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RIAs are rapidly becoming the ideal catalysts for nonqualified plans due to their inherent fiduciary responsibility to act in the client’s best interest, their fee-based only compensation, and their standards of transparency. As they move into nonqualified plans as a natural expansion of their market outreach, it’s time for a heads-up. The intent of this article is to inform RIAs of current challenges in funding nonqualified deferred compensation (NQDC) plans.

The prevalence of nonqualified plans for executive benefits continues to grow, driven forward by increases in federal and state taxes, a rise in corporate profits, and the restoration of executive bonuses.

Because of these changes, plan participants are paying closer attention to their nonqualified deferred compensation (NQDC) plans, and the proactive companies, serving as plan sponsors, are busy reviewing their NQDC plans for their efficacy and overall financial efficiency.

With IRC § 409A well in place, it is now easier to structure a NQDC plan for maximum flexibility, especially for short-term deferrals to retirement payments over the life of the executive. Companies can now use prototype documents to offer features at best practices standards. What’s more, simplified plan administration is readily available because many of the major 401(k) administrators and payroll services now offer a streamlined processing experience for plan sponsors and participants.

RIAS AS RINGMASTERS

While it may not seem obvious, RIAs who already take care of qualified plans are the cost-effective answer to sponsors wanting to adopt nonqualified plans. Five solid reasons why this is true: 1) 401(k) administrators can offer a full-service administration package at a fraction of the cost;

2) Most plan designs provide the opportunity for highly-compensated employees to defer in excess of the 401(k) contributions, and because a built-in platform already exists for 401(k) plan enrollment and communications, it is simpler to add a NQDCplan for both sponsors and their RIAs;

3) As mentioned earlier, with the advent of IRC § 409A, RIAs have access to well-drafted prototype plan documents not available in the past;

4) Another excellent reason to place NQDCs with RIAs is their immediate access to institutional platforms for the purchase of mutual funds and exchange-traded funds (ETFs). ETFs can be purchased by the company without tax on the earnings until the asset is sold. And mutual funds can be managed in a tax-effective manner.

5) The RIAs are hardwired to offer high-caliber investment advice, which can be put to work for NQDC sponsors and their participants to the benefit of the relationship well into retirement.

RIAS AS PACESETTERS

Exponential growth has taken place in the RIA sector over the past few years, underscoring their influence in financial services. In a 2013 RIA Benchmarking Study by Schwab Advisor Services, the largest of its kind with exclusive focus on RIAs, results revealed “that the median firm in the study ended 2012 with $572 million in AUM, an increase of 13.3 percent over the previous year, while revenues grew by 7.1 percent to $3.4 million in 2012. Based on the study findings, by the end of 2014 about one-third of advisor firms will have doubled in size over the previous five-year period.” But does size really matter?

According to the Schwab survey, “quality client service and an emphasis on relationships remain key drivers for client retention and of overall RIA growth and success.

When you look at market share, RIAs eclipse traditional full-service brokerage models by 2 to 1 in terms of growth, cites research firm Aite Group LLC in an August 2013 Investment News article.

RIAS MEET FUNDING CHALLENGES

With the rise in RIA influence, we expect to see more RIAs enter the nonqualified space. But they well may stub their toes on the issue of how to effectively fund NQDC without using corporate-owned life insurance (COLI), the standard approach in the past. Take comfort.

NEW ERA―PLANS IN REVIEW

Given legal changes and renewed interest in NQDCs, now is the time for companies to zero in on funding arrangements. And, in my opinion, the RIA is an ideal partner to help a sponsor ensure plan performance reaches full potential.

According to a number of major studies, the use of COLI, once the favored funding vehicle, has been declining since 2009. Clark Consulting indicated that out of the 61 percent of companies setting aside assets to fund nonqualified plans, 45 percent used mutual funds—up from 37 percent in 2007; 61 percent used COLI, down from 72 percent.

In 2011 Mullin/TBG, now owned by Prudential Insurance Company, indicated that the prevalence of funding NQDC liabilities declined for the second consecutive year to 58.7 percent from 64.6 percent in 2010. This decline was well below the height of COLI funding of 71.4 percent reached in 2009. Further, the Mullin/TBG study stated mutual funds outpaced COLI by more than 10 percentage points (52.6% vs. 42.1%), certainly triggered by the arrival of

INFORMALLY FUND NQDC PLANS

As a brief aside, corporate sponsors choose to informally fund the majority of NQDC plans for three primary reasons:

• To provide a degree of benefit security to participants;
• To match plan liabilities with a pool of assets; and
• To mitigate P&L funding impact of the overall program

DECLINE IN COLI—RISE IN MUTUAL FUNDS

Heavier focus on transparency of qualified plans put pressure on COLI funding because retirement and compensation committees were determined to understand the expense load of these arrangements. What’s more, evolution of the nonqualified field sped up as companies consolidated vendors, shifting nonqualified plans to their 401(k) provider’s platform, triggering more reexamination of NQDCs.

As change unfolded, there has been a logical shift to alternative investments— mutual funds, ETFs, Total Return Swaps (TRS), annuities, company stock and managed accounts. Of course, this makes perfect sense as mutual funds now enjoy favorable accounting treatment, further adding to the simplicity of managing a portfolio.

FAS 159 (Fair Value Option for Financial Assets and Financial Liabilities) opened up an opportunity for sponsoring employers who wish to informally fund their NQDC plans to account for certain financial instruments such as mutual funds at fair market value and report in earnings the unrealized gains and losses on securities for which the company has elected the fair value option.

FAS 159 is especially attractive to defined contribution plans where participants allocate their deferrals and account balances among a menu of notional funds. By using FAS 159, sponsoring employers can hedge their income statement exposure to certain kinds of benefit cost volatility. These facts present strong arguments for key changes in funding.

THE COLI IRONY

Few corporate investments are so significant yet receive so little scrutiny as COLI. Worse yet, few corporate investments have disappointed so many. Let’s review why:

• Management struggles to understand what predecessors purchased years ago.
• Life insurance presents certain complexities, dependent on tax laws and accounting advantages.
• Little or no transparency in insurance policy costs, unlike other corporate assets.
• Insurance companies hold broad discretion to change, without notice, expenses and loads for existing programs.
• COLI investments are not managed as well as other corporate investments.
• Confusion and distrust arise when brokers earn incentives to recommend replacing existing policies with new contracts, instead of restructuring current holdings.
• Securing objective information on COLI programs is almost impossible.
• Sellers of COLI programs hold knowledge of COLI workings close to the vest.
• COLI providers continue to sell more COLI, despite its decline in its use, because it pays to do so.

Let’s look at the menu of funding vehicles used over the past decade:

Now, let’s compare the advantages and disadvantages of the three most popular funding options: