How did we get to where we are today? This article will provide some historic perspectives to our climate today and then attempt to provide some thoughtful and effective strategies for benefit managers.
Increased Tax Environment
In 1986, President Reagan passed The Tax Reform Act of 1986, lowering individual federal income tax rates to a low of 28%. That rate seems almost unimaginable today following a steady rise in taxes on highly compensated individuals. Consider the tax rates faced by an executive in 2013. Between the new maximum marginal federal rate of 39.6%, plus investment surcharges, Medicare taxes, increased taxes on dividends and capital gains, and state income tax rates, top wage earners can find themselves paying a top marginal rate that approaches 50%. A top rate of this magnitude makes seeking out tax-favored retirement savings a priority.
Limits on Tax-Qualified Retirement Plan Savings
The natural answer to the issue of increased income taxes is to seek retirement savings through company-sponsored qualified retirement plans, with 401(k) plans being the most common. Unfortunately, Congress has severely capped contributions and benefits for highly compensated individuals, significantly eroding the value of these plans.
To this end, the Internal Revenue Service (IRS) recently announced that for 2014, the maximum contribution to a 401(k) plan will remain fixed at $17,500. For those individuals 50 or older, an additional $5,500 contribution may be made, for a total contribution of $23,000.
Defined benefit plans, for those so lucky as to still be a participant in such a plan, limit total benefits to $210,000 in 2014. Finally, the total amount of compensation that may be considered for qualified plan purposes is a maximum of $260,000. Any compensation in excess of that limit cannot be considered in calculating contributions or benefits from qualified plans.
Let’s examine the impact of these limits on the typical 401(k). Assume that a 45-year-old executive, who plans to retire at age 60, has a current 401(k) balance of $75,000. Let’s further assume that the executive makes the maximum 401(k) contribution annually until retirement, earning 7% each year, with salary increasing at a 3% per annum rate. The chart below shows the sobering picture this executive faces in attempting to retire solely on his or her 401(k) plan.
As the chart clearly indicates, even an executive with a starting salary of $150,000 that is less than the considered compensation limit of $260,000 faces a significant shortfall. At retirement, this executive’s 401(k) plan will provide only 35.2% of final pay. Coupled with projected Social Security, the total retirement benefit will be 52.2% of final pay. Consider the impact of being asked to take a 47.8% pay cut, which is exactly the situation this executive faces the day he or she retires.
For a senior executive at the other end of the pay spectrum, earning $750,000 per year, the situation is even bleaker. Qualified plan limitations progressively impact wage earners the higher they go on the pay scale. In this executive’s case, the net result is that they limit his or her final retirement benefit to only 7% of pay. Social Security will provide another 3.4% of pay, meaning that the total retirement benefit that this executive can expect is a sum total of 10.4%, or a whopping 89.6% pay cut.
As hard as it is to believe, this is most likely a best-case scenario. In it, we have assumed that the executive makes the maximum annual contribution every single year. In addition, we have assumed that the limit on 401(k) contributions rises by inflation every year. Note that from 2013 to 2014, the limit in fact did not increase at all. Finally, and perhaps most damaging, we have assumed that this executive earns a net investment yield of 7% per year, never having an off year where he or she actually has a negative yield. This is important because there are very few investment advisers who would not strongly urge an individual investor to take an investment that could produce a fixed 7% per year.
Consumer Confidence Levels
How are pre-retirees viewing all this? The Employee Benefit Research Institute recently released a study showing the confidence levels of pre-retirees towards their own retirement outcomes. The study compares the level of confidence for retirement readiness in 2007, with that of 2013. Across the board, the consumers are even less confident today than they were in 2007, and the 2007 levels weren’t exactly inspiring.
Tax-Favored Retirement Savings Options
There are limited options available to those who recognize the need to save for retirement beyond their employer-sponsored plans on a tax-favored basis. For many, the best solution will be to participate in a meaningful way in their employer’s nonqualified voluntary deferred compensation vehicle. Under a typical nonqualified plan, the participant can elect to defer a portion of his or her salary and/or bonus and incentive play, subject only to the plan’s maximum deferral provision. Unlike qualified plans, nonqualified plans do not limit the amount that a participant may defer on a pre-tax basis.
The downside of a nonqualified deferred compensation plan is that the participant is an unsecured creditor of the company, and benefits are subject to risks not found in qualified plans. The major risk of course is in the event of the company’s insolvency.
The Importance of an Irrevocable Rabbi Trust
To mitigate this risk, participants should insist that the employer informally fund their nonqualified plan by setting aside assets equal to the total amount owed participants in an irrevocable rabbi trust. The trust will protect participants against loss in the event of a change in control, or change in current management. In addition, the trust can be an important source of protection for plan participants in the event of the employer’s bankruptcy.
Recent bankruptcy cases have shown that in the event of a bankruptcy that results in a reorganization of the employer, as opposed to an outright liquidation, the courts have tended to look favorably on the assets in a rabbi trust from a participant’s standpoint. In these cases, the courts have allowed participants to keep their deferred compensation benefits, to the extent that they were informally funded in the rabbi trust. Thus, if the employer maintained assets equal to 80% of the owed deferred compensation liabilities, the participants were able to recover 80% of their benefit. In light of these decisions, a best practice calls for employers to keep assets equal to 100% of benefits owed.
Today’s high wage earners face significant obstacles in accumulating sufficient assets for an adequate retirement. High marginal tax rates and limitations on qualified plan contributions combine to limit effective retirement savings. Nonqualified voluntary deferred compensation plans offer an attractive solution to supplement retirement savings, but contain additional risks that need to be carefully addressed.
Jim Clary is a principal of Clary Executive Benefits, an independent boutique firm specializing in nonqualified executive benefit planning with more than 30 years of experience helping leading corporate employers. He can be reached at firstname.lastname@example.org.
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.