Opportunities Exist in Linking Equity Award, NQDC Programs

September 8, 2008 (PLANSPONSOR.com) - Recent regulatory changes are creating some new synergies between equity awards and non-qualified deferred compensation programs.

Those opportunities – and the shifts that have created them were addressed in a the latest of PLANSPONSOR’s Nonqualified Deferred Compensation Plan Web cast series by John N. Smith, III Vice President and Corporate Benefit and Institutional Specialist for Merrill Lynch Retirement Group.

In explaining the ways in which deferred compensation programs can work in partnership with equity award and retirement programs, Smith noted that salary and bonus deferred compensation plans grew out of limits placed on qualified plan deferrals or contributions.   “Companies typically used them as a supplemental retirement vehicle to restore employees to where they would have been without these limits on qualified plans,” he said.

Smith noted that public companies have sought ways to encourage employee ownership through a variety of approaches:

  • Employee Stock Plans-423 plans or stock purchase plans where employees can purchase stock at a discount or at market value
  • Stock Options-options to buy company stock in the future at a fixed price with special tax features assuming the employee does not have a disqualifying disposition
  • Nonqualified Stock Options-options to buy company stock in the future at a fixed price; however, the difference between the purchase price and the market value of the stock is taxable to the employee

Regulatory Matters

He then noted how current regulatory measures – specifically the introduction of Internal Revenue Code (IRC) Section 409A and application of Financial Accounting Standard (FAS) 123R had led to a convergence of deferred compensation and equity award programs.   Significantly, the former codified how deferred compensation plans could be designed, but also set forth the right to have distributions while still employed, rather than wait for retirement, which had been practiced before but without statutory support.   It also effectively meant that individuals could no longer defer gains – the gap between the fair market value and the strike place – by requiring companies to mark-to-market on their balance sheet the difference between the options and investments into which the individual participant may have diversified their deferred compensation account.   However, 409A did still allow for the deferral of restricted stock units.   

At the same time FAS 123R said that companies have to expense, in their financial statements, equity awards.   As a consequence, companies begin to reduce the number of stock options awarded and the number of employees to whom they grant them.   Additionally, companies begin to grant restricted awards and restricted stock units but to fewer people - and often, Smith noted, to the very people covered by deferred compensation plans.

Smith said that plan sponsors can use deferred compensation plan to be "tax neutral" for employees who have nonqualified stock options that need to be exercised, or restricted awards that will be lapsing.   Additionally, he cited the ability to use deferred compensation plans to plan around life events and invest accordingly, or to provide supplemental retirement benefits.

"When employees understand the value of the benefit programs delivered by the employer and how they can all fit together, the employer and the employee realize the greatest benefit," he noted.