Do you have highly compensated employees looking to reduce their taxable income or set aside additional money for retirement? With a nonqualified deferred compensation (NQDC) plan, you can help these clients accomplish both goals. Keep in mind, however, that there is some measure of risk to consider—unlike with other types of retirement plans, the money they’ve saved is dependent on the financial solvency of the employer.
Here, we’ll look at the details of NQDC plans, plus strategies to help manage the risk and diversify retirement savings.
The Ins and Outs of an NQDC Plan
Deferred compensation broadly describes any agreement between an executive and an employer to hold back compensation until a future date or event (e.g., retirement). Employers can offer NQDC plans to a limited number of executives, without mandated contribution limits.
Advantages. NQDC plans are used by employers to reward executives or key employees. These select individuals can then save money on a pretax and tax-deferred basis—often in amounts greater than what can be set aside in a qualified plan like a 401(k).
Depending on the plan’s structure, the account balance may consist of the executive’s compensation deferrals or include amounts from the employer. For example, the employer may offer a matching contribution or provide a discretionary contribution.
Until distributed, the NQDC account balance will grow tax deferred. The rate of return is determined by the employer offerings at the time the compensation deferral is made. This rate may be fixed or be based on an index or on a variety of investment choices.
The promise. In its simplest form, an NQDC plan is an unsecured promise from an employer to pay the account balance at a future date. It’s also an opportunity for the executive to defer a portion of compensation before tax. This money is withheld from the executive’s paycheck and is credited to the account. The NQDC account tracks the balance, which is the amount the employer promises to pay in the future. No actual cash or investments are deposited or purchased in an NQDC account.
Although not required, many companies set aside assets to informally fund the future distribution of an NQDC account. These assets remain a part of the employer’s assets and are subject to its creditors.
The risk. Because an NQDC account balance is unsecured, it’s subject to the bankruptcy risk of the employer. As such, if the employer files for bankruptcy, the executive will be waiting in line with other creditors to receive his or her NQDC balance. For comparison, qualified plan assets are held in trust, so they are protected from the employer’s creditors. Participating in an NQDC plan requires the executive to place his or her trust in the employer’s financial health and to firmly believe that funds will be available when due.
Managing the Risk
Although the bankruptcy risk for NQDC plan participants can’t be avoided, there are risk management strategies to help protect their retirement savings.
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Compensation deferrals: If the employer is struggling financially or economic uncertainty is anticipated, your client may want to limit compensation deferrals for that year. During the decision process, be sure to factor in whether the executive is receiving a matching contribution on compensation deferrals into the plan.
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Scheduled date distributions: The NQDC plan may allow the executive to access a portion of his or her balance at a scheduled date, prior to retirement. This flexibility provides access to funds for a future planned expense or leaves the door open for the executive to remove a portion of the NQDC balance before retirement. If your client would like to leave funds in the plan growing tax deferred, he or she can make an election to delay. The election must be made one year prior to the scheduled date and defer to a new date at least five years after the originally scheduled date.
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Rabbi trust: Determine whether a rabbi trust has been established. This is a separate trust that cannot be used for the employer’s business operations and provides a source of funds which may be used to satisfy the employer’s obligation to executives. Even in a rabbi trust, however, NQDC assets are considered employer assets and are subject to the employer’s creditors.
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Investment management: Evaluate the investment allocation in retirement savings accounts individually and within the overall financial picture. Ensure that the allocations are in line with the client’s risk tolerance while also considering the current and anticipated economic conditions.
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Diversification of retirement savings: As you help manage the client’s investment diversification, in a similar manner, review his or her retirement savings. For example, you may want to diversify retirement savings to include other vehicles, such as a qualified plan or nonqualified savings. By spreading out the risk through different types of savings vehicles, your clients won’t have all of their retirement savings eggs in one basket.
Complementary Retirement Savings Strategies
Under certain conditions, an NQDC plan can be a good fit to supplement retirement savings; however, it generally shouldn’t be the only strategy. Other retirement savings strategies can complement the plan, and they can work together to diversify your client’s overall portfolio.
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Qualified plans: As cash flow allows, your clients might consider making the maximum allowable contribution to a qualified plan to take advantage of pretax deferrals and tax-deferred growth. This will give your client the confidence that assets are protected, outside of the employer’s creditors.
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Nonqualified savings: Setting aside money in an investment account or bank account is another useful strategy. Although this option doesn’t provide pretax or tax-deferred options, it does allow an opportunity to diversify among other asset classes or fund managers outside of what is available in the qualified plan or nonqualified plan. They can also provide liquidity for “rainy day” funds, if the unexpected occurs.
Risk Vs. Reward
Although participating in an NQDC plan comes with some measure of risk, it can be a great savings vehicle for certain clients. Before you recommend this type of investment, however, be sure your clients understand the risks involved. That way, you can construct a diversified retirement savings strategy that they’re comfortable with.
