As with any growth spurt, this includes new practitioners proffering strategies that claim to protect plan participants against all risks, including bankruptcy. However, because Congress has been determined to keep nonqualified benefits at risk, it’s imperative that corporate management be aware of potential mine fields and recognize that developing or updating a well-designed nonqualified benefit plan requires careful thought taken when it come to a strategy for security. This article outlines four necessary security considerations that should be part of an effective nonqualified benefit offering.
Developing an Effective Security Strategy
When a company is considering funding and securing its nonqualified benefit plans, the following components should be included: a properly designed rabbi trust, a trustee who specializes in rabbi trusts, an integrated plan design, and appropriate funding.
The Rabbi Trust
The rabbi trust (called “rabbi” because a rabbi requested the first Internal Revenue Service (IRS) ruling on the trust) is a grantor trust—typically irrevocable—that segregates assets from the company for the protection and purpose of paying participant benefits. Therefore, plan-related assets are earmarked, but cannot be protected against bankruptcy. That said, not all rabbi trusts are the same; they are only as good as their design.
To provide effective protection, companies ought to consider the following points when implementing or updating a rabbi trust:
- The trust should be irrevocable, to prevent management from altering participant benefits. The document should require that contributions to the trust be irrevocable except for the payment of benefits, or in the event that the trust’s funding level exceeds the plan’s liabilities by a stated percentage. Known as reversion provisions, these typically require the trust’s funding level to exceed 110% to 125% before assets can be repatriated back to the employer.
- The trust agreement should require a continuous trustee throughout and after a change-in-control. A “no-fire” provision which eliminates the possibility of the trustee being fired during a change-in-control, should be included preventing the acquirer from replacing a trustee with one favorable to the acquirer.
- A “successor trustee” provision may be utilized that gives the existing trustee the power to select a new trustee should the incumbent resign after a change-in- control, thereby preventing new management from selecting a new trustee.
The plan sponsor can include a provision preventing the acquirer from making any amendments to the trust for a specified period of time following a change-in-control. The goal is to prevent the secured creditors of a company from going after plan-related assets, while retaining the substantial risk of forfeiture that prevents a participant from being taxed on trust benefits thereby reducing the number of creditors that can attempt to “attach” plan-related assets.
The selection of an effective trustee in setting up a rabbi trust is crucial, yet oftentimes the selection is due to a banking relationship, or because an “administrative trustee” is made available through the funding provider. However, a more important qualifier should be whether the trustee candidate will accept fiduciary responsibility on behalf of plan participants. Should an event happen that requires the participant to look to the trust for payment of benefits, it is critical that the trustee be willing to make an independent claim determination (or quickly pursue and implement a court order) in order to pay benefits directly to the participant. A trustee who has not accepted fiduciary responsibility will generally wait until litigation has decided the issue, putting the executive at risk.
A second qualifier should be that the trustee has experience in handling multiple change-in-control events and/or other triggering events, considering the amount of work involved and critical role played in protecting a participant during a triggering event.
Integrated Plan Design
Additional protections can also provide added layers of security in the plan design and plan document to increase protection to participants. For example, the plan document can incorporate language requiring no post-change-in-control amendments that adversely impact plan benefits as of the date of the change-in-control. This protects participants from losing benefits that they have already accrued. A new owner may be able to change benefits prospectively, but not retroactively.
Additional layers of security for participants are automatic lump-sum payouts that occur at some point after a change-in-control. If structured to occur 15 months after a change, it gives the participant 90 days to assess new management and make a determination about what their personal future holds. Should they desire to not take the automatic lump sum payout, 409A provides them with a mechanism to make a change in the scheduled distribution date. Under 409A, they are required to make that change at least 12 months prior to the date of the scheduled distribution, and further postpone the date by at least five years. This would allow the participant to avoid a taxable income event, and maintain the tax-deferred nature of their deferred compensation/supplemental executive retirement plan (SERP) benefit for at least five more years.
And while much is being made of the need to ensure participant security, not to be overlooked is the need to structure the trust with sufficient flexibility to allow ongoing business needs to be met. This is accomplished by allowing changes to the rabbi trust after a period following a change-in-control, if approved by the participants (based on a percentage of the actual participants and/or the participant dollars in the plan.)
Appropriate Informal FundingA final consideration for review in creating an effective benefit security solution is the informal funding of the plan. There are two components to the informal funding equation – enhancing the participant’s security, and reducing the company’s effective cost of providing the benefits. From a participant perspective, informal funding does several things. First, it provides confidence to the participant that the company has set money aside to meet what is really just a promise to pay at a future date. Informal funding can also potentially reduce the risk that participants will lose all or a portion of their benefits during company bankruptcy. And while rabbi trusts cannot protect participants against bankruptcy, bankruptcy cases have shown that in instances where the company undergoes a reorganization (as opposed to a liquidation) and where there is a funded rabbi trust in place, participants most often receive some or all of their benefits.
To this end, it is recommended that companies establish a written informal funding policy for their nonqualified plan(s) similar to one that they might maintain for their qualified retirement plans. Such an informal funding policy should detail not only investment guidelines funding insight and limitations but also contribution frequency and the level to which liabilities will be informally funded. The policy should also spell out how often the funding of the trust will be reviewed. We also suggest the policy (and trust document) require some ongoing excess funding level post change-in-control. The additional security this can afford participants also provides the rabbi trust with a source of funds for litigations or other expenses, if needed, without putting distributions at more risk.
From the company’s perspective, informal funding is important to reduce the long-term costs of providing plan benefits. Nonqualified plans generate current profit and loss (P&L) expense that can be hedged or offset through funding. In addition, they have long-term cash flow expenses that funding can mitigate.
An important consideration in informal funding is the tax impact and gap that exists. The tax gap is a term used to explain the fact that the company is crediting participants with pre-tax returns on their deferred compensation balances, while often earning after-tax returns on assets held by the rabbi trust. Tax-efficient strategies using institutionally priced life insurance contracts designed specifically for funding nonqualified liabilities can reduce or eliminate this tax gap and decrease the overall cost of informal funding. In some cases, they can provide a superior accounting result, lowering current P&L charges for the plan.
Nonqualified benefits will no doubt continue to provide companies with this much-needed reward for its top talent, but in doing so critical steps are needed to secure this promise which include carefully combining a well-designed plan, choosing an experienced trustee willing to accept fiduciary responsibility, and orchestrating a well-structured trust that includes appropriate funding.
About the Author
Jim Clary is a principal of ClaryExecutive Benefits, an independent boutique firm specializing in nonqualified executive benefit planning with more than 30 years of experience helping leading corporate employers.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.