course the millennials are sitting in the back. You guys need to move forward; be part of the rest of the group. I shouldn’t even tease; those are my security team back there, and they’re trying to make sure nobody rushes the stage. I appreciate that. But after the baby boomers, you have Gen Xers, and Gen Xers are a much smaller population, a smaller cohort. That’s what I am. My wife is. And the problem that employers are facing is that the baby boomers are retiring, and there are not enough people in that next group to fill in the gap. So we have a big issue. I don’t have enough people. I have unemployment that is at an all-time low. Underemployment is at an all-time low, and guess what? It now costs me more to find people, and it costs me more to retain people. And as an employer, I’ve got to figure out different ways that I can solve this problem without having rampant wage growth.
So right now in our environment today, this is the issue that the employers are facing. And there are a couple of different studies. I won’t go through the details on all of this, but suffice it to say, there’s a Towers Watson study, and the Employee Benefits Research Institute also came out with a study that talks about the cost of replacing top talent. And here’s the thing: Most employers, more than 50 percent of the employers surveyed, are saying that they’re having a hard time finding high performers and finding potential high performers. And they’re having an equally difficult time holding on to them once they find them.
There’s a financial cost when (a) I have to take a lot longer to hire somebody, and (b) somebody who works for me leaves. It’s always better to hold on to those who are capable and competent than to have them leave and try to replace them. The Employee Benefits Research Institute’s calculation was a little bit higher than the numbers that you see here. [visual] What they said is that to replace somebody at the top echelon is going to cost you somewhere between 75 and 150 percent of your annual comp. So if I lose somebody who’s making $300,000 a year, I have to take time to find somebody. I can’t just go into the Yellow Pages and pull; they don’t do that anymore. But I can’t just jump out on jobs.com or something and find somebody who’s going to slide into that position. It’s going to take time, and then I’ve got to integrate him or her into our corporate culture. And there’s an expense associated with that.
So, when I look at it as an employer, and all of these folks are responding in the same way, they’re saying it’s better to hold on to people. If I have them, I want to keep them. And then I’ve got to figure out a creative way to bring them in for the people who are retiring. So if I’m going to do that, I should know what my employees want. And in the survey that we recently did through plansponsor.com and through the Boston Research Group, here’s kind of the information. [visual] These are the top things that are critical to somebody in that group, in that highly compensated key employee group.
They want to be able to save money on a pretax basis. And by the way, can we, just as a group, agree that in almost all circumstances, savings on a pretax basis is better than savings on a posttax basis? Now, I know there’s going to be somebody in the room who says “Well, what if?” I know. There’s always a unique circumstance in a situation. But as an individual, it is almost always better, unless, of course, you find yourself in the unique position that when you retire, you move up three or four tax brackets. And if you’re in that position, God love you. That’s awesome. I will not be in that position. My tax bracket will probably decline because retirement simply means nobody else is paying me.
So folks in this group, what are they concerned about? Retirement savings. They’re also concerned about savings for other issues. I didn’t mention this at the very beginning, but not only have I worked with nonqualified plans for the last 23 years, I’ve also been in financial services for 25, non-qual plans for 23 years. I love them. I think they are one of the most creative benefits that employers can offer and that advisors can help employers offer to their key employees. They’re a fantastic benefit. I’m also a participant in a deferred compensation plan. So I’m kind of one of the worst. I’m like a pastor preaching to the choir because I’ve already been committed to it. I love non-qual plans. So understand as I’m showing you these things that these relate to my life as well.
Here’s the other one, the third block down below: managing taxes. [visual] So, it’s retirement savings, savings for future goals, other things that I have, and managing taxes. Do any of you have clients who are in high marginal tax brackets today? Don’t be shy. Do any of you want to have clients who are in high marginal tax brackets right now? Of course we do. These are the people whom we want to work with. And those are the people who are in a distinct need position where they want to save money. So, we’ve got folks, and we’ve got an employer who’s trying to figure out creative ways to bring people into the fold. We have employees who say, “Here are our major concerns.” And then we’ve got another aspect.
If you look at this chart, here’s what we see. [visual] If you play by the rules and you defer money on an ongoing basis from the moment you start working, as your income climbs, your ability to create a replacement ratio that’s sufficient for most people to live on declines. It’s interesting. If you drew a line from the C in current income, do it straight up. [visual] That’s somebody who’s making about $175,000 to $180,000 a year. I’m not talking about somebody who’s in the $300,000 to $1 million-comp range and above. I’m talking about regular folks who just happen to be blessed to be making a decent income. Because the qualified plan limits us, doesn’t it? It limits how much you can put away. And if you’re like me, you didn’t start saving the max in your 401(k) the day you started working because, I don’t know, you were trying to buy a car and a house, and you and your wife kept having more and more kids. And they’re expensive. And it wasn’t until the kids got a little bit further on that it was like, Holy mackerel, I need to save! And then you get to the point where your income is sufficient, and you are closer to the end of employment than the beginning. You have a savings gap.
Now, some people will look at that and say, “Well, 80 percent replacement ratio? You don’t need that much money.” I have a plant in the front row who believes the same way that I do. Here’s the reality: We’re going to need that much money. You’re going to need that if you want to maintain the standard of living that you and your spouse or significant other have become accustomed to, and your clients have been accustomed to. So you notice I’m going to kind of bounce back and forth talking about how you can use a non-qual plan to meet the needs of your key employees or your clients and how it also relates to us as individuals. Don’t let that disturb you, and if it throws you off a little bit, just wave your hands, and I’ll stop. And I’ll just speak in the third person on that.
So, we have an issue in our environment today. We don’t have enough people. We have corporations that are expanding. We have the desire to replace people as they’re retiring, and I don’t have folks coming behind, so what am I faced with as an employer? I pay people more to try to recruit and reward them. The problem is when I pay people more, what happens? It doesn’t meet the needs that we saw on the previous slide. They want to save on a pretax basis, and so just throwing more money at them doesn’t necessarily do it. You get to a certain point in the margin utility, and that extra dollar doesn’t really matter.
So, we have a problem. Let’s look and see a potential solution for it. Just so everybody is on the same page, what is a deferred compensation plan? What’s a nonqualified plan? If you strip all the bells and whistles out, a nonqualified plan is simply an agreement between you as an employee and your employer, where you say, “Listen, don’t pay me this money—salary, bonus, commission, whatever it happens to be.” Or “Don’t give me the bonus you were going to give me. Put it away for me on a pretax basis. Let me help you with the investments. Let me make investment choices with regard to that and pay me that money at some point in time in the future.” Doesn’t that sound suspiciously like a 401(k) plan?
What do I do with a 401(k) plan? I defer money pretax. I get to pick and choose the investments that the 401(k) plan has and when the money comes out, I pay ordinary income tax just like a deferred comp plan. Very similar. And in today’s world, which is very different from what it was 22 years ago, nonqualified plans are built to look and act, in most cases, like a 401(k) plan, unless we’re doing a one-off plan for an individual, and I can touch on that a little bit later.
Nonqualified deferred compensation plans look and act like a 401(k) plan. There is a benefit for the employer and a benefit for the employee. And we’re going to talk a little bit about how they get built. We’ll talk about that in just a second. Just so that we’re clear on this, it’s a very simple process. The employee defers money into the plan, and/or the employer makes contributions for the employee. The plan has the money. It’s holding an asset and a liability. Then, at some point in time, the employee takes a distribution from that plan, and guess what? He pays ordinary income tax on it. And he takes either lump-sum distribution or payments over time depending on how he’s set it up. And from an employer perspective, the employers gain a benefit as well. Not only have they been able to solve a problem for their key employees, but they also get a benefit that can be, in many cases—especially if we’re using corporate-owned life insurance, which again, I’ll talk about in a second—a tremendous benefit for them.
This is why employers use the non-qual plans. It’s pretty straightforward. The employers are using the non-qual plan because it allows them to fix a problem. Remember I said a non-qual plan is like a solution in search of a problem? I’m an employer, and see if this resonates with any of you in the businesses that you work with. I have 20 highly compensated employees. I have 1,000 non–highly compensated employees. Well, guess what? The 401(k) plans and qualified plans require discrimination testing. And that discrimination testing essentially says we need to be fair and equal with everybody. Our highly compensated people can’t have a benefit that’s out of whack with the non–highly compensated people.
I’ll give you an example. I work with a grocery store chain, a small regional grocery store chain, and they have 2,500 employees. They have 22 highly compensated employees. When they do their discrimination testing every year, the highly compensated people can’t even do the $18,500, if they’re over age 50, catch-up contribution amount. They’re limited. They’re limited to 2 percent more than the non–highly compensated to contribute.
Now, I’m giving you a bunch of numbers, but, essentially, that group of employees is contributing about $6,000 or $7,000 a year. Somebody who’s making $200,000 or $300,000 a year, that’s not enough. It’s not enough retirement savings. And so a nonqualified plan fixes that problem. The nonqualified plan is discriminatory and discretionary as well. Normally those are horrible words. We don’t want to talk about discrimination on any level. We want to be kind and nice to people.
In this context, it’s beneficial from an employer’s perspective because it allows the employer to pick and choose. It’s not a one-size-fits-all solution. I’ve got to pick and choose to whom I provide a benefit. Why do the employees want the plan? Well, for the same reasons we saw before. They need to save more money, and they know it. And the plan, a nonqualified plan, is a meaningful issue for employees when they choose to take or seek new employment. It allows them to do all sorts of wonderful things.
Let me stop right there. What we’ve talked about is we have an environment that is less conducive to having employees and makes it harder for employers to recruit, reward, and retain people. We have employees who are looking for more creative ways to be compensated so they’re not being killed on personal taxation. We have a need for retirement savings. We have a need for the employee to put away money, and we have a need for the employer to do something for this key group of employees, and they can’t afford to do it for everybody else.
So, the question I would ask you and that you can ask yourself is how is this relevant and germane?
You might say to me, “You know what? This is great, Kirk. I don’t really deal with retirement business at all.” OK. Do you deal with disability for corporations? Do you work in that market space? Do you have any clients who work for organizations, for companies? Or are they all retired? Do you have any clients who are highly compensated? Do you believe that savings on a pretax basis is better than posttax? I’m just going to assume that everybody does. And, would it benefit you to have the knowledge about deferred compensation plans so you could help them solve their problems? So just think for a second about that.
Question: On one of the slides, you indicated this is a pretax contribution. I’ve always thought of nonqualified as being after-tax contributions. Can you explain that?
Answer: That’s a really good question. And remember when I said at the beginning that there are lots of different deferred compensation arrangements and plans. Now we can have 162 plans, split-dollar plans, one-off employer executive benefit plans that are for business owners. In a situation like that, for the recipient, it is an after-tax deferral. What they’re doing, and I’m going to overly simplify it, so forgive me on this, is in essence using a life insurance policy to create like a super Roth IRA, where they’re putting away after-tax money because they don’t have the ability to defer anymore. Now, in that situation, you are 100 percent correct.
We also have the ability to create a 401(k) look-alike plan for non-owners of entities—S corp, LLC, LOP, it doesn’t really matter. C corporation is great, public or privately held C corporations. Where the entity says we have nonowner key employees that we need to reward and retain, and in that case, it’s pretax for the individual. And so their experience is a pretax deferral.
Answer: In a pass-through entity, and without going too deeply into the weeds, remember at the beginning when I said what a deferred comp plan was, where the individual says, “Don’t pay me this money. Hold on to it for me. Invest it for me, and pay it to me later.” So, as an individual, I haven’t received the compensation. I haven’t received the income today. I’m going to get it later. But since I haven’t taken it today, I have a promissory note from my employer promising to pay me this money plus growth in the future. I didn’t take it today, so I don’t have a tax consequence as an individual.
What if I happen to be so blessed as to be both highly compensated and the owner of an S corp. I’ve got 50 employees? We do a rug cleaning service and I’ve got vans that run everywhere else. And in the company, there are two people who are highly compensated: my wife and me. In that situation, as a pass-through entity, I don’t derive any direct benefit from deferring into a plan like this. Why? Because I take it as W-2, but no, I leave it with the company. What happens at the end of the year for a pass-through? It’s K-1 tax to me. And the tax rate is the same. So the individual who owns the organization doesn’t derive a direct benefit from deferring his or her own compensation. If it’s a C corporation, it’s a different deal.
C corporations, especially now with the tax changes, which we’ll talk about in just a second, have a lower corporate tax rate. So there’s a benefit.
The question asked was about the owner of pass-through entities. So I’m moving money from one tax bracket to the other. There’s no direct benefit. If we have a C corporation, and I’m a 10 percent owner of the C corporation, and I defer W-2 wages, I’m leaving it with the corporation. So I’m not paying personal income tax at my highest marginal tax bracket today. I’m leaving it with the corporation. The corporation has retained earnings and has tax associated with that. But it’s a lower tax bracket. They’re in California, so they’re paying a 29 or 28 percent federal and state combined tax rate. The corporation owes me this money. I deferred $100,000. I left it with the company. The company owes me that money. We invest that money, and it grows every single year. And we’re going to invest it inside a corporate loan life insurance policy so there’s no tax on the appreciation.
Then, 10 years from now, I can step back from my primary role with the organization, and I take distribution. So now, as an individual, I’m no longer getting paid by the company, so I’m in a lower marginal tax bracket. Maybe I move to Nevada where we have no state income tax. Is there state income tax in Florida? No. So I move to Florida because I like Florida better. There’s more ocean there than there is in Nevada. So I move to Florida, and now I’m taking distribution. And I’m in a lower federal tax rate, and I’m not paying state income tax on the money that’s distributed out to me. I deferred it at my highest marginal tax bracket; I take it at the lower tax bracket.
Now my ownership is neutral in the company. Because the company delayed a tax deduction when I deferred the money, they had to pay tax. But now, 10 years down the road when they pay me the money, they’re expensing it, and they’re recognizing the tax deduction. So it’s a neutral proposition for the employer. I am deferring it when I’m at my highest marginal tax bracket, and I’m receiving it when I’m in a lower tax bracket. Great question.
Question: There are many executives who are retiring. And they’re not necessarily in a low tax bracket because of the social security and maybe mandatory distributions, and then you add this on top of it. So does this concept work when you are indeed in a higher tax bracket?
Answer: That’s a great question. If I’m in a higher tax bracket when I retire, do I benefit? It depends. Probably not. That would be my gut assessment. But then I would ask you how long is the money going to be deferred? Because remember, when I deferred the $100,000, if that came to me, I’m paying federal and state—Uncle Sam and Uncle Jerry in the state of California—so I don’t have $100,000 coming to me; I have $60,000 coming to me, if I leave it and invest it, the entire amount—my money plus the money that Uncle Sam and Uncle Jerry are compounding. And so that compounded growth, depending on whether I have enough time, on money that wouldn’t have come to me in the first place, even though I have to pay tax on it when it gets distributed to me, depending upon how long and the growth that’s occurred, I may be better off, having used the deferred comp plan. Again, and I appreciate the questions, I don’t want to get too deep in the weeds on this because I don’t want to lose everybody with regard to it. But there are circumstances where even in a higher marginal tax bracket in retirement, it’s beneficial to me.
Now, if I’m deferring money today, and I’m going to take it out in three years, then no, it’s not worth it. It’s probably not worth the effort on your part. In other circumstances, where I have a longer investment time horizon, it’s potentially worth it.
Here’s how we design the plan: the who, what, when, and how. The who is the employer. The employer can pick and choose who’s eligible for the plan. Remember, I said that it’s a discriminatory plan? The employer can pick and choose. Now, the IRS says that they’ve got to be key or highly compensated employees of an organization or decision makers who have the ability to design or manage the construction of the plan. They also ask us to limit it to no more than 10 to 11 percent of the total employee population.
So it’s a relatively select group of employees. And as it turns out, it’s kind of consistent with how corporations pay people. Usually you don’t see an organization where everybody is a super highly compensated employee, unless it’s an attorney or a doctors’ group, and I’ll talk about them in a second.
We can also decide what contributions or what types of money are allowed to go into a plan. It could be employer or employee contributions or a combination thereof. You can allow the employees to defer a portion of their salary and a portion of any bonuses or commission, 1099 compensation—it’s up to the employer. And part of what we do, we being principle and other companies that do what we do, is to help the employers design the plan based on industry best practices. The employer can decide when you get the money and how you get the money.
Generally speaking, in today’s world, the when is pretty flexible. Separation of service and retirement are synonymous from the Internal Revenue’s perspective. However, we also allow for in-service distributions because, unlike a qualified plan, there’s no cap on how much money can go in, and there’s no penalty for early distribution. So the employee can set up to take money out while he or she is still working. I have done that myself. And it’s a wonderful thing.
And you probably guessed it. I set up money to take out while I’m still working because I’ve got kids going to college, and I was able to save money on a pretax basis for expenses that I knew were going to happen.
The employer gets to determine how the money gets paid out—operating, giving the parameters for the employees, lump sums or payments over time. So there’s a lot of flexibility with regard to how the plan gets designed, the paying for it, and the financing—that’s the interesting thing. We’ll see a slide about financing in just a second.
This is from a best practice perspective. Now, this is from a plansponsor.com survey of all the plans that are out there. [visual] Here’s the reality: With the plans that I write today, almost all of them have employer and employee deferral capabilities. Almost all of them give in-service distribution for employees. Why? Because it’s beneficial for both parties in the equation. So there’s a lot of flexibility in terms of how the plan gets designed to meet the particular problem the employer is facing.
Now, financing. At the very beginning, I mentioned a deferred compensation plan is simply this: It’s an agreement between you and your employer where you defer money. You leave it with the employer, and the employer gives you a promissory note. He owes you this money plus some growth component at some point in time in the future. Well, the employer can, if he wants to, pay you in the future out of company cash flow. I can look and say, “Listen,” and Fortune 500 firms used to do this exclusively. It was kind of the easy thing to do.
GE is probably a bad example right now, but let’s pretend. Let’s pretend that they haven’t had some struggles. What if I’m GE, and I’m saying, “OK, I owe my key executives $2 million in distributions this year. That’s a rounding error for us based on our global revenue.”? It doesn’t really matter. Now, that was the old school thinking.
Today, employers say, “Well, listen, if the employees are deferring the income, if I’m putting money away for the employees, it would behoove me to have a liquidity pool to have assets to be able to pay people because Lou might not wait to leave 10 years from now. Lou might leave next year. Maybe his life changes, and he retires earlier, and he needs this money sooner than I anticipated.” And so most employers today, about 95 percent of the employers that we work with, set aside a liquidity pool. They set aside a pool of assets so they have money to pay the employees. The other advantage is that I’m offering Lou a 401(k) experience. Lou has a bunch of mutual funds that he gets to invest that $100,000 that he deferred. As the employer, I’m accruing a liability. I owe Lou that $100,000 plus growth, right? So it would make sense for me to invest that $100,000 of asset in a manner similar to how Lou’s investing so that I eliminate market risk. I have an asset that grows at the rate or declines (if Lou makes early poor choices) at the same rate. So it eliminates market risk for me as the employer. Why?
Because as the employer, I’m not trying to make two cents on a length of pipe off a deferred comp plan. I’m trying to solve a problem for my key executives. I want to recruit, retain, and reward you. And I’m offering this benefit that you can’t get anywhere else, and it allows you to save more money than you can save in any other circumstance. So I’m going to invest the asset in a similar manner. And when I do that, that’s when those top two things apply. [visual] Below where it says Top Employer Financing Options, we see Mutual Funds and Life Insurance (COLI). The third item, Company Cash Flow, is kind of old school. We don’t see that nearly as much. Now some employers will do a combination of all three.
But here’s where it gets good.
If an employer has a short-term plan—I’m putting a plan in place for Lou and for Jerry, and when they retire, the plan is going to disappear. That’s a short-term plan. Maybe not super short term, but they’re going to retire in the next five, seven, or ten years. It’s not a permanent benefit. And so logically, as an employer, I’m going to use the least expensive investment vehicle. It only makes sense. So in those circumstances, we see employers using mutual funds as a financing tool. I offer them mutual funds as an investment on the liability side. I put the money in the same mutual funds as the asset side. It all works out. When I pay them the money, the plan is done.
When I have a plan that is permanent or perpetual where an employer says, “Listen, our 401(k) plan is irretrievably broken, and I want to offer a benefit to reward my top talent. I want this to be a benefit that’s ongoing for them. And when Lou retires, somebody is going to replace him.” So this is going to be an augmentation of my existing 401(k) plan, but it’s special just for my top people, and it allows me to provide a benefit for Lou that I don’t have to do for everybody else. Now it’s more of a permanent plan. And in that scenario, corporate-owned life insurance almost always is a more attractive vehicle, which I suspect, since most of you are affiliated in some way, shape, or form with either insurance sales or an insurance agency, and that’s where it becomes a little bit more attractive.
But, the thing to keep in mind is that what a company chooses to do is really going to be dependent upon the tax bracket, the earnings assumption, the realized versus unrealized capital gains, and the cash flow requirements. But with the new tax law, it really is contingent upon the perception of permanency or temporariness. That’s what it boils down to. Is this a plan that we’re going to have for this generation and the next generation of employees, or is it something that’s going to be done and gone in the next five to seven years?
I won’t belabor this particular point. Here’s what ended up happening. There was a brief period of time when the first proposals came out with the tax cut where they said that we were going to get rid of deferred compensation entirely. I was on a vacation, a 25th wedding anniversary vacation, with my wife in Europe at the time. We’d saved up for it, and we were out there. All of a sudden I started getting little pings on my phone. They said, “Have you read the proposals?” My wife asked me what it meant.
I said, “Well, it might mean that we’re looking for a new job.” Fortunately, it took about two or three days before cooler heads prevailed, and the lobbying efforts from corporations said, “Wait a minute, wait a minute, wait a minute! This is a huge benefit for our top people. You’re going to hose them and us, a technical term, if you end up killing these plans.” And so that went by the wayside. And, in fact, the nice thing about it is that it kind of reaffirmed the value of deferred compensation plans. And, what did we just have? We had a reduction in corporate tax rates for C corporations, a significant reduction. And here’s the downside for an employer.
I’m going to leap ahead on a bunch of slides and tell you this. It’s the delayed tax deduction. If Jerry defers $100,000 to me, I’m not paying it to his compensation today. I don’t get to expense it and deduct it in the current period. I don’t lose the deduction. And forgive me for getting too CPA and accounting on you. I don’t lose the deduction. I’m just delaying receipt of it. I’m going to get it when I pay it to her. And, because of the buildup that occurs with the asset, the future deduction is going to be greater than the one I delayed today. And so there’s a benefit that inures to me as the corporation. That lower tax bracket for C corporations does two things.
No. 1, it makes it less painful for the corporations to have deferrals today. How many of you believe in your heart of hearts that 10 or 15 years from now corporate tax rates are going to be as low as they are right now? How many of you believe that they are going to climb? I’m kind of in that boat too. And No. 2, it’s a revenue issue. It’s a political issue; it’s a revenue issue. Who knows? I don’t want to prognosticate too far. But the reality of it is that I’m a C corporation. I’m delaying a deduction at a 21 percent federal and maybe a zero percent in Florida estate tax rate. It’s not that big of a deal. And when I pay the money out to you 7, 10, or 15 years from now, and the tax rates have changed, I get a bigger deduction. It’s a win-win for me. So a lot of positives came out of it.
Now, I am going to go through the primary uses of non-qual plans. So stay with me. We’re going to go quickly through it.
No. 1 is fixing the 401(k). That’s the low-hanging fruit of deferred compensation. Our 401(k) is failing. The people who don’t make very much aren’t contributing enough, and so the people who do make a lot can’t contribute very much.
My dad, who was a closet socialist, says, “Hey, boo-hoo, you’re making too much money. It sucks to be you.” I say, “It’s not really fair. It’s not equitable. If you can defer 10 percent of your income, shouldn’t I be afforded the same opportunity?” Current plans don’t allow it under qualified plan benefit. And if you’ve noticed over the years, they’ve reduced that amount. So, No. 1 is fixing the 401(k).
No. 2, we saw on that gap slide before. What happens? As my income increases, even if I’m maxing out my 401(k) plan, I’m not going to be able to fill up that gap. I’m not going to be able to save enough to have a retirement replacement ratio that’s sufficient for me to retire on. That means I have to work longer, and I don’t want to do that. I’d like to be able to retire and do all of those unique life events that we were talking about that are going to make my life memorable, instead of doing the same thing over and over and over again. So I want to save for retirement, and this plan allows me to do it because there is no effective limit on the deferral amount for the employee.
No. 2 is also an employee benefit: taxation timing. I’m at my highest marginal tax bracket right now. If I defer income to the future when I’ve separated service, except for the rare and unique circumstance where I’m blessed, I’m going to be in a lower personal tax bracket. Or I’m going to be in the same if we see an increase in the marginal tax brackets because retirement just means nobody else is paying me any income.
If I defer it today, and I’m in the same or a lower tax bracket 5, 10, or 15 years down the road, I’m ahead of the game. And so, as an employee, the idea of deferring income today and moving myself to a lower marginal tax bracket is really attractive.
The other thing that I can do is I can take the deferred compensation money out first, the qualified plan money I have to be age 59.5 to take distributions. For non-qual, there’s no age. So I decided to leave at age 57. I retired at age 57. I take my deferred comp money until I’m 62. I take a five-year distribution, and then I start drawing on my other sources of income. It allows me to No. 1, potentially retire sooner, and No. 2, push the receipt of that qualified money further out into the future. It’s a tremendous benefit for me.
Now, here’s a real quick slide, it’s fairly self-explanatory. [visual] This is almost my life except my kids aren’t named Mary and Michael. I have Alex, Katie, and Ben. This individual is making $120,000 a year with a $40,000 bonus, and he said, “I’m going to defer 10 percent of my salary and half of my bonus. Now I’ve got $32,000 worth of savings that I couldn’t save anywhere else. And most of it is going to go to retirement, but not all. Because I know I want to pay for Mary to go to college, I want to set some money aside for her. I have a 529 plan, and it’s wonderful, but 529 plans only can be used for education. It’s after-tax money, and I’m in a high marginal tax bracket. This is pretax money, and I don’t have to use it for education. But I can. And so I’m saving money for life events that I know are going to happen, and for my retirement.” This is tremendous flexibility that I can tell you, from 22 years of personal experience, key executives and corporations love.
This last piece is corporation specific. It allows me to manage compensation. If I have to just pay Lou more money, how compelling is that to him? He likes it, right, short term. But does that create a huge benefit for him? It really doesn’t. What it does for Lou is it puts him in a position where he has a higher tax bracket. Now I’m in a bidding war with my competitors for Lou’s services.
When I use a nonqualified plan, I say, “Hey, Lou, instead of paying you an extra $20,000 or $30,000 this year, I’m going to put that into the deferred comp plan for you so you have more retirement savings.” And Lou says, “Fantastic.” And I, as the employer, can add a vesting schedule if I want to. I say, “Lou, I’m going to give you more money, but you really need to stick around for that.” And so I can golden handcuff my top talent, which solves the problem I saw on one of the first slides about people leaving. And I don’t have to give the same amount to Lou that I give to Jerry. I can give them different amounts. I can base it on Lou’s production or his performance. I can do things that are good for me as a corporation, so now, instead of paying out money, I’m tying it to corporate performance, and guess what else? What happened in 2008? It was a little economic downturn, a little hiccup.
People started losing their jobs. Now, if I was paying Lou $200,000 a year, and now I increase his salary to $250,000 a year, if we have an economic downturn, can I say, “Lou, I’m sorry, dude, I’m going to drop you back to $200,000”? No. I can’t do it from an HR perspective, and Lou is going to balk at that idea. However, if I say to Lou, “You’re making $200,000 a year; I’m putting $50,000 of profit sharing into the deferred comp plan,” and then I say, “Hey, Lou, things are tough. We’re not going to be able to make that contribution,” Lou’s just grateful he didn’t get laid off. So it’s a way for the employer to provide compensation management. It allows me to recruit, retain, and reward top talent.
What does it mean to me? Do I work with people who would benefit from taxation time, putting money away today and taking it in the future? Do I work with companies, or do I work with individuals who work with companies that have limitations on their 401(k)? And, do I work with individuals and/or corporations that would like to develop a more unique way of compensating their top talent? If any of those things are true, non-qual plans are going to be beneficial to you.
Here are the benefits for the plan sponsor, and, if it sounds repetitive, it is a little bit. [visual] Help organizations recruit, retain, and reward key employees. It’s a discriminatory, discretionary plan that they can offer to the people whom they want to, and they don’t have to offer it to the people whom they don’t. Everybody on this side of the room, I’m going to make a contribution. Everybody on that side of the room, not so much. Now, that’s a little extreme. I would do it for all of you too; you’re very nice people. But the employer has that discretion. The employer can make contributions or not at his or her discretion. The employer can use this plan to fix all the problems with 401(k) plans. It allows me to reward and retain people whom I can’t in any other way, shape, or form.
The downside? Delayed tax deduction. That’s the downside to a deferred comp plan. Now one of the other things that is up there: the cost of administration. [visual] It actually costs less to administer a non-qual plan than it does in most cases to do the 5500 filing and discriminating testing you have to do on the qualified plans. So it’s a simple and economical and efficient solution that employers can provide to fix the problems that they have.
That last one, human resources time? [visual] Not so much. That’s what you, as advisors, and I, or we as non-qual professionals, do. We communicate that both to the employer and the employee.
Benefits for the employee include the ability to defer additional income, the ability to take income while they’re still employed, and the ability to take income without penalty no matter when they separate service. These are tremendous benefits across the board for the employees. And, the employees can take this money out first and delay receipt of their qualified plan money. So I get to fill in that savings gap that I have, and I can take the money earlier. It allows me control over my existence today, lowering my tax bracket today. It’s putting money away for the future when retirement just simply means nobody else is paying me.
The issue for an employee, and this is the big one, is a contractual obligation. I have a promissory note from my employer. I don’t have money set aside in an ERISA-based account. So here’s the big thing, and in 22 years, with every single plan that I’ve helped advisors implement, this is the question I ask their executives as they’re learning about the plan. I say, “Are you worried about your employer filing for bankruptcy protection in the next two to three years? If you are, don’t do this. Ask for an advance on your salary. Try to get the bonus paid to you earlier.
“If, however, you are in a circumstance where you say, ‘Well, no. I mean, anything can happen, but we have Sarbanes-Oxley new reporting requirements, and there’s a little bit more corporate oversight. And I work for the company. I’m not a rank-and-file employee; I’m the VP of sales. We’re good. I like it. It’s a good company. We do a good thing.’ If that’s the answer, then that risk of forfeiture becomes less meaningful.”
Here are sales ideas. [visual] How do I identify a good NQ prospect? C corporation, public or private. That’s a layup. S corp, LLC, LLP for the nonowner, highly compensated. Is there continuity in the business? Do people believe that the company is going to be around in the next several years? If they don’t, walk away. If they do, this is a viable solution for them. Is there a sense of corporate financial integrity? Those two kind of go together, don’t they? Do I believe the people whom I work with are relatively decent human beings? Within reason. And if so, then a plan like this is fantastic. And this is sort of a self-evident thing. Are there highly compensated employees? If there aren’t, there’s no point.
This slide is looking for new plan sales opportunities. [visual] The first is employers in need of a 401(k) or qualified plan repair. Employers who are looking for a better way to recruit and retain top talent. Let’s go back to the first couple of slides. And employees say, “Listen, I can’t save enough. I need an option,” or anything like that. Any individual or corporation that you work with that falls into that category could use a non-qual plan. So what I would suggest is that if you have a book of business today, and I presume that you are since you’re sitting in the room, look at that and ask, “Do I work with corporations?” If you don’t, that’s fine, no big deal. “Do I work with highly compensated employees who are still employed?” If you do, maybe there’s a way for you to provide a benefit. “Do I provide disability insurance or other types of coverage, medical, dental, whatever it happens to be, to the employer?” I have a relationship already, and I could ask them if they are struggling to reward and retain top people. If they are, I have a solution available to you.
People ask, “What if they have a non-qual plan in place?” What’s interesting is that in the years that I’ve been doing this, it used to be Fortune 100, Fortune 500 firms. But the design efficiency and the pricing has come to the point where I have employers who have 50 to 100 employees who are implementing non-qual plans because it makes economic sense for them.
What we have found is that there are a ton of plans that were written incorrectly. There are a lot of people doing sketchy business out there who put plans in place simply because they wanted to sell a whole bunch of really expensive insurance and get paid. And guess what? Those plans aren’t getting the love and attention they deserve and need. And so for you, as an advisor, you’re either working with an individual who has a deferred comp plan or a corporation that may have one. It allows you to review the plans for them from a best practice perspective. Is this plan doing what it should be doing? And if it is, that’s great. If it’s not, we can fix it.
Question: This issue with the liability between the corporation and the employee, do we have any stats on how many plans fail? How many plans have failed? Is there some number that we can throw out there to sort of ease this answer?
Answer: Well, there’s not a good answer to that question. And here’s why. It would be nice to be able to give some of these specifics with regard to it. Deferred compensation plans require a DOL filing letter. Nothing else. And so if you look at the DOL listings of plans, there are so many of them out there that don’t even exist anymore. It’s not necessarily because of a bankruptcy issue, but it’s because the company terminated it for whatever reason. And so we have a lot of that. A failure is going to come in a couple of different ways. What if the company says, “You know what? We don’t need the plan anymore. The people we had the plan for retired. We didn’t add new people plan-wise. We’re doing this to get rid of it.” So there are a lot of different reasons for it. I can tell you that the bankruptcy courts in a post-Enron world have been consistent in making sure, or doing their best to make sure, that the participant deferrals are made whole. Now, if your employer puts away $1 million for you a week before filing for bankruptcy protection, you’re not going to get that. And there are other ways. I won’t take up the time, but there are other ways to help provide security. With the use of rabbi trusts, the liquidity pool, employers have the ability to terminate the plan in advance. As long as they know 12 to 24 months in advance of a bankruptcy protection filing, they can terminate the plan and pay everybody out. So there are a lot of things that you can do. The risk of forfeiture I can’t get rid of.
Question: That was my question. If you’ve got to do that, why not just do a 162 bonus and fund it outside of the corporation so you could take that liability off of the corporation and the employees?
Answer: There’s a great question. There are a couple of different reasons. A 162 is an employer contributory plan as opposed to the elected deferral on the employee side, No. 1. No. 2 is that it’s after-tax money. So from an employee perspective, what if I’m looking at deferring my own compensation? I love 162 bonus plans, don’t get me wrong, but there’s a time and place for the different benefits. And so what I see is for a smaller employer who has one or two key executives, a 162 bonus plan is going to be phenomenal for me. I can allow them to put money away; they pay the tax; I’ve got insurance on them. That’s the other issue. It requires underwriting on the individual, which they may not be able to do. So I’ve got an employer contribution and underwriting on the individual, and it isn’t as efficient with a larger plan.
Question: I have a compensation question for you. If I’m a fee-based RIA only with a life insurance license, and we look at funding options, are you guys able to build in advisory fee versus paid commissions for both mutual funding and insurance funding?
Answer: That’s a great question. So it’s a comp question that he’s asking because of his role as an RIA. What’s awesome about that question is that in today’s market, I see more and more people moving away from the “20 years ago I want to get a 50 percent of first-year premium commission” to the “I want to get 20 percent of first-year premium commission” to “People are moving more to the managed money concept,” but not everybody is. The way we design policies and plans today, if you’re an RIA and you want to hold mutual funds and/or life insurance, we sell a life insurance product where we strip all the commissions out, or more importantly, we leave all the commissions in, so the performance of the product is substantially better. It’s phenomenal because I’m not paying an advisor. And, whatever you want to bill them from an advisor perspective, we can deduct out of the asset that we’re holding. Now, most of the time I tell the employer, “Let’s not put the money into the asset and then pull it from the asset to pay the advisor.” You know what you’re paying them. Why don’t you just pay them that? It’s an expensable thing for the employer. And put a little bit less money into the asset if you want to.
To answer your question, I have more and more people who are RIAs or working in that perspective. We’re able to sell non-qual plans and meet whatever your compensation demands are through the plan itself, and what it does is it increases the asset performance for the employer, that asset that they’re holding.
Kirk Wolf, CFA, is the managing regional vice president of nonqualified plans for the Principal Financial Group for the Southern California/Southwest Region. Wolf works with financial professionals and corporate plan sponsors to design, implement and deliver executive benefit solutions. He works in all areas of deferred compensation plan sales, ranging from marketing, plan design, proposal development, plan presentation and implementation. Wolf has worked in the financial services industry since 1993, and specifically in corporate retirement plan development since 1996.