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Compensation that can be deferred into savings plans helps attract and retain key executives.
Three years ago, Republic Services Inc., a mid-cap firm (with a market value of $3.5 billion), created a nonqualified deferred compensation plan for its top people. “We realized that the 401(k) program alone was not meeting the needs of our highly compensated employees,” says Craig Nichols, vice president of human resources at the nonhazardous solid waste collection services provider in Fort Lauderdale, Fla.
Once seen only as a perk for senior executives at Fortune 500 firms, more small- and mid-cap companies (under $5 billion in market value) are offering nonqualified deferred compensation plans to key employees. “I have a lot of low-cap and mid-cap clients asking about deferred compensation plans right now,” says Richard V. Smith, a vice president at New York-based Clark/Bardes Consulting, a large writer of such plans. Smith counsels Republic on its deferred compensation program.
With the economy faltering and cash tight, smaller companies, which in the past relied mostly on straight base pay, are looking for new ways to compensate key people. Nonqualified deferred compensation (NQDC) plans are one solution, and service providers have created new products tailored to the small- to mid-cap market, says Smith.
Republic is a fairly new company with no defined benefit plan, so personal savings take on a greater importance for a secure retirement, Nichols says. “We think it’s important and want employees to save for their financial future. This program gives highly compensated employees a solid program to save,” he says.
NQDC plans allow participants to defer salary or bonus payments until a future date, such as retirement or termination of employment. The deferrals are credited to an account, which may be a funded account or merely a bookkeeping entry, and may accrue interest. If the account is funded, the money is generally transferred to a vehicle called a “Rabbi Trust,” whose assets are subject to the claims of the company’s creditors in the event of bankruptcy.
The plans are not “qualified” under the Internal Revenue Code or the Employee Retirement Income Security Act (ERISA), the way 401(k) plans are, for instance, because NQDC plans are offered only to certain highly compensated employees. That means they are exempt from most ERISA and reporting requirements; there are no caps on contributions and no minimum distribution rules, says Andrew Shapiro, national manager of the compensation incentive program at Columbus, Ohio-based Nationwide Financial, which markets NQDC products to firms of all sizes.
However, to ensure exemption from ERISA mandates, employers should offer the plan to no more than the top 10 percent of earners, Shapiro says. “While a qualified plan generally has to be made available to all employees, a nonqualified plan must discriminate to avoid ERISA requirements,” Nichols says.
The Republic plan, for instance, is offered only to employees who meet the Internal Revenue Service’s (IRS) definition of a highly compensated employee—anyone making more than $90,000 in total compensation. Only 260 of Republic’s 12,000 employees are eligible to participate, Nichols says.
Republic’s plan is designed to wrap around and mimic the company’s 401(k) program, says Nichols, a plan participant. “The plan helps me to save for the future on a tax-deferred basis in a way I can’t in the 401(k) program,” he says.
IRS rules prevent highly compensated employees from getting a match similar to the one enjoyed by other employees under the 401(k) program, he explains. But employees participating in Republic’s NQDC program can contribute up to 25 percent of their pay to the plan, and the company matches 50 percent up to the first 4 percent of pay. Elections must be made before the start of the calendar year and cannot be changed until the following year, says Nichols. Contributions remain in the plan until the employee reaches age 55 or leaves the company and withdraws the funds.
NQDC Assets and Risks
Republic created its NQDC program to fill what management believed was a void in its compensation program “since employees could not save as much as they would have liked because of the discrimination rules,” says Nichols. Republic also believed that potential executive recruits were favoring larger companies that were more likely to provide an NQDC program. “There was a clearly felt need,” says Nichols, who brought the idea of an NQDC plan to Republic’s compensation committee. The board of directors then decided to offer the plan.
For employers, an NQDC plan provides several benefits at little cost. “These plans are very inexpensive to set up and administer,” says Shapiro. Deferrals are booked as an asset of the company, which can increase cash flow. For example, suppose an executive who has a $100,000 base salary chooses to defer $25,000. The company does not pay payroll taxes on the $25,000, and that amount remains on the company’s books as an asset until paid out.
Offering an NQDC benefit boosts retention efforts—particularly if the plan has “golden handcuffs” and is set up with vesting restrictions—as well as aids in recruiting, Shapiro says.
Furthermore, adds Nichols, an NQDC plan works with other elements of an executive compensation program. “There are a lot of things you can do with a deferred comp program that you can’t do with a qualified plan,” he says, including allowing deferrals of long-term incentive bonuses into the program. “It marries up to other compensation programs that we offer or may offer in the future better than a qualified plan,” he says.
However, the executives have no direct ownership of the deferred funds until the funds are paid out, says Brad Sorensen, associate vice president of product marketing at Nationwide Financial Services.
“The deferred money is at risk because it remains a general asset of the company and therefore is subject to claims of creditors if the corporation were to go bankrupt or get sued,” says Shapiro. “The employer could protect the assets from outside creditors by placing them in what is known as a ‘secular trust’; however, this causes immediate taxation to the executive.”
But while there are risks, there are major tax advantages for executives as well. No taxes are due on the amounts deferred until the employee receives the money or, if necessary, when the money is placed into a secular trust. So if the $25,000 is earned in 2003 and deferred until 2006, the executive will not have to pay ordinary income taxes on it until 2006. While the company retains that money, it can be credited with interest. Some companies even mimic the mutual fund lineup they have under the 401(k) plan and allow executives to pick and choose investments. “The typical plan looks, acts and feels a lot like a 401(k) plan,” says Sorenson.
Because they have paid no taxes on the initial principle amount, executives get a lot more in interest or investment gains, Smith explains. For example, if an executive defers $10,000 of his salary, after taxes he would receive approximately $6,000. If he invested that $6,000 at a 5 percent return, he would receive $300. But if the $10,000 were deferred under an NQDC plan and credited with 5 percent interest, the executive would earn $500.
An NQDC plan also allows highly compensated executives to save for retirement at the same rate or higher as the rank and file because it is outside the ERISA nondiscrimination rules and contribution limits that apply to 401(k) plans, Shapiro says.
An NQDC plan is not meant to replace a qualified plan for senior executives; the two types of plans are meant to work in tandem with each other, Shapiro says. “Anytime executives are maxing out on their 401(k) contributions, there is no reason not to offer them a nonqualified plan to allow individuals to maximize their contributions,” says Shapiro.
Nichols agrees that employees should max out 401(k) contributions before contributing to an NQDC plan. That is why only 150 of the 260 eligible employees participate in Republic’s program. Employees near the lower end of the $90,000 limit would not max out their 401(k) contributions until late in the year, if at all.
An indirect benefit of NQDC plans is they can encourage savings. That was the main driver behind establishing this kind of plan three years ago at CH2M Hill, an employee-owned infrastructure building and services firm in Denver.
“In 2000, we determined that a nonqualified deferred compensation plan might offer benefits to employees in terms of capital accumulation,” recalls Robert Allen, senior vice president of HR at CH2M Hill. “If income is deferred, it’s more likely saved.”
The message seems to have caught on: Of the company’s 11,000 employees worldwide, 500 participate in the NQDC plan—a 60 percent participation rate among those eligible. Participants can defer up to half of their salary, all of the incentive stock payment and half of incentive cash payments yearly.
Appealing to Smaller Firms
Ten years ago, NQDC plans were virtually nonexistent outside Fortune 500 firms, says Sorenson. “If [smaller firms] had one, it might have been drafted by an internal lawyer who designed it for one or two top people,” he says. Few smaller firms offered NQDC plans, says Smith, because the advantages of these plans were not well-known.
More important, vendors never focused on providing products or services for small- to mid-cap firms. “This market didn’t get a lot of attention,” Smith says. In the past, a smaller company that decided to implement an NQDC plan may have had problems finding a marketer. But today, smaller firms have a choice of providers and products, he says.
A small company can get a turnkey prototype NQDC plan up and running in 20 to 30 days, says Terry Hardee, senior vice president of Ferris, Baker Watts, a brokerage firm in Virginia Beach, Va.
Also, advances in software and other technology over the past decade lowered administrative costs, making it more feasible to offer these products to smaller companies, says Sorenson.
The economic environment of the 1990s also helped. A number of small startup companies quickly grew into larger firms then, says Smith. Many consulting firms recognized the opportunities involved in getting in on the ground floor and growing with the company.
“Traditionally, the market wasn’t served. But the focus on marketing to this client base started six to seven years ago, with the Silicon Valley technology boom driving it,” he says. NQDC plans, along with stock options, became an attractive recruitment and retention tool because they required little immediate cash expenditures, says Smith.
For that reason, even with the economy stalling, smaller employers still view NQDC plans as a low-cost way to attract and retain employees and cut payroll costs. “A lot of small and mid-size companies are now strapped for cash,” says Smith.
But there are other forces driving this trend. At many companies, owners and key employees are maxing out of 401(k) plans and other types of qualified retirement benefits, Hardee says. “A nonqualified deferred compensation plan lets them participate at whatever level they want and makes up for the shortfalls in 401(k) plans,” he says.
New products continue to expand the reach of NQDC plans to smaller firms. In March, Nationwide launched a new turnkey NQDC program for small- to mid-cap businesses, says Shapiro. With a turnkey product, a company trades flexibility in plan design for cost savings and easy administration, he says.
Chesapeake, Va.-based Adroit Utilities went live with Nationwide’s new program in February so Brian Malcolm, president and owner, and his partner, Gregory Snipes, could save for an early retirement, Malcolm says.
Annually the company, an underground utilities construction company, contributes 10 percent of pay to a defined contribution plan for each of its 25 employees. But the discrimination rules had limited what Malcolm and Snipes could contribute. “I want to retire at 55, but under the qualified plan I have to be 59 1/2,” Malcolm says.
“While currently structured only for the owners, the intention is to use it for key employees in the future,” he says. Malcolm and Snipes also expect the plan to become an effective recruitment and retention tool when they retire and hand the reins to their successors, Malcolm says.
The NQDC program has worked well for Republic, says Nichols. “It fulfilled its promise of providing a good tax deferred savings opportunity for highly compensated employees and being a good retention/attraction tool.”
In a good economy or a bad economy, you need to plan for your financial future, “and that’s what a nonqualified plan helps us do for our people,” Nichols says.
Elayne Robertson Demby is a freelance business writer in Weston, Conn.
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