Proposed Legislation Could Lose Hedge Funds 'Deemed' Investments

Some nonqualified deferred compensation plans permit the plan’s participants to have a “deemed” investment in a hedge fund. Sponsors of such nonqualified deferred compensation plans often invest in the hedge fund to avoid having an unhedged obligation to the plan’s participants. Both the House of Representatives and the Senate have passed bills that, if signed into law, would impose new restrictions on a wide variety of nonqualified deferred compensation plans. The House passed H.R. 4520, the American Jobs Creation Act of 2004, on June 17, 2004, and the Senate passed S. 1637, the Jumpstart Our Business Strength Act, on May 11, 2004. If the Senate’s version of the legislation is signed into law, nonqualified deferred compensation plans may not be able to offer deemed investments in hedge funds. The sponsors of the nonqualified deferred compensation plans, therefore, would no longer invest in hedge funds to avoid having an unhedged obligation to the plan’s participants.

Unlike tax-qualified retirement plans, nonqualified deferred compensation plans are not subject to the qualification requirements of the Internal Revenue Code of 1986, as amended. Nonqualified deferred compensation plans, therefore, can be designed to cover only highly compensated employees. The cost of this flexibility is that nonqualified deferred compensation plans do not receive the favorable tax treatment afforded tax-qualified retirement plans, such as a tax deduction for an employer when it makes a contribution to the plan. Nonqualified deferred compensation plans take many forms, including arrangements in which employees may elect to voluntarily defer their receipt of compensation to a future date and arrangements in which selected highly compensated employees supplement their pensions under tax-qualified retirement plans.

To defer tax on compensation deferred under a nonqualified deferred compensation plan until the employee actually receives the compensation, the deferred compensation must remain the property of the employer during the deferral period. This can be accomplished by not funding the plan or funding the plan with a rabbi trust, which is an irrevocable trust whose assets are subject to claims of the employer’s general creditors in the event of the employer’s bankruptcy. Nonqualified deferred compensation plans often provide that the compensation deferred under the plan is credited with earnings during the deferral period based on a deemed investment selected by the employee at the time the deferral is elected. Each participant has a book entry account that is credited with such amounts as though the amount deferred had actually been invested in the deemed investment selected by the participant. Currently, there are no restrictions on the deemed investments that nonqualified deferred compensation plans can offer. The deemed investments sometimes include a fixed rate of return, an equity index or options that mirror those offered under the employer’s tax-qualified defined contribution retirement plan, such as a 401(k) plan. A return based on the performance of a hedge fund is also sometimes offered. Though not required to do so, employers typically actually invest in the deemed investment selected by the employee to avoid having an unhedged obligation to the employee. The employer’s actual investment in the deemed investment should not cause the employee to be taxed on compensation deferred before actually receiving his or her money, under the “doctrine of constructive receipt,” as long as the assets purchased by the employer remain part of the employer’s general assets (or are held in a rabbi trust) and are subject to its general creditors’ claims. Accordingly, if an employee elects to have his or her deferral under a nonqualified deferred compensation plan earn a return based on the performance of a hedge fund, the employer typically invests in that hedge fund.

The Senate version of the bill would amend the Code to add a new section that would, among other things, provide that the deemed investments available under a nonqualified deferred compensation plan must be comparable to the investments available under the employer’s tax-qualified defined contribution retirement plan that has the fewest investment options. If the requirements of the new Code section are not met, the participants in the plan would have adverse tax consequences. The Senate bill does not define “comparable”; however, the Senate Finance Committee’s report on the National Employee Savings and Trust Guarantee Act of 2003, which is a prior Senate bill that contains similar provisions to S. 1637, provides that deemed investments available under nonqualified plans may be less favorable or more limited than investments available under a qualified plan and brokerage windows, hedge funds and investments in which the employer guarantees a rate of return above what is commercially available are prohibited from being offered under nonqualified plans. If an employer does not have a tax-qualified defined contribution plan with participant-directed investment options, the Senate version of the bill provides that the deemed investments available under the employer’s nonqualified deferred compensation plan must meet such requirements as the Treasury Secretary may prescribe.

If the Senate version of the bill is enacted, the deemed investments available under an employer’s nonqualified deferred compensation plan and the investments available under the employer’s tax-qualified defined contribution retirement plan with the fewest investment options must be comparable. Employers may need to change their nonqualified deferred compensation plan, tax-qualified defined contribution plan or both plans to comply with this legislation. Because hedge funds are risky and participation in them is limited to certain qualified purchasers, tax-qualified defined contribution plans generally do not offer hedge funds as an investment option. Therefore, an employer that provides employees with a tax-qualified defined contribution plan with participant-directed investment options and a nonqualified deferred compensation plan that permits deemed investments in hedge funds will need to eliminate the hedge fund option. Hedge fund sponsors that maintain nonqualified deferred compensation plans for their employees would no longer be able to permit deemed investments in their hedge funds. It is uncertain whether a nonqualified deferred compensation plan can permit deemed investments in hedge funds if the employer doesn’t maintain a tax-qualified defined contribution plan that permits participants to select how their accounts are to be invested. In this situation, the nonqualified deferred compensation plan would need to comply with the requirements contained in regulations that have not yet been promulgated.