Employers looking for ways to attract and retain key talent can enhance their retirement plans with a nonqualified deferred compensation plan (NQDC).

NQDC plans can solve for shortfalls in savings for highly compensated employees and provide retirement preparedness equity to those who have already maxed out their qualified plans limits. They do this by helping these individuals save beyond the limitations imposed by the IRS on qualified plans.

At the same time, employers can use NQDC plans to recruit, reward, and retain top talent, while minimizing the impact to the company’s financials. These plans offer employers:

Increased flexibility: NQDC plans are not qualified, which means the employer does not need to follow Employee Retirement Income Security Act (ERISA) requirements. This allows more plan flexibility and customization tailored to the company.

Additional cash flow: Since NQDC plans “postpone” employee compensation until a predetermined time in the future, they free up company cash that can be used to cover short-term business needs.¹

Minimal set up and administration costs: After legal and accounting fees have been paid, NQDC plans do not involve additional annual costs or require government agency filings.²

Asset options for NQDC funding

While any asset can be used to finance a NQDC plan, the most prevalent and commonly used funding vehicles are cash, mutual funds, and corporate-owned life insurance (COLI).

Before an employer selects how to fund their NQDC plan, it’s important to realize that these are still company assets. So, whether they’re sitting at the company, in a brokerage account, or in a Rabbi trust, any tax issues or consequences that occur when owning these assets are the company’s responsibility.

Below are the advantages and disadvantages of some commonly used funding options:

Cash (also known as “Unfunded”)

Depending on the size of the company, it may make sense for the employer to keep the cash normally paid to a participant—an “employee pay-as-you-go” scenario. This option can increase company cash flow, allowing the employer to put away money until the employee is paid in the future.

Before an employer chooses to establish an unfunded NQDC plan, however, it’s important to evaluate the primary disadvantages:

• Compounding liabilities: Unfunded liabilities can be substantial, and the company must financially prepare for this undertaking. If, for example, a company experiences an unexpected loss in revenue or assets, it may result in a perpetual state of “catch up” to replenish the NQDC plan. This could ultimately impact the key employees receiving these benefits in the future—with the potential for them to receive less deferred compensation than the amount agreed to in the plan.
• Active and consistent management: Companies must ensure that the accounting for the unfunded plan is actively managed and meticulously tracked. Deferred compensation shows up on the company’s balance sheet as a liability and must be reconciled consistently each time a payout is made.

Mutual funds

Mutual funds are another common way to fund a NQDC plan. Simplicity is the biggest draw for employers choosing this option—setting up and administering a NQDC plan with mutual funds can be easier than when using other funding methods. Mutual funds offer other advantages, too, including:

• Account flexibility: When selecting mutual funds as the funding vehicle for a NQDC plan, employers have maximum flexibility and customization. For example, some choose to mirror their companywide 401(k) plan, while others deliver more customized offerings for executives and key employees. Either way, the choice is up to the employer.
• Low-cost investment options: This type of NQDC plan offers additional funds and exchange-traded funds that are available on the platform. Most offer institutional pricing, depending on the size of the purchaser, which provides plan participants lower fund expenses and fees in comparison to the standard retail pricing.

The major disadvantage when using mutual funds as the funding asset is the tax consequence. In fact, every time participants reallocate their portfolios, the company will need to pay taxes on any gains if they’re engaged in the contract. And any distributions from the mutual funds, whether interest or capital gains distributions, will result in a company tax leakage.

COLI

COLI is permanent life insurance that’s owned and realized on the company’s books, insuring the lives of its select participants. Like other life insurance policies, COLI’s tax advantages make it an attractive way to fund NQDC plans. More specifically, a COLI offers:

Tax-deferred cash value growth: Cash values within the policy grow on a tax-deferred basis, which means that the employer does not need to set up a deferred tax liability—as long as the company plans on holding the policy until the individual’s death.

Tax-free death benefit: The policy’s death claim on its key employees is delivered to the company income tax-free. Many employers use this tax-free death claim to recover the costs associated with paying for the NQDC plan.

Tax-advantaged reallocation: An employer that uses a variable universal life (VUL) policy to fund their NQDC plan can reallocate the cash value inside the policy on a tax-free basis. Unlike mutual funds—which are taxed on any capital gains when a share is sold—the funds within the life insurance policy won’t generate additional tax costs when the employer wants to rebalance the portfolio.

Tax-advantaged access: The employer can participate in tax-free withdrawals, up to the premium dollars paid into the policy, within certain limits determined by the IRS. In addition, the employer can also take policy loans on a tax-free basis—as long as they’re repaid—which means a company does not need to wait until a key employee’s death to use proceeds.

Selection of competitive investments: COLI offers a variety of investment options into which the employer can choose to invest the policy cash value.

But like all asset vehicles, there are some disadvantages to using a COLI to fund a NQDC plan:

Cost of insurance (COI): The cost of insurance, or the fees associated with certain types of life insurance products, can create a drag on the policy’s returns.

Even so, an employer that’s comfortable sacrificing some of the cash value returns would still be able to avoid paying tax costs with COLI.

Complexity: These types of funding assets aren’t as simple as mutual funds.

However, if a company is willing to take on a little more complexity, it may be worth enjoying the tax advantages that accompany a COLI policy, depending on the employer’s overall financial objectives.

Read full article to learn more about how a NQDC works, a 5 step strategy for implementing a plan and important considerations.

CONTRIBUTORS:

Kevin Segal, M Member Firm Principal

Randall Peck, M Member Firm Principal

1 Employers, however, will need to have the cash available for distributions down the road.

2 NQDC plans must follow IRC Section 409A regulations, and many employers use professional administration services to meet these requirements.