On March 31, the Employee Benefit Research Institute revealed that only 4% of American workers surveyed feel “very confident” about their retirement. “Retirees report that they are significantly more reliant on Social Security as a major source of their retirement income than current workers expect to be. Half of current retirees surveyed say they left the workforce unexpectedly (due to health problems, disability or changes at their employer, such as downsizing or closure.) Many workers report they have virtually no savings and investments. In total, 60% of workers report the total value of their household’s savings and investments, excluding the value of their primary home and any defined benefit plans, is less than $25,000.”¹
With all of this information, we know two things are true of tomorrow’s retirees: 1) American workers must save more money every year, and 2) They need to work longer. Saving money is a discipline that spans all socio-economic walks of life. Highly compensated employees (HCEs) need to save more money, just like the non-highly compensated employees (NHCEs). HCEs are employees who are more than 5% owners, receive compensation in 2012 of more than $115,000, or may be in the top 20% of employees when ranked on the basis of compensation. Just because they earn more doesn’t mean they have less of a need to save more.
Last fall, I met with an attorney who controlled a $9 million 401(k) plan and said, “Almost every year, there are attorneys who work for our firm and receive a refund of their excess 401(k) plan contributions. The attorneys are sitting on pins and needles wondering how much of their 401(k) contributions from the previous year will count.” The law firm’s plan was top-heavy and didn’t pass the Average Deferral Percentage (ADP) test.
Non-qualified deferred compensation (NQDC) plans are perfect compliments to a 401(k) plan arrangement that discriminates against HCEs. There are a number of non-qualified plans that an employer may choose to implement. The various options include pure deferred compensation plans, supplemental plans, excess benefit plans, supplemental executive retirement plans (SERPs), top hat plans and death benefit only (DBO) plans.²
Here, we will focus on just two plans; the excess benefit plan and the SERP (also known as the top hat plan).
Excess benefit plans
Congress has restricted qualified plans so they will not favor HCEs. As a result, excess benefit plans were created to overcome those restrictions. Excess benefit plans are a NQDC strategy designed to automatically roll over excess contributions from the qualified retirement plan into an excess benefit plan. The Employee Income Security Act (ERISA) defined an excess benefit plan as “a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by IRC Section 415.” Therefore, some benefits specialists refer to these plans as “make-whole” plans.
Since excess benefit plans can only make a participant whole for the loss of benefits caused by the IRC Section 415 limits, a SERP plan is usually the best choice for employees who earn considerably more than the qualified plan compensation limit. SERPs can provide benefits that greatly exceed those provided by the company’s retirement plan calculations. Employers may use a SERP to recruit, retain and reward key employees. SERPs can be designed either as performance incentives or retirement supplements. Taxes are generally deferred for employees until NQDC benefits are constructively received. At that point, the HCE plan participant pays taxes at ordinary income tax rates. The corporate plan sponsor does not deduct any taxes up front for informal contributions to the NQDC plan until they are ultimately paid out to the HCE plan participant as outlined in the NQDC written agreement.
Because SERPs are unfunded plans, any taxes due on investment gains are paid by the plan sponsor. Companies can use mutual funds or other taxable investments to informally fund this arrangement, or they can fund these NQDC benefits through the separate accounts built on a life insurance chassis. Life insurance provides potential tax deferral as outlined in IRC Section 7702.³ Life insurance death benefits are inherently tax free, as noted in IRC Section 101(a).4
Employers interested in using NQDC plans should consult with a wealth advisor and insurance specialist to assist in plan design and administration. The team should have legal and tax counsel, insurance and investment advice.
This article is not meant to be construed as legal or tax advice. Please consult with appropriate advisors and read all prospectuses before investing.
2. CRPS Curriculum Book 1, “Types & Characteristics of Retirement Plans,” College for Financial Planning, 2002. (See pages 69-76, 97)