Are There Hidden Financial Risks in Your Clients’ NQDC Plans?

Posted by Maureen Baxter, CLU, ChFC

November 15, 2017 at 1:30 PM

hidden financial risks in your clients’ nqdc plansNonqualified deferred compensation (NQDC) plans can be an effective tool for employers to recruit, reward, and retain select executives. But if they aren’t set up properly, there could be hidden financial risks in your clients’ NQDC plans that could be detrimental to both the firm and the covered employees. For example, some plans rely on future cash flows to meet their obligations. This may not be an issue for well-established businesses with a solid balance sheet, but for other companies, events that trigger benefit payments sooner than anticipated may cause unexpected financial strain. Here, I’ll offer some options to help you manage a plan’s financial risks, so you can mitigate potential disruption for your business-owner clients.

First, a Refresher on NQDC Plans

As I mentioned, many employers use NQDC plans as a recruiting, reward, and retention tool. The plans allow executives to defer taxes on current income while setting aside additional funds for retirement.

In order to defer taxation of benefits:

  • The plan must be unfunded.
  • The benefits can’t be guaranteed.
  • All benefits must remain subject to the business’s creditors.

Income tax is due once the benefits are paid out, but the business doesn’t realize any tax benefits until it actually pays the benefits to the executive.

NQDC plans are available for both for-profit and nonprofit businesses. In the nonprofit sector (including the government), NQDC plans are often referred to as 457 plans, and their plan design may differ. True deferral plans allow executives to defer their own compensation and bonuses. Supplemental executive retirement plans allow employers to fully fund the plans. And some plans are a combination of both employee deferrals and employer contributions.

What’s the Difference Between For-Profit and Nonprofit Plans?

For-profit companies. NQDC agreements in for-profit companies fall under Section 409A of the Internal Revenue Code (IRC). To be in compliance, plans must:

  • Be in writing
  • Outline specific triggering events: death, disability, retirement, or specific time periods
  • Benefit a select group of executives or highly compensated individuals
  • Be unfunded (i.e., assets used to finance the arrangement must remain an asset of the entity and subject to creditors’ claims)
  • Make assets to finance obligations available to the business’s creditors
  • Have restrictions on acceleration of benefit payments
  • Require the executive to elect how much to defer and the structure of the general benefit payout, prior to earning any income

Generally, plans provide an option for a lump-sum, five-year, or ten-year payment. Most executives are required to make this election annually. In a for-profit business, the executive may vest in the benefit without immediate taxation. Although the executive vests in the benefit, it is still only a contractual right that remains subject to the business’s creditors.

Nonprofit companies. NQDC agreements in nonprofit organizations may fall under both IRC 409A and IRC 457 regulations. There are two types of 457 plans: 457(b) eligible plans and 457(f) ineligible plans (457(f) plans are subject only to Section 457(f) of the code). Generally, one contributes first to a 457(b) plan and then contributes the over-the-limit excess to a 457(f) plan.

As with for-profit plans, to remain in compliance, nongovernmental 457 plans must follow these rules:

  • The agreement must be in writing.
  • The plan must outline specific triggering events or a time period for benefits.
  • 457(b) plans must be subject to contribution limits, similar to a 401(k).
  • 457(b) plans may include both employee deferrals and employer contributions.
  • Assets for 457(f) plans must be subject to the organization’s creditors.
  • There must be limits on acceleration of all benefit payouts.
  • Prior to earning any income, the executive must elect how much to defer.
  • In 457(b) plans only, the individual may elect a payout schedule (this option is not available in 457(f) plans).

Note that with nonprofit (nongovernmental) arrangements, once employees vest in the benefit, they typically are immediately subject to income taxation, though proposed regulations from the IRS offer some additional clarity. Also, the only benefit payment option with a 457(f) plan is lump-sum payout.

Options for Managing Financial Risk

As we explore different methods to manage a plan’s financial risk, remember that these arrangements have two different components:

  • The agreement and promised benefit itself
  • Financing instruments for managing employer financial risk

So how can you help manage these hidden financial risks in your clients’ NQDC plans? There are several options available, each with its own benefit—and risk.

Cash flow. This is the “no-plan plan,” and a number of NQDC agreements rely upon this to meet future promised liabilities. The financial risk exposure is self-evident.

Sinking fund. To establish a sinking fund, the employer contributes to an employer-owned brokerage account or other investment vehicle. The employer owns and controls the sinking fund assets and makes periodic contributions to cover liability for future costs under the plan.

Pros

Cons

Simple 

All taxes assessed to employer

Fairly liquid assets

Possibly subject to annual administrative charges and surrender fees

No underwriting required

Financial risk of early benefit payments

 

Interest rate or market risk

Annuity. An employer can purchase and contribute to an employer-owned deferred annuity. The employer makes periodic contributions to cover liability for future costs under the plan. The annuity is owned and controlled by the employer, and the executive is the annuitant. An annuity owned by an entity is subject to the “nonnatural person” rule. This means that the annuity holder loses the income tax deferral on any gains, and the interest earned inside the annuity contract is taxed to the business annually.

Pros

Cons

No health underwriting 

All income tax assessed to employer

Fairly liquid assets

No tax deferral due to the nonnatural person rule; gain taxed annually

 

Financial risk of early benefit payments

 

Interest rate or market risk, depending on type of product

Life insurance. If the executive is healthy and insurable, life insurance can be an effective financial risk tool. The policy’s tax-free death benefit insures against cash-flow risk. This allows the company to meet the promised benefit obligation, as well as recover the funds invested in the life insurance—tax free.

The employer contributes periodic premium payments to an employer-owned life insurance policy (EOLI) to cover the liability for future costs under the plan. The life insurance policy is paid for by the employer, and the employer is also the beneficiary. The executive may be the insured under the policy, or, if there are health concerns, another participant’s insurability may be used to assist in covering benefits. 

Keep in mind, premiums paid by the organization for EOLI are not income tax deductible. As with any EOLI policy, the employer must comply with notice and consent requirements and file Form 8825 annually to retain the tax-exempt status of a benefit payout.

Pros

Cons

Income tax deferral of gains 

Health underwriting

Fairly liquid assets—cash-value life insurance

Cost of insurance and fees

Insurance benefit payout is
tax-exempt

Compliance with EOLI rules

Limits financial risk of early benefit payments

Interest rate or market risk, depending on type of product

Should the life insurance be term or permanent? I prefer permanent life insurance and would emphasize that cash-value accumulation assists with living deferred-compensation plan distributions. When properly designed and managed, an employer may take distributions from the life insurance to pay benefits—without income tax consequences. In some situations where the cost of permanent coverage is prohibitive due to ratings, term life insurance may be a better option, as it can offer risk management benefits in the event of the executive’s death.

Every Business Is Different

NQDC plans can be a valuable component of a benefits package, but they need to be carefully managed to ensure that they don’t put your business-owner clients at undue risk. Be sure to assess each situation, and consider multiple approaches to manage hidden financial risks in your clients’ NQDC plans effectively.

Do you have business-owner clients with NQDC plans? Have you used any of these techniques to manage a plan’s financial risks? Share your thoughts with us below.

Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.

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