May 29, 2020

NQDC PLANS: LESSONS LEARNED IN THE COVID-19 ERA

Can I Withdraw Funds From my Account, or Freeze Deferrals?

We have all learned a few lessons in recent months as we struggle to cope with the sudden and dramatic changes to our personal lifestyles, and to the pursuit of our business interests.  Among the most important is the need for liquidity.

While we have always known that maintaining a liquid asset reserve is a fundamental principle of prudent financial management, we have just received a very clear reminder.

COVID-19 Triggers a Search for Cash

Over the last few months, our firm has received a number of calls from participants in NQDC plans asking if it is possible to either cancel deferral elections for the current year, and/or withdraw cash from their account. They may have read that the CARES Act included certain relief provisions for participants in a Section 401(k) plan that permit loans and withdrawals on a favorable basis. Unfortunately, there are no such relief provisions in the Act for NQDC plans.

Liquidity Options with NQDC Plans

Non-qualified deferred compensation plans have long been, and continue to be, a fundamental component of the total rewards package for executives and other key employees.  They provide an opportunity for supplemental tax-advantaged savings for participants and an effective incentive and retention tool for the employer/plan sponsor.

While non-qualified plans offer significant flexibility of plan design, the liquidity of a participant’s account is limited. In response to a few high-profile corporate scandals, Congress substantially re-wrote the tax law covering non-qualified deferred compensation programs in 2005. Under new Section 409A, withdrawals and distributions from a participant’s deferred compensation account are restricted to specific events, the timing of distributions and withdrawals must be elected up-front at the time of deferral, and the acceleration of benefits is generally prohibited.

However, there are some options available to a participant in a NQDC plan in search of cash.

  • “Hardship” Withdrawal and Suspension of Deferrals: May be permitted under Section 409A, but it is subject to significant restrictions as discussed below.
  • Distribution of Pre-Section 409A portion of account balance:  If the plan includes pre-Section 409A grandfathered accounts from years prior to 2005, there may be more flexibility to access that portion of a participant’s account under the old tax rules.
  • Plan Termination:  It is possible for an employer/plan sponsor to terminate a NQDC plan on a discretionary basis and liquidate all participants’ accounts.  However, it may not be effective in meeting an immediate need for liquidity.
  • Cash-out of a Small Account Balance: Finally, many NQDC plans have a provision that permits the employer/plan sponsor to cash-out a small balance in a participant’s account. However, once again, this provision is of relatively little value to satisfy a significant cash need.

Hardship Withdrawal for an Unforeseeable Emergency

A NQDC plan may allow distributions, based on a “severe financial hardship” resulting from:

  • Illness or accident to the participant or his or her spouse or dependent,
  • Property loss caused by casualty not covered by insurance,
  • Funeral expenses and,
  • Other extraordinary and unforeseeable circumstances resulting from events beyond the control of the participant.

While it may seem counterintuitive, suffering a reduction in pay or being furloughed from your job as a result of COVID-19 may not qualify as an “unforeseeable emergency” under the strict rules of Section 409A.  Note that these rules are different from, and more restrictive than, the requirements for a hardship withdrawal from a Section 401(k) plan.

Furthermore, to obtain a hardship distribution from your account, you must show that the need for cash could not otherwise be met by insurance, or the liquidation of other assets; and, the amount of the hardship distribution is limited to the amount needed to satisfy the emergency, plus applicable taxes.

Cancellation of Current Year Deferrals

Deferral elections under a NQDC plan made for the current year are generally irrevocable. A different election could be made for the following year; but the election for the current year cannot be changed. However, if you can establish that an “unforeseeable emergency” has occurred, and your employer approves the request, then the plan may permit the suspension of deferrals under an exception to the general anti-acceleration rule.

In one recent case among the companies with which we work, the employer approved requests by participants for a hardship distribution and/or the suspension of deferrals based on their representations and warranties that the COVID-19 crisis has caused them to suffer a severe financial hardship due to an unforeseeable emergency (as defined under the plan and applicable tax law), and that the amount of the requested distribution did not exceed the amount necessary to satisfy the financial emergency (plus taxes) after taking into account insurance and/or the liquidation of other assets.

A second narrow exception to the general rule prohibiting the cancellation of a deferral election is the disability of the participant. Note, once again, that the definition of “disability” for this purpose is different from other definitions.

Access to Pre-409A, “Grandfathered” Accounts

Some NQDC plans that were implemented prior to the January 1, 2005 effective date of Section 409A have a segregated component of participants’ accounts related to compensation deferred and vested before December 31, 2004 (“grandfathered accounts”).  In that case, distributions and withdrawals may be subject to the generally more favorable tax law in effect prior to Section 409A. For example, the pre-409A plan might provide for a discretionary 10% “haircut” withdrawal.

Small Balance Cash Out

Many NQDC plans have a provision that permits a lump sum distribution of a participant’s account if the balance is below the Section 402(g)(1)(B) limit (the maximum amount of elective deferrals for a Section 401(k) plan).

This liquidity option is of limited or no value to most participants; but is an alternative the employer/plan sponsor should be aware of.

Termination and Liquidation of a NQDC Plan

As noted above, several of the key provisions of Section 409A were written from an anti-abuse perspective; that is, to prevent some of the perceived abuses of NQDC plans that may have occurred in the past. One of those provisions prohibits the acceleration of benefits under the plan.  However, there are certain exceptions, for example, in the case of a change-in-control.  Another exception to the anti-acceleration rule is for the discretionary termination and liquidation of the plan, subject to strict guidelines:

  • The termination must not be related to a downturn in the financial health of the company,
  • All NQDC plans of similar design sponsored by the employer must also be terminated,
  • No new non-qualified replacement plan may be implemented for 3 years and,
  • The payments to participants in liquidation of their accounts must not begin until 12 months after the date of the termination and must be completed within 24 months.

As a result, a discretionary termination of a NQDC plan is not a simple solution to an immediate need for liquidity among the participants and has a number of other implications.

Financial Planning Lessons Learned from COVID 19

  1. It’s time to re-think your strategy: To re-consider the allocation of savings and retirement assets to maximize growth potential while minimizing risk by taking into consideration the timing of cash needs, appropriate asset class diversification and the creation of a non-taxable “bucket” of retirement savings.
  2. A NQDC plan is a long-term savings vehicle. While a NQDC plan is a powerful, tax-advantaged savings vehicle, it is long-term in nature that provides limited options for short-term liquidity. And unfortunately, unlike 401(k) plans, there are no relief provisions in the CARES Act for NQDC plans.
  3. Actively manage NQDC plan distributions. To provide a degree of liquidity and maximum flexibility, take advantage of the short term “in-service” distributions and re-deferral provisions under the plan:
    • For example, you could defer compensation earned in 2020 for the minimum deferral period under the plan (say to 2022), and then in 2021, 12 months prior to specified 2022 distribution date, re-defer the distribution until 2027 (five years out or later). You could cascade these short-term deferrals year after year.
    • In 2021, if you expect a need for cash in 2022, you could stick with the original 2022 in-service distribution election.
  4. Consider tax-qualified plans. While the savings benefits of a 401(k) or other tax-qualified plan are limited for highly compensated employees and professionals, they may have greater flexibility to meet an immediate need for liquidity. You should always consider maximizing qualified plan savings first before electing to participate in a NQDC plan.
  5. Contribute to a Roth IRA, too. After you fill your 401(k) bucket, consider using a Roth IRA to diversify the tax treatment of retirement income. You can contribute up to $6,000 to a Roth IRA in 2020 in addition to your 401(k).
  6. Consider a life insurance-based supplemental savings plan.  Contemporary programs, using significantly improved products in recent years, offer “Roth-like” tax characteristics, competitive investment options (including some with downside protection), liquidity, freedom from contribution and distribution restrictions, portability and cost-effective life insurance coverage.

Work with Unbiased Financial Advisors

In light of the lessons learned from the 2008 financial crisis and from COVID-19, we recommend that you consider working with a financial and tax advisor to obtain a clear picture of the role that non-qualified deferred compensation all other savings and retirement options should play in achieving your financial goals.

  • Executive Benefit Solutions, LLC is an independent consulting firm that specializes in the design and management of supplemental compensation and benefit plans structured to meet the specific needs of highly compensated executives and professionals. More information about the firm can be found at: www.executivebenefitsolutions.com.
  • My Financial Coach, LLC offers a precision financial planning platform to model investment and savings and retirement options on a coordinated basis with your personal assets and corporate benefits. My Financial Coach will match you with a Certified Financial Planner® (CFP) with the knowledge and tools to help you in the planning process. More information about My Financial Coach can be found at: www.myfinancialcoach.com.

Feb 10, 2017

How to Minimize Disability Risk for High-Income Earners

Seventy-seven percent of workers think that missing work for at least three months because of injury or illness would cause a financial hardship, while half think it would cause a “great hardship.”

Nearly all households, ninety percent, say that they would suffer financial hardship if they were disabled and unable to work for a year.* For this reason, disability insurance remains a long-standing core employee benefit.

Most companies provide their employees with a group long-term disability plan (LTD) that typically covers a percentage of their salary, typically 60 percent. Income Replacement Benefits are paid in the event of a sickness or injury resulting in a disability while employed.

For low to middle-income employees who derive most their compensation from a base salary, LTD can be an effective tool to ensure they can meet their financial obligations in the event of a disability.

By contrast, high-income earners, such as corporate executives, professionals and business owners, often have more sophisticated compensation packages that can include benefits like bonuses, partnership distributions, retirement contributions and restricted stock units. For these individuals, suffering a disability could lead to significant income shortfalls.

Four Types of Non-Salary Compensation

Different forms of non-salary compensation for high-income earners are:

Annual Bonuses

According to human resources consulting firm Aon Hewitt, the percentage of total payroll dedicated to performance-based annual bonuses has increased since the economic downturn of 2008.

Aon Hewitt concludes that companies have become more comfortable with pay-for- performance, as well as limiting their exposure to fixed salary expense in the event of another recession.

This compensation trend presents two challenges to high-income earners regards most LTD programs: 1) often, the base salary of these employees exceeds the maximum coverage amount; 2) bonuses, commission and other incentive payments are not covered.

As an example, ABC Company offers a group LTD plan that covers 60 percent of salary up to a benefit of $15,000 a month. If John Smith of ABC earns an annual salary of $300,000 and an annual bonus of $180,000 (total compensation of $40,000 per month), he is limited to 37.5 percent coverage ($15,000/$40,000), as opposed to 60 percent for lower-earning employees.

Partnership Distributions

Law firms commonly use partnership structures. Equity partners of a law firm are entitled to a share of the company profits, in addition to earning a salary and other employee benefits.

While some law firms adjust their LTD plan to include higher monthly benefit caps to accommodate high-earning partners, exposure still exists in the event of a disability.

To illustrate this problem, let’s examine a mid-size, California-based law firm with 20 partners and total earnings (salary plus partnership distributions) between $500,000 and $800,000 annually. The firm maintains an LTD plan that provides a 60 percent benefit up to a maximum $20,000 monthly benefit; that is, partners earning up to $400,000 realize full coverage. However, LTD plan will only cover between 30-48 percent of the total compensation of the 20 high-earning partners.

Retirement Plan Contributions

A recent Retirement Plan Survey conducted by Aon Hewitt shows nearly 70 percent of employers report that 401(k) plans are the primary retirement vehicle they offer to their employees.

This study confirms the trend of the last 30 years─namely; employees must fund most of their retirement. Highly compensated employees face the additional burden of limitations to how much they can save in 401(k) plans, as well as the amount of benefit they will receive at retirement from Social Security.

In the event of a disability, an employee not only misses the opportunity to defer his income into a 401(k) plan, he also does not receive any match offered by the employer. Depending on the beginning age and length of the disability, this limitation could have a significant impact on future retirement plans for high-income earners.

Restricted Stock Units (RSUs)

RSUs involve a promise by the employer to grant restricted stock at a specified point in the future. RSUs became a prevalent form of compensation in the early 2000s when changes in accounting rules lessened the advantages of offering stock options to employees.

A review of publicly traded company proxy statements reveals that the amount of RSUs paid out to executives can often be three to five times annual compensation. This pay out creates a substantial challenge for highly compensated employees in the event of a disability. To understand the potential magnitude of the problem, let’s review the details of the compensation plan of Mary Miller of XYZ Company.

  • Annual Salary of $750,000 with an annual bonus of $250,000;
  • RSUs of $2,000,000 with 50% vesting at three years and the remainder vesting after four years;
  • Total compensation is $3,000,000; after-tax income (35% rate) is $1,950,000.

Mary’s monthly income, in the event of a disability, would be $30,000 ($20,000 from LTD and $10,000 from individual coverage) meaning she would receive only slightly less than 20 percent of her current after-tax income.

Supplemental Solutions to Consider

As evidenced above, the different forms and magnitude of compensation earned by successful individuals can present a serious gap problem in the event of a long-term disability.

When looking to solve the potential income shortfall, a highly-compensated individual should consult an insurance professional with a thorough understanding of supplemental coverage.

Supplemental coverage options can range from individual disability insurance policies, which can address the needs of those with bonus and other forms of incentive compensation to specialty products that cover those with significant partnership distributions, as well as restricted stock units.

*Source: Consumer Federation of America and Unum, “Employee Knowledge and Attitudes About Employer-provided Disability Insurance,” Opinion Research Corporation Survey, April 2012.

If you would like more information on how to address the disability risk of high-income earners, you may contact Don Curristan, Managing Director at EBS. Voice: 760.788.1321 Cell: 619.318.6620 or e-mail to dcurristan@ebs-west.com.