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An overwhelming majority of employers have no intention of terminating their nonqualified executive retirement plans as a result of final Internal Revenue Code rules governing these arrangements, according to a Buck Consultants study.
Nonqualified Plans: A RefresherNonqualified deferred compensation plans play an important role in attracting and retaining high-level talent. They can be structured as defined benefit or defined contribution plans and allow executives and other highly paid employees to delay receiving some or all of their compensation until they leave their job or retire. The plans typically pay interest (sometimes at guaranteed rates) or investment returns that are tax deferred, and some plans match executive deferrals.
The regulations for nonqualified plans are less restrictive than those governing qualified plans such as defined benefit pensions, defined contribution 401(k)s and profit-sharing plans. Nondiscrimination rules do not come into play; the benefit amount can far exceed what qualified plans can provide, and they can be offered to as few or as many employees as desired. As a result, nonqualified retirement plans have become increasingly popular among executives who are paid more than $125,000 annually.
In 2004, the American Jobs Creation Act added section 409A to the Internal Revenue Code, establishing the first statutory rules specifically governing the operation of nonqualified deferred compensation plans. While there had been interim guidance from the Treasury Department and the IRS over the years, in April 2007 long-awaited final regulations were issued.
Buck's Nonqualified Deferred Compensation Survey, conducted after the IRS issued its final rules in April 2007, found that:
•95 percent of respondents will retain their executive defined contribution plans.•89 percent will continue their executive defined benefit plans.
However, in response to the final section 409A rules, named after the section of the tax code that contains them, approximately 30 percent of these nonqualified plans have been split into two parts to take advantage of grandfathering provisions in the final rules.
-------------------------------------------------------------Some 30 percent of nonqualified plans have been splitto take advantage of grandfathering provisionsin the final rules.-------------------------------------------------------------
“Benefits vested as of Dec. 31, 2004, are grandfathered into the old deferred compensation rules,” explains David Wax, principal in Buck's talent management and rewards strategies practice. “Many employers are taking advantage of this grandfathering by splitting their plans into two parts in order to preserve the flexibility of the pre-409A portion.”
The survey also found that:
•73 percent of respondents permit executives to choose from a menu of investments in their nonqualified defined contribution plans.•Of those, another 73 percent offer the same investment choices (or a subset of investment choices) as offered in the 401(k) plan.
“One of the ways nonqualified plans have evolved recently is in the range of investment choices offered,” says Wax. “In the past, these arrangements provided only a fixed rate of return defined by the plan, or a limited investment choice.”
As regards plan funding:
•A majority (62 percent) of plan sponsors informally fund their executive defined contribution plans at 100 percent of pre-tax accrued liability using a so-called "rabbi trust," whose assets are subject to the claims of the company’s creditors in the event of bankruptcy.•Only 19 percent report similar funding of executive defined benefit obligations. The primary reasons given for not funding nonqualified benefits are “finding better uses for corporate cash” (69 percent) and “the size of obligation does not justify funding” (41 percent).
“This is another evolving area,” says Wax. “In the past, it was not uncommon for plan sponsors to avoid funding their plans. The benefits were paid out of corporate assets when due. Because the liabilities on these plans have gotten so large, however, we're seeing increased funding in order to demonstrate security to the participants.”
•47 percent of plan sponsors favor mutual funds as a funding mechanism, while sponsors of funded executive defined benefit plans generally prefer life insurance. The expected pre-tax return on funding assets is used as the primary metric for making funding decisions. •52 percent of sponsors have written policy statements governing the funding of executive defined contribution plan obligations, while only 33 percent of executive defined benefit plan sponsors have documented their funding policies.
Surprisingly, one-fifth of sponsors have never conducted a performance review of their funding programs for nonqualified plans. “This survey result suggests there is room for improvement in monitoring the performance of company assets that fund these plans,” says Peter Bell, a principal at Buck Consultants. “A well-written funding policy with performance objectives is not only good business practice but also helps management understand why funding was established and what it is expected to deliver.”
The survey further reveals that among nonqualified defined benefit plans:
•Sponsors overwhelmingly use a final average pay formula (89 percent). Pay is defined as base salary plus annual incentive. Long-term incentives are rarely included in the determination of the benefit. •The most common service period used for full benefit accrual is 30 years (used by 36 percent of respondents). •The majority of plans provide unreduced benefits at age 65. However, 48 percent have plans that will pay unreduced benefits at an even earlier age. •Most plans (76 percent) permit participants to receive a reduced benefit at age 55.
Eighty organizations, representing a broad range of industries and employer sizes, participated in the survey, out of which 44 percent sponsor at least one nonqualified executive plan and 14 percent offer five or more such arrangements.
Stephen Milleris manager of SHRM Online's Compensation & Benefits Focus Area.
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