How to Fill Gaps in the NQDC Story

Imagine that a client – a 42-year-old manager of a privately held company – calls you, concerned and seeking advice. He says: "I've been offered an opportunity to participate in my company's non-qualified deferred compensation (NQDC) plan. It's quite an honor."

You ask why he is concerned.

He says: "Participating in NQDC gives me the opportunity to defer salary and bonuses rather than taking taxable cash. But my tax bracket isn't very high yet, and I could use more liquidity, especially since my children are moving toward college age. Mainly, I'm concerned how safe y money will be in the plan. I can't access my NQDC money until I leave the company, die or retire. Although the plan is funded with corporate-owned life insurance (COLI), the policy belongs to the company, not me. I would be a general unsecured creditor of my employer. If the company becomes insolvent, I'm worried what would happen to my money."

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You tell him you will look into it, and here's what you find: His company has been expanding rapidly with borrowed money. It is a secretive private company with financial statements that are closely guarded and not accessible to most executives. The company operates in a competitive industry with vulnerability to the economic cycle. Its owners want to recruit and retain executive talent, but they aren't willing to pay salaries comparable to competitors'.

Why is this information valuable? NQDC has become one of the hottest products of the life insurance industry, and agents are aggressively promoting its benefits to companies of all types and sizes. However, for reasons detailed in this article, NQDC is not suitable for some types of companies or executives, especially when compared to alternative benefits or savings/investing programs. Even in companies with a valid need for NQDC, executives should carefully consider the pros and cons of participation with professional help.

Some life insurance companies are omitting part of the NQDC story. Your ability to fill the gaps will make you a more valuable advisor, and this article can help.

A Brief Review of NQDC

NQDC represents an agreement between an employer and its executives under which the executives agree to defer compensation until a future date, mainly to delay payment of current federal income tax. By meeting a few basic "top-hat" requirements, the employer can adopt the plan without the obligations or restrictions of ERISA and selectively decide which executives participate.

NQDC plans may be unfunded or "informally funded," but in either case, the employee may not derive economic advantages from plan assets until benefits are paid out. The failure to comply with this provision will result in having compensation immediately included in the participants' gross income for federal income tax purposes. Under the Section 409A requirements of 2004 tax law, if the IRS determines that deferred compensation should be included in gross income, it may levy on the plan participant an additional 20% excise tax, plus interest.

In today's market, most NQDC plans are funded with corporate-owned life insurance (COLI), and variable COLI is claiming a growing share of the market. Variable COLI offers each executive a menu of investment options, similar to a 401(k) plan, along with the opportunity to participate in equity-like returns with tax-deferral.

COLI also offers tax-deferral advantages for corporations because the inside build-up of cash value is not currently taxable. Because participants in NQDC tend to be relatively healthy, upscale, and white-collar, COLI can offer more

streamlined underwriting and better pricing than individual life insurance contracts. In some cases, more than 100% of first-year premium is credited to cash value.

Filling the Gaps

The life insurance industry is doing a good job making the case for NQDC plans funded by COLI. However, key points in the story aren't always addressed. When you are aware of these gaps, you will become a more objective advisor in helping companies and executives evaluate these plans. They include the following:

Personal liquidity – Some corporate executives are deferring money into NQDC before they have achieved adequate personal liquidity. Under the 409A regulations, plan assets have become less liquid and distributions can't normally be accessed or accelerated except for death, disability, or unforeseeable emergencies. Otherwise, distributions are allowed at separation from service, change in company ownership or control, a specified future age or date, or subject to a domestic relations court order.

Planning note: An executive who needs money to make college tuition payments probably will not be able to tap NQDC money because college costs are foreseeable and non-emergency. Some executives have been forced to resign from their companies to gain access to the liquidity they need for important financial needs.

Lending to the employer – In today's market, as traditional bank financing has dried up, many small companies are paying interest rates of 10%+ for financing. As a general unsecured creditor of the company, the NQDC participant probably will earn less than a 10% return on plan assets. In bankruptcy proceedings, courts can erase or greatly diminish the value of claims by all unsecured creditors, including NQDC participants. According to the U.S. Economic Census, the average U.S. start-up company lasts about 12 years before going out of business. Therefore, many companies will not outlast the lock-up provisions of their NQDC plans.

Lack of diversification – Executives who already have a large part of their net worth tied up in their own company may be poor candidates for NQDC. If employers fail, they may not have enough diversification to weather the storm. In public companies, most executives who already own substantial employer stock or options would not consider it a great idea to buy the company's bonds. Yet, as NQDC participants, they stand with (or even behind) bondholders in line to be repaid.

The cost of COLI – Although COLI offers better insurance costs than individual life insurance, it isn't cheap. Each executive's NQDC account typically mirrors the growth of policy cash value less insurance contract costs. In variable COLI, this can be roughly equity market returns less 2-3% per year. When equity markets were achieving 10% average gains per year from 1975-2000, executives could grow NQDC accounts by 7-8% annually. But over the last seven years, the S&P 500 Index has averaged a total return of just 2.5% per year, leaving an average variable COLI NQDC account about flat after expenses. It's small compensation for the risk of being an unsecured creditor during a period of economic uncertainty and credit market distress.

Tax cost and complexity – The life insurance industry often touts the attractive tax benefits of NQDC without mentioning tax drawbacks. First, the IRS requires FICA and FUTA (federal unemployment) taxes to be assessed on deferred amounts at the time they become vested – which usually means in the same year they are deferred. Secondly, several states have adopted "source tax" rules designed to tax any compensation earned in-state. To make sure they receive their share of income tax, these states limit the maximum tax deferral period to 10 years. Due to complexities and lack of consistency among states, NQDC practitioners say it is difficult to obtain clear and accurate information on state income tax rules.

Planning note: In 2008, the employee's portion of FICA tax is 7.65% on the first $102,000 of gross earnings and then 1.45% on any additional earnings. (6.2% is the capped Social Security portion and 1.45% is the uncapped Medicare portion.) However, Barack Obama has proposed removing the cap on the Social Security portion above a specified level of gross earnings. Such a change, if enacted, could increase the tax impact on NQDC participants, who must meet payroll tax and any state source tax obligations by pulling cash out-of-pocket.

Administrative complexity – The life insurance industry is touting simplified "turnkey administrative packages" for the NQDC market, even though it's difficult to cookie-cutter plan administration in this market. For example, companies that sponsor both qualified and NQDC plans must make sure that their documents and communications do not link NQDC eligibility with an executive's agreement not to participate in the qualified plan. Companies must make sure that the NQDC plan has been formally adopted by the Board of Directors and that participants have no ability to gain economic benefit from plan assets, such as using those assets directly or indirectly as collateral for personal loans. The IRS urges its auditors to "determine whether the company (sponsoring the NQDC plan) has paid a benefits consulting firm for the executive's wealth management," presumably to establish whether the company is commingling current and deferred benefits for top executives.

Planning note: It's important for NQDC participants to realize that even if the company is clearly responsible for administration errors, participants will bear most of the tax cost, including any excise taxes and interest assessed by the IRS.

The drift of income tax policy – For executives, NQDC will work most effectively if federal income tax rates are lower in the future than they are today. Of course, it's impossible to know whether federal income tax rates go move higher or lower. But growing federal deficits and populist sentiment favoring higher taxes on the wealthy (e.g., the "Obama plan) should be considered. Some executives take NQDC payouts in a lump-sum, either because the plan mandates it or they no longer wish to be an unsecured creditor after leaving work. Lump-sum payouts can push executives into a higher federal tax bracket – e.g., from 28% to 33%.

Planning note: It may not make much sense for "executives-on-the-rise" to participate in NQDC because future increases in compensation may push them into higher tax brackets, even if federal income tax rates stay constant. The higher the executive's tax bracket is now, the more sense NQDC makes.

Miscommunication – The NQDC story isn't quick or easy to tell, and it's possible for executives to hear a story not supported by facts. For example, Rabbi Trusts are touted as a proven way to protect NQDC funding. However, Rabbi Trusts have value in protecting assets against a change in company ownership/control – not against insolvency or bankruptcy.

The tougher 2004 rules on NQDC plans were prompted by abuses at Enron, where more than 100 top executives received accelerated distributions totaling more than $50 million just before the firm collapsed. In the post-Enron era, when IRS auditors are examining the fine print of NQDC plans in great detail, experienced practitioners say there is no reliable way to protect plan assets against a company's insolvency without subjecting compensation to inclusion in the participant's taxable income. Because bankruptcy judges can "claw back" NQDC plan distributions made up to 12 months prior a bankruptcy filing, executives are not "off the hook" until a full year after distributions are made.

Transparency – NQDC participants in private companies can be even lower on the creditor chain than some secured creditors. For example, a bank that loans money to a company on an unsecured basis usually has access to a full set of financial statements, and it can write a loan agreement containing specific terms and covenants. Plan participants working for private companies may not have this leverage or transparency. Even if an NQDC plan is funded with COLI, it is possible that the plan could pledge the policy or borrow its cash value, especially if the company needs cash in a pinch. The more highly leveraged a private company's balance sheet is and the less visibility it gives plan participants into financial statements, the less attractive NQDC may be.

Economic cycle vulnerability – Executives with strong loyalty to their employers may not be aware how vulnerable the company is to changes in the market environment or economic cycle. To gain objectivity, it's usually a good idea for an executive to order a Dun & Bradstreet credit report on the employer before deciding to participate in NQDC. The report can illuminate the company's current financial and competitive position, creditors, and other key data.

Planning note: NQDC should supplement competitive executive pay packages. When companies offer NQDC in lieu of competitive salaries, they are asking executives to finance part of their own compensation, and this can be a warning sign of vulnerability.

More attractive alternatives – The life insurance industry's prima facie case for NQDC is the fact that highly paid executives may have limited ability to participate in their company's 401(k) plan due to nondiscrimination requirements and top-heavy rules. But that was before the Pension Protection Act of 2006 created a streamlined new "safe harbor" for 401(k) plans that adopt Qualified Automatic Contribution Arrangements (QACAs). You can read about it here:

Automatic Enrollment Is the Future of 401(k) and 403(b) Plans

Plans that adopt QACA guidelines and agree to make a non-elective contribution of 3% for each non-highly compensated employee (or an annual employee matching contribution) are no longer subject to non-discrimination tests or top-heavy rules. For companies with fewer than 100 employees, SIMPLEs offer relief from discrimination tests and top-heavy rules.

For 2008, a corporate executive age 50+ is eligible to defer $20,500 into a 401(k) and also participate in employer contributions up to a total of $46,000 in annual plan additions, assuming the plan has adopted a QACA. The argument that top executives are handicapped in their ability to plan for retirement with 401(k)s is no longer as compelling.

Also, in many companies with younger executive teams, Executive Bonus Plans funded by life insurance may be more appropriate benefits than NQDC plans. In these plans, executives can own the life-insurance policies, tap cash values for personal liquidity, and rely on the death benefit for family protection – without the complexities of NQDC administration or the risk of company insolvency. (The drawback is that executive bonus plan premiums are paid by the executive with after-tax dollars.)

In Summary – Know When NQDC Works

When you are able to fill gaps in the NQDC story, you will be in better position to recommend participation to executives when it is suitable. For example, NQDC works best when: 1) the participant is in a high tax bracket and has already built personal liquidity; 2) the participant has a well diversified portfolio not over-concentrated in employer securities; 3) the company has a strong balance sheet not over-leveraged; 4) the company gives participants transparency into its financial statements; and 5) all plan details are carefully reviewed by a competent third-party administrator. It also helps when the employer is supplementing the participant's own plan deferrals with company contributions through a "401(k) mirror" or Supplemental Executive Retirement Plan (SERP) design.

Suppose you are prospecting to install NQDC plans at the company level, and you encounter a company where all of the above requirements are met. In that case, you can be more confident that the plan will become valuable for the company and its executives and profitable for you. The NQDC plan sale at the company level opens doors to providing personal insurance and investment services to executives and building strong long-term relationships with them. However, the plan can only be a winner for insurance companies and agents if its benefits trickle down and materialize for all participants, many years from now.

By filling the information gaps for NQDC participants, you also will become more effective at qualifying companies that are the best prospects for these plans and making sure they keep working on a continuing basis.

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