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One piece of legislation changed deferred compensation plans forever—Section 409A—because it places any money you defer at real risk.

Most executives participating in nonqualified deferred compensation (NQDC) plans and supplemental retirement plans (SERPs) are aware that those benefits are “subject to the claims of general creditors.”

“Unsecured general creditor” status was not as risky before the 2005 adoption of 409A as it is now.

the Internal Revenue Code added Section 409A, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. The effects of Section 409A are far-reaching because of the exceptionally broad definition of “deferral of compensation.”

In part, Section 409A was enacted in response to the practice of Enron executives accelerating payments under their deferred compensation plans; they wanted to access the money before the Enron went bankrupt. Secondarily, Section 409A addressed a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt tax doctrine.

Section 409A had a major impact on all for-profit and not-for-profit companies with one exception: the PGA (Professional Golf Association) players. Unless you play on the PGA tour, 409A will be in your life as it relates to deferred compensation.

Here’s a link to good information on this exception.

HOW WERE EXECUTIVES PROTECTED AT ENRON?

In the weeks before it filed for Chapter 11 bankruptcy protection, Enron allowed a small group of executives to withdraw their money from a deferred compensation program, giving them preferential treatment over some former managers who had also requested early withdrawal, according to former and current executives at the company.

The company paid millions of dollars in deferred salaries and bonuses to midlevel and high-level executives still working in late November shortly before the Dec. 2 bankruptcy filing, which forced the company to suspend all such payments.

But a group of employees who had retired or recently left the company was denied similar payments.

Because of the bankruptcy filing, about 400 senior executives and former executives, who were part of Enron’s deferred compensation program became, according to rules governing the plans, unsecured creditors of the company.

This unwanted development placed their claims behind those of secured banks and other creditors in the bankruptcy court, leaving them exposed to losing most, if not all, of the money in their accounts.

It is unclear whether top executives, like the former chairman, Kenneth L. Lay, withdrew money from the deferred compensation plan just before the collapse. It is also unclear whether Enron violated any rules or laws in making the preferential payments. Nonetheless, some former Enron employees filed a lawsuit in hopes of recovering millions of dollars in deferred compensation they say they are owed. Their effort failed.

HOW WERE DEFERRED COMPENSATION PLANS PROTECTED BEFORE 409A?

In the 1980s and 1990s, Enron, like other corporations, allowed mid-level and high-level employees to save on taxes and build up a larger nest egg for retirement by deferring a portion of salary and annual bonuses in an investment program like a 401(k)-retirement plan.

Unlike a 401(k), however, the money in the plan remained as general assets of the company and did not belong directly to the executives. Even if they segregated those assets in a rabbi trust, those assets were still “subject to the claims of company creditors in the event of a company bankruptcy.”

When Enron disclosed its financial troubles, some employees and former employees elected to accept a 10 percent penalty and an immediate tax bill to get their money out of the Enron deferred compensation plan established in 1994. By mid- to late November, however, at least a dozen former employees said they had their requests denied, even as friends and colleagues still working at the company had their requests granted.

This 10 percent penalty was known at the time as the “haircut provision” and found in most nonqualified plans. Because executives had the ability, “at any time for any reason,” to pull the trigger and take their money minus a 10 percent haircut, they were never at substantial risk.

Think about the value of this provision. You elect to take your money over a 15-year period at retirement to minimize taxes. Your former employer has a financial setback. You simply pull the trigger and take your money. But 409A took this valuable benefit away.

With the enactment of 409A, it became impossible to use some of the old devices, and much more difficult to devise new ways, to secure promised compensation while deferring income tax on that compensation. Section 409A precludes the use of haircut provisions and other participant control. And it severely restricts the conditions for tax deferral of promised compensation.

WHY DID EXECUTIVES AT CHRYSLER LOSE THEIR DEFERRED COMPENSATION?

It was all about timing.

When Chrysler faced bankruptcy in 2008 (after the adoption of 409A), it used $200 million in funds from the rabbi trust for company operations. Many executives believed those assets could only be used to satisfy deferred compensation liabilities. That is true, except in bankruptcy.

A rabbi trust is a great vehicle to protect deferred compensation against the employer’s change in control, change of heart and default, and change in financial condition short of bankruptcy.

Some 400 retired executives (including former chairman Lee Iacocca) were left with nothing in their accounts. After getting no relief in the Chrysler reorganization proceedings, the retirees filed a complaint against State Street (the rabbi trustee) and Chrysler’s parent company Daimler A.G.

After scuffles back and forth in state and federal court, a federal judge ruled that the plaintiffs could not pursue state law claims of fraud and breach of trust about an ERISA benefits plan because ERISA preempted those claims. Further, the court ruled any breach of fiduciary duty claims under ERISA would be futile as the nonqualified plan did not protect retiree accounts in bankruptcy.

The Sixth Circuit Court of Appeals affirmed those rulings. Back in district court, the plaintiffs filed expanded ERISA claims about the rabbi trust and a new claim on age-discrimination; the court dismissed both claims.

In a second appeal, the Sixth Circuit Court of Appeals ruled (again) that plaintiffs have no viable ERISA claims because the plan and trust operated as described in plan documents. For the age discrimination claim, the court ruled the filing too late. In short, with a defeat on all pleading and procedural grounds, and absence of a trial, we may never understand what happened during the Chrysler collapse.

In a New York Times article, David Neier, a lawyer and partner at Winston & Strawn said; “There are thousands of retired Chrysler executives running around trying to figure out what their rights are.”

Mike Melbinger, a partner and chairman of the employee benefits and executive compensation practice for Winston in Chicago, said, “They’re not going to find an answer or a way to get their money.” Publicly, Chrysler has stated that it will figure out how to handle its plan as its bankruptcy unfolds.

WHAT 409A TOOK AWAY

Not only did 409A take away the ability to secure nonqualified benefits with concepts like the haircut provision, but it put many restrictions on how you defer and take out money.

As an example, once you make an election to defer money and pick a distribution election (i.e., lump sum, 5, 10, 15 or 20 years), you are locked into that election. Only a few exceptions stand. Either you terminate employment before the date and receive a termination benefit, or you die or become disabled.

409A does allow re-deferrals, but you must push your election out for five years from the original date of distribution.

Before 409A, companies simply terminated their plans and paid executives out. Other than a 12- month look back in bankruptcy court for insiders under the fraudulent convergence period, you were home free.

Now, 409A has special rules for modifying, terminating or freezing a plan and instructions on how money should be paid out.

To be sure, 409A creates significant roadblocks to modifying existing NQDC plans. And with the few exceptions noted below, any variation in the time (either acceleration or further deferral) or the form (changing a scheduled lump-sum payout to an annuitized stream of payments) constitutes an NQDC plan failure. Here are the exceptions:

Termination of NQDC Plan

One of the few exceptions of benefits acceleration under an NQDC plan is the full and discretionary termination of that NQDC plan. For companies to qualify for termination, the regulations require all the following:

• Termination and liquidation of the NQDC plan must not occur because of a “downturn” in the employer’s financial health;
• Terminate all related NQDC plans (other similar nonqualified NQDC plans);
• No payout under the NQDC plan may occur within 12 months of board action to irrevocably terminate the NQDC plan;
• All payments must be made within 24 months of the NQDC plan termination by the board; and
• The employer must not adopt a new similar type of NQDC plan within 36 months from the date the employer first took the board action needed to terminate the NQDC plan irrevocably.

These exceptions emerged from the first requirement that there not be a downturn in the employer’s financial health. IRS National Office personnel verified that the critical element of this financial health requirement involves a meaningful change in the employer’s ability to pay the unsecured deferred compensation benefits. That is, was there a negative development that acted as a practical impediment to the employer’s paying the deferred compensation?

If you pay close attention to the language in the regulation, the relevant time for examining the employer’s financial health is not only when the formal action is taken to terminate the NQDC plan but also as benefits are paid out one to two years later.

Another issue involves the second element of this termination exception, the requirement to terminate the relevant NQDC plan and all others of a like class (all account-balance NQDC plans maintained by the employer for all participating employees).

The regulations indicate that all such NQDC plans terminate without reinstatement no sooner than three years later. That means the decision to terminate the NQDC, with a particular participating employee, can be initiated by one or a few key people.

HOW TO TAKE ADVANTAGE OF NQDC AND MITIGATE RISK

If you have zero concerns with your creditor risk, or you can afford to take the risk of losing all money deferred, you cannot find a better wealth accumulation vehicle than a NQDC plan. You can mitigate the risk of company bankruptcy by tapping into the many planning opportunities available to minimize taxation and maximize your retirement income.

Unknowingly, executives may hold a great deal of financial risk by being overexposed to their employer. Aside from the salary, benefits, and other perks provided by the company, employees encounter exposure through stock options, equity compensation plans and, of course, participation in NQDC plans.

Depending on your situation, choosing to lock up a portion of your cash compensation for an “unguaranteed” payment later can represent a significant additional risk. However, as you look at the major benefits of NQDC plans, it is hard not to take some risk.

To help alleviate executives’ concerns, the employer may establish a rabbi trust, as mentioned earlier, to accumulate assets to support the payment of benefits obligations under the plan. The trust receives contributions from the employer, makes investments, and makes distributions according to the terms of the plan.

Rabbi trusts protect plan participants from being denied payment due to a change in management or a hostile takeover. Another form of trust, a Secular Trust, will further secure the benefits for the participant but could result in some undesirable tax consequences.

Until now, these trusts were the only ways to provide some protection.

A Los Angeles-based company, StockShield, developed a new risk management strategy that could be the answer, the Deferred Compensation Protection Trust (DCPT).

Deferred Compensation Protection Trust™

Now, executives can access a cost-effective risk management strategy to protect NQDC account balances. The Deferred Compensation Protection Trust (DCPT) can protect with the following key features:

• The DCPT is a new, “non-traditional” approach to NQDC risk management;
• Based on the time-tested principles of both Modern Portfolio Theory (MPT) and Risk Pooling, the DCPT developed from the company’s Stock Protection Fund for protecting concentrated stock positions;
• Risk pooling enables the cost-effective spreading of similar financial risk across participants in a self-funded plan designed to protect against losses;
• Risk pooling and MPT positions the DCPT to transform single-account/single-company balance risk by enabling investors to “mutualize” and, therefore, substantially reduce downside risk, while retaining all future appreciation of their NQDC assets and income, all at an affordable cost.

Affordable Protection for NQDC Balances

Participants in NQDC plans are often forced to take lump-sum distributions to mitigate the risk of unsecured general creditor status. Also, they may overlook the advantage of tax deferral and deferral compounding on a tax-deferred basis.

For those participants aware of the risk of becoming a general unsecured creditor, the DCPT offers greater assurance and security that in a catastrophic event, like the sponsoring-employer’s bankruptcy, participants’ net worth will not be decimated.

It is important to point out that protection can be structured over a five- or ten-year period and is renewable. The annual cost could be as low as 0.10 percent of the value you wish to protect (when factoring in the probability of a full refund minus the administrative charge), far less than the state income taxes you would pay by not spreading your payments.

If you would like more information on the valuable protection provided by the Deferred Compensation Protection Trust, you can visit their website by clicking here.

It’s taken a long time to build your retirement. It’s time now to protect it.

From the Managing Directors at EBS