Nonqualified deferred-compensation plans are growing again in response to last year's expiration of Bush-era tax cuts, which effectively increased income taxes on high-wage earners.
The plans, often called “top hat” or “excess” plans, are offered to company executives earning significantly more than most workers, enabling the executives to shelter a greater share of their taxable income than permitted under federal rules governing qualified deferred-compensation plans, such as 401(k) plans.
The plans have risen in popularity among midmarket employers, according to PricewaterhouseCoopers LLP. About half of midmarket employers offered nonqualified deferred-compensation plans in 2012, up from roughly one-third of employers two years earlier.
The Employee Retirement Income Security Act limits how much employees can set aside in qualified tax-deferred retirement plans through a formula adjusted annually for inflation. This year's deferrals are capped at $17,500, while workers older than 50 are allowed to contribute an additional $5,500.
TAXED ON WITHDRAWAL
But executives in nonqualified deferred-compensation plans can save as much as they want, and contributions and investment income accrued are taxed after they are withdrawn, just as 401(k) plans.
The popularity of nonqualified deferred-compensation plans waned during the Great Recession. While industry experts attributed the decline mostly to economics — high-wage earners had less discretionary income to save, just like their rank-and-file counterparts — the plans also lost favor when many were seized by bankruptcy courts to pay corporate debts.
Funds in nonqualified deferred-compensation plans are considered corporate assets, regardless of whether they were contributed by the company or its executives. In response, some companies recently have purchased individual universal-life-insurance products to protect executives' retirement income.
During the recession, “a lot of firms began to phase out these types of plans. However, with the tax rate increases, we're seeing more demand,” said Jack Abraham, a principal at PricewaterhouseCoopers.
The percentage of Fidelity Investments' midmarket clients offering nonqualified plans increased over the past five years to 11%, from 8%, said Kevin O'Fee, vice president in defined-contribution-product management.
“There is certainly an upswing,” he said. At the same time, the percentage of plan assets increased 50% from the first quarter of 2008 through the first quarter of 2013, reflecting participants' stepped-up contributions.
“Whenever there are tax changes, you see increased interest in these types of financial programs,” said Yong Lee, chief operating officer of MullinTBG, a subsidiary of Prudential Financial Inc. that specializes in executive benefits. “Some of the executives' tax rates have gone up. They are looking to bring that down by deferring some compensation.”
A 2012 MullinTBG survey found that 91% of companies offer nonqualified deferred-compensation plans. Also driving this resurgence is the fact that companies are contributing less to executives' retirement, forcing them to save more on their own, said Doug Frederick, leader of executive benefits at Mercer LLC.
“Over the last three to five years, companies have reduced retirement benefits for the entire workforce. Most moved to defined-contribution plans. Similar things have happened at the executive level ... The nonqualified deferred-compensation plan is a good outlet, especially with the tax rate increases at the start of this year for the very-high-wage earners,” Mr. Frederick said.
Such plans, however, can be risky. If the business goes bankrupt, creditors can take all the funds in nonqualified deferred-compensation plans.
“Think of Lehman Brothers [Holdings Inc.]. Those folks lost it all,” said Robert Barbetti, head of the global executive compensation advisory service at J.P. Morgan Private Banking.
"RABBI TRUST'
“The only thing that an organization can do to protect individuals is to create a "rabbi trust,'” a contractual obligation that the company will pay the benefits to the executive, said Lisa E. Silva, senior vice president of executive benefits at Longfellow Benefits. “But the money is still a corporate asset if the company goes belly up.”
Among life insurance options to protect retirement funds is ING Insurance Solutions' self-owned life and retirement cover, which provides a death benefit and helps accumulate retirement funds, said Maggie Mitchell, vice president of advanced sales in Minneapolis.
Though the premiums must be paid on an after-tax basis, “growth on investments within the product is tax-deferred,” she said. Moreover, executives can take out loans, which is not allowed under federal rules governing nonqualified deferred-compensation plans.
