For Key-Employees on the Move, Bigger is Not Always Better

Deferred compensation can work for small to medium-sized employers, too

by Mark West, JD, CLU

Mr. West is Assistant Vice President, Advanced Solutions at the Principal Financial Group, specializing in executive benefit planning, business succession and estate planning. He is a frequent speaker and author on topics related to life insurance, tax, executive benefits, estate and business planning. Connect with him by e-mail: [email protected].

Key employees are once again mobile in our post-recession economy. As a result, employers of all sizes are looking for ways to recruit, retain and reward their top talent. Large companies have long held an edge. Big incentives have helped big companies attract and keep their star executives. Stock options, restricted stock units and nonqualified deferred compensation (NQDC) plans are commonplace.
For smaller, privately held companies, it’s challenging to put together a competitive package of incentives. But with help from a financial adviser and the right NQDC plan design, these growing employers can level the playing field.

Company size isn’t a major factor

Like large companies, small to medium-sized employers can offer NQDC plans, but there are two major factors to consider. Surprisingly, size isn’t one of them. When it comes to NQDC, a company’s financial stability and business continuity are much more important.

For stable companies with a solid business continuity plan, employer-funded NQDC is unquestionably an attractive incentive to provide to key employees. It allows the employer to target which employees to include in the plan and what appropriate incentive will be used to generate the employer contribution.

An employer, for example, may target just two key employees:

  • Chief financial officer (CFO)
  • VP of sales

For the CFO, the annual reward to be placed into the NQDC could be based on profit targets. The reward for the VP of sales could be based on sales. For both employees, the plan would offer supplemental retirement income to help fill their retirement gap.

Meet employer’s needs, address their concerns

It is important to use a NQDC plan that fits the particular needs and concerns of the employer.
Consider how people purchase an automobile. Even if they can afford the most expensive Rolls Royce, they may not necessarily buy one. Similarly, just because a Nissan Versa is one of the least expensive cars sold, it doesn’t mean all people will buy that model.

People buy automobiles that fit their needs. A similar approach can be taken with deferred compensation. In the case of a business only seeking to provide a deferred compensation program for a small number of employees, particularly if the contribution is less than six figures, why pay for features that are not needed?

Core plan design features for small to medium-sized businesses

There are many plan design features that can be used with NQDC plans, but the core features for a small NQDC case might require:

  • A simple design where the employer makes a flexible annual contribution to the plan
  • Vesting options if the employer wants to place golden handcuffs on the employer’s contributions
  • A tax-efficient way to finance the plan. A proven product for this need is life insurance
  • A short list of investment options to measure the benefit for the key employee
  • Sample documents to assist local counsel in complying with IRC 409A
  • Options for receiving the benefit in a lump sum or for a designated set number of years
  • Annual administrative reports for employers and employees at no cost

 

Features which may not be necessary for such a plan:

  • The ability for the executive to contribute to the plan
  • Multiple funding options
  • An expansive list of investment options and payout options from which the key employee can select
Like large companies, small to medium-sized employers can offer NQDC plans, but there are two major factors to consider. Surprisingly, size isn’t one of them. When it comes to NQDC, a company’s financial stability and business continuity are much more importan

While these are great features in some cases, these are bells and whistles a small plan may be willing to sacrifice for simplicity and cost savings.

Tax implications must be considered

For decades financial advisers have been active in implementing and managing NQDC plans for small to medium-sized employers. In some situations, the employer handled the plan administration internally or through a third-party administrator. In other situations, the financial adviser provided administration.
Unfortunately, in far too many situations, the administration was not adequately provided over the life of the plan. The adoption of IRC 409A in 2004 has upped the stakes. A non-compliant plan is subject to substantial, immediate taxes, including a 20 percent penalty that is the responsibility of the participant.
On a positive note, IRC 409A has helped solidify the procedures for a compliant plan and has provided a roadmap for how to design and implement a successful plan.

Type of corporation matters, too

Deferred compensation plans are common for executives of large, publicly held companies. In a privately held C corporation, stockholders can participate in a NQDC plan. The requirement is that they are part of a select group of management or highly compensated employees. Key employees of C corporations are also excellent candidates for this type of plan.

Many closely held companies, however, are so-called “flow-through” entities. They are often S corporations or limited liability companies (LLCs). It is sometimes misunderstood how NQDC plans can help these businesses. For a key employee who owns a substantial portion of a flow-through entity, there isn’t an advantage to participating in a NQDC plan.

An employer-financed deferred compensation plan can still be highly effective for key employees that either own no stock or only a small percentage of the stock. They, too, can be motivated to stay with their company if they know there is a reward for their loyalty.

If NQDC isn’t a good fit for a business client there are other designs that may help the client accomplish their goals. There are a variety of executive bonus plans available along with plans specifically designed to meet the needs of owners of flow-through entities.

Leveling the playing field

A properly structured NQDC plan gives the small to medium-sized employer an opportunity to compete with large employers. Consider how these growing companies may not be able to get the same level of participation in their 401(k) plans as larger companies.

They also may not be able to offer comparable health, insurance and stock benefits.
With a NQDC plan, though, the small to medium-sized employer can target key employees and provide an attractive golden handcuff where it is most needed. They can both recruit and keep key talent, putting them on a more even playing field with larger competitors.

Be the bearer of good news

A financial adviser can help a business owner sort through the issues and opportunities associated with key employee benefits. Often, it is a win-win situation for all the parties. Providing the benefit helps the employer recruit and retain key talent while helping the key employees supplement their retirement income.

Since many small- to medium-sized employers think NQDC is only for larger companies, the financial adviser can be the bearer of good news:

  • Streamlined, simplified NQDC designs can be a great fit for a growing employer with a handful of key employees.
  • Life insurance makes a simple and reliable financing vehicle, and it can all be done with little or no administrative cost.
  • For those business clients that want additional features and services, more robust plans are also available.

When working with clients on supplemental retirement solutions, be sure to discuss the broad array of solutions available to meet clients’ needs.