Dec 7, 2018

You’ve Got Options: Revisit Your Retirement Savings Before It’s Too Late

With so many corporate executives accumulating millions of dollars in nonqualified deferred compensation (NQDC) plans, it’s time to revisit the importance of these plans to provide needed retirement savings.

However, when NQDC plans become the topic of top-level executive meetings, company leaders often long to understand plan fundamentals far better than they do.

In truth, these plans are not as complex as they seem. Yes, they do come with a language all their own that can initially confuse even sophisticated human resource executives. But at their core, NQDC plans are simply a way for the highly compensated executive to save money on a tax-deferred basis.

This post stretches beyond a basic understanding of NQDC plans and focuses more on today’s needs for retirement planning compared to earlier generations. For a comprehensive understanding, please download our master paper on “Designing Nonqualified Deferred Compensation Plans to Competitive Advantage.”  

The Why Behind NQDC Plans

Executives carry a disadvantage when saving for retirement. The rules imposed by the Employee Retirement Income Security Act of 1974 (ERISA) limit the amounts that highly compensated executives can contribute annually to qualified plans such as the 401(k).

For example, the “highly compensated” are restricted to a contribution into the company’s 401(k) of not more than $18,500 ($24,500 if you are over 50) in 2018.

ERISA was enacted to protect the rank and file from potential abuses by senior management, and in that regard, it has been a success. But ERISA also placed restrictions on the senior management group, even though these highly compensated individuals produce relative value to the business enterprise.

Companies must find ways to attract and retain these highly valued employees if they are to succeed in their growth objectives and create positive returns for their shareholders. To address the inequity created by ERISA, and to provide a valuable executive benefit, companies began to offer savings plans considered “nonqualified,” meaning they are exempt from the “qualified plan” limits imposed by ERISA (e.g., $18,500 limit in 401 (k) plans).

NQDC plans help to level the playing field when companies work to attract, retain and reward top talent in the company. Eighty-five percent of the Fortune 1000 offer NQDC plans because no other executive benefit costs so little and provides plan participants so much.

However, most of these plans were adopted before the enactment of 409A, a piece of legislation that dramatically changed NQDC plans, especially regarding benefit security. What’s more, income tax rates were much higher in years’ past as noted in the chart below:

In a recent blogpost, What We Learned from Enron and Chrysler, you see the striking change: The 409A legislation. Now, factor this into the mix— as Generation X and Y began climbing the corporate latter, their needs took on a different complexion than their parents’ plans. For instance, the tendency to remain with one employer over an entire career has, for the most part, disappeared.

Two Generations Deferring Comp

At this juncture, we need to share the experiences of a father and his two sons, all three of whom are participating in NQDC plans.

The father, we’ll call Joe, like many people in his Baby Boom generation, worked at the same company for 30 years. In 1988, when he was only 45-years old, he began to participate in the company’s NQDC plan. Even though his deferrals fluctuated year-to-year, based on his bonus, we’ll use the illustration of a flat $50,000 per year so we can make a fair comparison with his sons.

As discussed in the Enron and Chrysler post above, Joe faced very little creditor risk because his plan carried a “haircut provision,” which allowed him to access his money at any time, regardless of his elections. Another important assumption to make a fair comparison, Joe selected the S&P 500.

His first son, Robert entered the labor force out of college and worked with a consulting firm for five years. Now, at age 50, Robert has been with his current employer for five years, entering the company’s NQDC plan when he was 45. We will illustrate his benefits, assuming he stays with his employer until age 65, which is unlikely.

The second son, Sean is age 46. He, like his brother, has had a few employers before joining his current one. During his three years with the current employer, he enters a Roth-type plan, not a traditional NQDC. As we project his retirement benefits, we need only to focus on his age at retirement and not whether he remains employed with the same company because his plan is portable.

The Father’s Deferred Compensation Plan

Again, Joe, the father, began deferring money in 1988, shortly after the 1986 Tax Reform Act. Before this Act, most deferred compensation arrangements provided above-market fixed-rate interest plan (e.g., Moody’s Bond Index plus 5%). This provision was due primarily to the way plans were financed, which the 1986 Act took away.

When he entered his plan, he deferred into a portfolio that resembled his 401(k) plan. For purposes of illustration, we assume he put it all in the S&P Index to show the volatility during his accumulation and retirement.

When he entered the plan in 1988, he was off to a great start— the S&P 500 earned 31.69% that year. Also, he enjoyed some great returns for the next nine years.

By deferring $50,000 per year, his account balance in 1998 was $2,021,847 on deferrals of $550,000. As he continued to defer his $50,000 per year, the market returns over the next nine years until retirement were not as strong, with four negative years, which included the down market of 37.00% in 2007 (see chart above).

At retirement, age 65, Joe’s account balance reached $1,819,296, which represented a return on his deferrals of 5.41%.

As he was planning out his retirement, the plan administrators assumed he would realize a 7% annual return for his 15-year payout, which would have given him $199,748 per year. But because of market volatility, his payments for the last ten years differed. Most people focus on accumulation and pay very little attention to distribution, which is a big mistake.

Joe’s projected ten years of benefits (@7%) was $1,997,748, but due to market fluctuation, he only realized $1,613,148, a pre-tax amount. He anticipated being in a much lower tax bracket. Instead, he continued at the highest bracket even into his retirement years.

New Generation:  Robert Mitigates Security and Market Risk

Like his father, Robert participated in a traditional NQDC plan. Beginning in 2008, he invested like his father in the S&P 500. However, his employer offered a unique fund (Collared Index) which gave him the upside of the S&P with a cap of 12% and a floor of 2%. That means if the S&P is negative, he will not lose anything.

Here’s what his returns looked like over the ten-year period.

A glance in the rear-view mirror shows that Robert would’ve been better served in the S&P 500 Index versus the Collared Index. However, one must look forward. Joe, the father, could have had a much better income stream at retirement if his plan offered the Collard Index.

Several questions you need to ask yourself: 1) Are you going to realize all up years above the cap in years to come? Will we see negative years with the S&P? Of course, we can’t predict.

The Collared Index gives Robert the upside of the market without the downside. If he wasn’t in the Collared Index, chances are he’d take a more balanced approach allocating some of his deferrals into fix-rate investment. And the probability of Robert staying with his company for ten years or longer is slim, too.

The Collared Index will also give him a benefit his father didn’t have, more predictability in retirement payments. He can stay in the market at retirement without the worry of an impact from negative years, as his father experienced in 2007.

New Tool for NQDC Risk Management

A new risk management tool, the Deferred Comp Protection Trust can help Robert mitigate the “unsecured creditor” risk at retirement. Designed by StockShield, this trust can protect Robert in the event his employer files bankruptcy.

What Gen Xers/Gen Yers Do for Wealth Accumulation

Sean, Joe’s youngest son, was born in 1964, a trailing edge boomer but on the border of Gen X. It’s instructive to compare Gen Xers with Gen Yers (aka Millennials). The Pew Research Center claims that millennials’ job tenure is no shorter than that of the prior generation with only 22 percent and 21.8 percent staying five years or more.

Because of short deferral periods, someone like Sean will not realize the true impact of NQDC compounding returns.

Moreover, one runs the risk of ending in a higher tax bracket during payout, only further compounding the problem.

Fortunately, studies show Millennials contribute more to Roth 401(k) plans than the generation before. What do these savvy Millennials know?

When you contribute to a traditional pre-tax plan, you earn a tax break up front. However, you must pay taxes when you take the money out in retirement.

With a Roth account, you contribute after-tax dollars, and the money you contribute, as well as the earnings, grow tax-free and distributes tax-free in retirement.

Younger workers—with lower wages and lower tax rates—stand to benefit more from the Roth option.

As our first chart above indicates, we’re at the lowest level tax rates we’ve been in for many generations. Add to this, NQDC plans don’t offer a rollover option, like 401(k)s, so you are taxed on payout under the plan’s termination benefit.

In Sean’s case, his employer offered him a Roth-type NQDC plan called the Insured Security Option Plan® (ISOP®). With this arrangement, contributions are made after tax into an institutionally price life insurance policy with the same Collared Index as his brother Robert’s NQDC plan.

The major advantage for Sean with his ISOP is portability to take with him as he changes employers during his career. What’s more, like a Roth, the ISOP grows tax-deferred and pays out income-tax-free. And the ISOP is not subject to all the restrictions of 409A or the claims of his employer’s creditors.

Let’s study ISOP mechanics. Sean makes the same $50,000 contribution annually. At tax time, he can withdraw his taxes from the fund, say $20,000 in a 40% tax bracket, without any penalty. What’s unique here is he will continue to earn the same return from the Collared Index on the money borrowed.

Therefore, he has an after-tax plan that credits earnings on the pre-tax amount. Also, his plan provides him with a $1.2 million life insurance benefit that grows to over $2 million at retirement.

At the same crediting rate as his brother, Sean will have more after-tax income and not have to worry about benefit security or future tax rate risks.

Know Your Options

For highly compensated employees, few options exist to save effectively for retirement. Many organizations offer traditional NQDC to help employees better plan for retirement. If you are in this situation, please evaluate your situation based on the factors I’ve outlined before you decide to participate.

Remember, in retirement planning, this maxim says it all:

“It’s not what you earn or accumulate, it’s what you keep.”

From the desk of Bill MacDonald, Managing Director at EBS

Executive Benefit Solutions
20 Park Plaza, Suite 1116, Boston, MA 02116
Boston | Dallas | Milwaukee | Orange County | Philadelphia| Richmond | San Diego
www.executivebenefitsolutions.com   V:  617.904.9444

Nov 5, 2018

Lessons Learned from Enron and Chrysler: How to Secure Nonqualified Deferred Compensation Plans

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: http://taxprof.typepad.com/taxprof_blog/2004/10/pga_golfers_sco.html

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 http://stockshield.com/our-products/deferred-compensation-protection-trust/

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

From the Managing Directors at EBS