Anecdotal evidence suggests that nonqualified deferred compensation plans (NQDPs) are on the upswing as highly paid executives and employers grapple with the challenge of supplementing future income from a traditional retirement plan on their own in an environment of low interest rates and rising tax rates.

Advisers can scout opportunities to introduce the idea to clients that may not have yet considered the concept, and possibly assist with investment selection when informal funding arrangements are put in place.

Another factor in the growing popularity of these plans, according to attorney Stephen L. Ferszt, a partner with Tarter Krinsky & Drogin LLP in New York and specialist in NQDPs, is increased funding pressure on defined benefit plans that has led some DB plan sponsors to scale back on those obligations, but need to a way to keep key people whole.

“These types of programs are appropriate for many different types of businesses and in some cases, tax exempt employers, such as hospitals, academic institutions and the like,” Ferszt says.

A “blank canvas”

The NQDP, covered under Section 109a of the Internal Revenue Code, “is like a blank canvas with almost unlimited flexibility in design parameters and the ability to be selective about who receives the benefits,” according to Steven Kaye, founder and president of AEPG Wealth Strategies in Warren, N.J.  The plans are useful if you want to exceed the benefit constraints of traditional ERISA plans.

Thomas D. Ming, president of Tower Rock Advisors in Bakersfield, Calif., says he has clients who are re-analyzing their compensation strategies in light of the improving economy, and NQDC plans are increasingly sounding like an attractive option to some, often as a recruiting tool for top talent.

The catch, of course, is that the deferred income promise does not have to be funded. Or if it is, the covered employee does not have a direct claim on those assets until they are distributed, typically many years later. Corporate creditors, however, would have first crack at them if the business goes sour. Even a merger or acquisition could threaten the ultimate benefit.

 “The most typical plan for small employers is a plan that looks and smells like a 401(k) plan using an approved document and using corporate owned life insurance and a rabbi trust to protect the benefits funded,” Ming says.

Kaye says he’s not a big fan of the life insurance route “due to the large initial sunk cost and ongoing expenses in a permanent insurance policy.” Simple sinking funds are an alternative to life insurance but that funding decision is generally up to the employer.

Benefit Formulas

The typical NQDC plan benefit for small employers is expressed a percentage of pay (e.g., five) over a specified number of years. The benefit can be vested, using a graded or cliff structure, to enhance the golden hand-cuffs effect. The formula can also be tied to performance metrics for individuals and teams, Kaye says.

He offers a few caveats about NQDC plans. First, he notes, in a small company where secrets are hard to maintain, “cultural rifts can occur when you are selective about who gets a particular benefit.” But those can be managed.

Also, the financial frailty of many small companies needs to be considered, hence the desirability of an informal funding arrangement. While as noted those assets could be taken away by creditors or settling any other legal claims, any funding is better than none. Even so, the tax implications must be kept in mind. The employer receives no tax deduction for informal funding arrangements until the benefits are paid.

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