Drawn by the big bucks
involved, providers are offering lots of new investment
options to nonqualified plans
» Mirroring 401(k) Options
» Doing Something Exotic
It really is the DC-ification of the deferred comp
industry," says Tom Johnson, chief marketing officer at
Springfield, Massachusetts-based MassMutual Financial
Group, about what is happening with nonqualified plans
these days. Many now have investment options a lot like
those available in 401(k) plans.
Nonqualified plans have seen a boom in recent years.
Ninety-three percent of the Fortune 1000 had one of these
plans in 2003, according to Jennifer Sanders, a Los
Angeles-based senior vice president and managing director
at Clark Consulting. "The prevalence of these plans has
increased dramatically over the past 10 years, as other
tax-savings opportunities are no longer allowed," she
Providers have noticed, and started offering a wide
array of investments to these plans. "Traditionally, most
of your large retirement-services players did not look at
nonqualified plans and get all excited," Johnson says,
because the cash flow into the plans seemed modest in
comparison to 401(k)s, "but, now, all of the companies are
saying, 'We have to get on the bandwagon.' They have woken
up to this in the past couple of years. It has been more of
a cottage industry that is coming together."
Mirroring 401(k) Options
Five or more years ago, most nonqualified plans just
credited a simple declared interest rate, and had no choice
of investments. Many plans tied the rate to the Moody's
corporate bond index, the prime rate, or Treasury
However, as interest rates fell and suppliers got more
savvy about the big dollars involved in these plans,
investment options started to be introduced. Insurance
products with embedded mutual funds dominated the choices
for some time, says David Sugar, a senior consultant at
Hewitt Associates LLC in Lincolnshire, Illinois.
"Most were put in by insurance brokers, and were funded
by COLIs [corporate-owned life insurance policies]," says
Ken Kirk, Atlanta-based managing director of retirement
strategy at Mellon Financial Corp. "They were able to sell
the concept that these insurance policies would subsidize
the very high interest rates. Some plans had a 15% to 20%
crediting rate." Many sponsors bought COLIs to fund
deferred compensation benefits; when a policy paid out, the
money helped fund the deferred comp plan on an aggregate
However, in the past several years, the momentum has
swung toward nixing the fixed rate and offering investment
choices similar to those in companies' 401(k) plans. "Some
companies have chosen to replicate what the 401(k) offers,
and others offer similar asset classes but different
funds," Sanders says, referring to investment options.
"Maybe as much as a third mimic the 401(k). The other
two-thirds offer something different."
Several things led plans to start introducing investment
options. "Number one, sponsors empirically saw that
insurance products were not performing in the way they
expected them to perform," Kirk says, "and Congress began
chipping away at the tax benefits of insurance contracts,
which subsidized the yields." Congress took away the
interest deduction employers got from leveraging the
policies, he says.
The stock market's run-up in the 1990s brought pressure
from participants to get those impressive returns. In
addition, sponsors increasingly wanted similar investment
setups in both plans, since it means simpler plan
administration and greater leverage with a single service
Yet, COLIs still have a place in the market. Today,
about 70% of plans are funded, Johnson says, half via COLIs
and half via mutual funds. Sugar thinks that the majority
of funded plans still invest in COLIs as opposed to Wall
Street funds that parallel 401(k) offerings, primarily
because it helps lower corporate taxes.
Some major suppliers like Fidelity Investments have
created cloned funds used in insurance products, Sanders
says. "There has been a lot of movement from the big
investment houses to create cloned funds that can be used
with these insurance products," she says. However, the
insurance products retain some tax advantages.
Doing Something Exotic
Going forward, sources say, participants want
alternative investments uncorrelated to the stock market.
"One of the hot issues is volatility, particularly with
senior management who are maybe within three, or five, or
seven years of retiring. CEOs and other higher-level
managers often take lump-sum payments, and they either have
already elected that or are forced to by their companies,"
Kirk says. They remain wary of the kind of big dip the
market had earlier in the decade, he adds: "Had they gone
out in 2000 or 2001, they would have gotten killed on the
nonqualified plan." The current mutual fund options do not
address the volatility concerns of many executives enough,
he adds, since they often have to make a distribution
election far in advance.
Expect interest in private-equity deals, Johnson says.
"The high-net-worth investor wants to buy the same thing as
a billion-dollar pension fund."
New derivative instruments are popping up, Kirk says,
typically funds created with a derivative overlay to
protect principal. "They are crediting a rate based on the
S&P 500 index, with no chance of principal loss," he
says. "That is paid for by the dividends: The dividends
finance the derivative structure that guarantees the
principal. That has allowed a lot of senior executives to
maintain their asset allocation in equity, rather than go
to fixed income."
Some senior executives also want hedge funds in
nonqualified plans. "A lot of plan sponsors and
participants feel there is not going to be a great deal of
growth within the fixed-income or equity markets over the
next several years," Kirk says. "A lot of alpha is going to
come from hedge funds."
However, many executives also want daily net asset value
and daily liquidity in the plans, says Mendel Melzer, chief
investment officer and president of Newport Group
Securities, Inc. That seems likely to slow the embrace of
some alternative assets in these plans. "The number of
firms that will accept that low level of liquidity and
transparency is small," he says, "but there certainly will
be expansion of liquid alternative assets. There are 100
different mutual funds out there that pursue alternative
Plan sponsors also may want to go with milder options
among alternatives. "There will be a lot of resistance to
being the first one out with cutting-edge ideas," Sugar
believes. "In this era of corporate governance and
everything related to executive pay being under a
microscope, I do not know that senior management wants to
publicize the fact that they are off doing something