Seeing the Opportunity in NQDC
Helping eligible employees explore the value of these plan.
Nonqualified deferred compensation (NQDC) plans can be an important tool—alongside the 401(k) plan—for plan sponsors to retain executives who are interested in saving and want to better prepare for retirement.
At best, a 401(k) will provide only 50% of the retirement income a highly compensated executive will need in retirement. An NQDC plan can boost that to 75% or more, says Tina Wilson, senior vice president, product management at MassMutual Retirement Services in Springfield, Massachusetts.
The Internal Revenue Code (IRC) limits 2015 contributions to 401(k) plans to $18,000, with another $6,000 in catch-up contributions for those ages 50 and older. In all likelihood, those annual savings of $24,000 will not adequately prepare a highly compensated executive making $150,000 or more a year for retirement, says Jamie McInnes, senior vice president and head of total retirement solutions at Prudential Retirement in Newark, New Jersey. NQDC plans have no IRC limits, but plan limits are possible.
Yet, although employees eligible for these plans are often well-compensated, they may not understand the need to have supplemental retirement savings outside of their qualified plans and therefore need to be supported with robust education, according to the MullinTBG/PLANSPONSOR 2014 Executive Benefit Survey.
While plan sponsors appear to be aware of the need for NQDC education, few actually provide it, responders say. Asked what they think is the most important factor in helping executives decide to participate in an NQDC plan, sponsors cite education about the plan. On a scale of one to 10, sponsor respondents to the survey rated education and communication about the plan at 5.19.
Overall, 84% of companies in the survey offer an NQDC plan, but that number varies by company size. For example, 87.9% of plans with assets greater than $1 billion offer an NQDC, while 78% of plans with under $1 billion in assets offer one.
Education for NQDC plans is years behind qualified plans, says Rocky Grimes, vice president of Lockton Retirement Services’ executive benefits group in Kansas City, Missouri. Much of the information executives are presented with is “static and dense,” he says. “Most of them seem to learn about the plan from their co-workers, who don’t always have all of the information.”
Education begins by helping eligible employees understand the value of the plan available to them. Gary Dorton, vice president of nonqualified solutions and services at Principal Financial Group in Raleigh, North Carolina, agrees that education about NQDC plans is critical. The executives eligible for these plans “are successful, intelligent individuals, but that doesn’t mean nonqualified is something they are necessarily knowledgeable about,” Dorton says.
“The first reason an executive should be given to participate in a nonqualified deferred compensation plan is that the NQDC gives him the opportunity to defer compensation in addition to the 401(k) plan—a key point,” McInnes says. Highly compensated executives are in great need of this additional savings in order to retire with an adequate nest egg, he says. “Second, contributions, as with a 401(k) plan, are made on a pre-tax basis, lowering their taxable income. And third, the most interesting reason: Advisers need to work with executives to help them understand how they can use an NQDC plan to prepare for near-term and long-term objectives, such as putting money aside for college tuition or paying off a mortgage—not just retirement.”
However, retirement is generally the biggest reason why executives participate in NQDC plans, McInnes says. “Half of high-net-worth investors have difficulty with retirement planning, and about a third of them are concerned about being able to retire comfortably. Providing an NQDC plan can give them confidence and comfort.”
The complexity of such plans, and the options available in how the executives receive the money, is why Jason Maples, executive vice president at Lockton in Denver, has found that in-person educational meetings work best. “You really need to sit down with an executive, understand his or her cash flow and balance sheet, and explain the advantage of the arbitrage between marginal tax rates and effective tax rates,” he says. Once the plan has been explained, the main hesitation most executives have in participating is credit risk, because “the way these plans work, if the company goes under, the funds are lost,” he says. “But if you feel comfortable buying the company’s stock, you should feel comfortable saving in the nonqualified deferred comp plan.”
Grimes adds, “When people hear they could lose money, they have a visceral reaction. But then I ask them how many of them are, or would be, stockholders of the company. Almost everyone says ‘yes.’ Then I explain that, in an NQDC plan, they become creditors to the company. In the event of something going wrong, creditors get paid before stockholders. That is always enlightening.”
PLAN DESIGN'S IMPACT ON PARTICIPANT BEHAVIOR
According to experts, there are four best practices sponsors should consider when designing their nonqualified deferred compensation (NQDC) plan. First, it is important to support participant education, says Jamie McInnes, with Prudential Retirement. The impact can be dramatic, agrees Rocky Grimes, of Lockton Retirement Services. Since providing education to one client’s executives about their NQDC plan, over the past three years Lockton has been able to increase the number of participants in the plan seven-fold, he says.
The second best practice for NQDC plans, McInnes says, is to keep them simple. Adds Brian Ellerman, managing director of Sheridan Road Financial in Chicago: “Nonqualified plans offer tremendous flexibility in terms of plan design features, distribution options and the like. But with flexibility comes complexity, and too many choices can be overwhelming for participants. Keeping the plan design simple will typically result in better participation.”
A third best practice is to offer model portfolios with preset allocations, based either on risk tolerance or a planned retirement date, such as a target-date fund (TDF), McInnes says. The fourth, he notes, is to offer a match, which often boosts participation. —LB
HOW NQDC PLANS WORK
A nonqualified deferred compensation (NQDC) plan defers a portion of an executive’s compensation—salary, bonuses, commissions or other earnings—to a future date, and the deferrals can be up to 50% of total compensation. The funds are typically paid out when the employee leaves the company, becomes disabled or dies. Because the funds are deferred, so are the taxes. This can be beneficial to an executive at retirement as he will be in a lower tax bracket. As it is nonqualified, an NQDC plan is not subject to the Employee Retirement Income Security Act (ERISA) and its nondiscrimination testing limitations.
An NQDC plan can either be elective, whereby it is optional for the executive to participate and to determine the amount of salary he wants to defer, or a supplemental employee retirement plan (SERP), whereby the company enters a legally binding agreement to pay the executive supplemental income on top of his salary and bonuses. The deferrals can be placed into an account paying a set interest, or they can be invested.
There are some downsides to NQDC plans for both employees and employers. The benefits may be forfeited under circumstances including: if the employee leaves before the vesting date or before normal retirement age; if the person enters into competition with the employer; or if he is terminated for cause.
In addition, the funds are unsecured, which means they are not protected from the claims of general creditors of the company. Also, Internal Revenue Code (IRC) Section 409A says that an executive who chooses to defer compensation may not change that during the year, and once a date is set for when the participant wants to receive the money—say, to coincide with a tuition payment—it cannot be accelerated.
For the employer, unlike with qualified plans, contributions to an NQDC plan may not be deducted until they are paid out. In addition, the employer must pay taxes on any investment earnings, dividends or realized gains. —LB