Designs for non-qualified executive comp plans are being rethought

Washington

With the full force of a new Internal Revenue Service regulation set to take effect on Dec. 31, companies will have to consider whether to amend, or entirely revamp, their non-qualified executive compensations plans. So noted three experts at the annual meeting of the Association for Advanced Life Underwriting, held here earlier this month, during a workshop on IRC rule 409A, an outgrowth of the American Jobs Creation Act of 2004.

“The new IRC rule is causing us to rethink designs for non-qualified executive compensation plans,” said Jim Clary, president and CEO of Mullin Consulting, Los Angeles. “We’re moving into a world where non-qualified plans look a lot like qualified plans in terms of the governing regulations.”

Prominent among 409A’s provisions are restrictions on elections and distributions. The rule stipulates, for example, that deferred compensation cannot be distributed earlier than the plan participant’s death, disability or the six-month period following the individual’s “separation from service” (e.g., termination).

Executives also must weigh the impact of compensation they elect to defer after Dec. 31, 2005, for two reasons: The election cannot take effect until 12 months after the election date; and the first payment must be deferred for not less than five years from the date such payment would otherwise have been made. What is more, 409A prohibits accelerated distributions.

Also to consider: All amounts previously deferred are immediately taxable unless subject to a substantial risk of forfeiture; executives pay an additional 20% tax on deferred compensation if they fail to comply with the rule; and they might not collect on the compensation because the 12-month/5-year rule magnifies their exposure to a change in company control, cash flow and bankruptcy risks.

The various restrictions might prompt some companies to opt for alternatives to traditional, non-qualified plans. William MacDonald, president and CEO of Retirement Capital Group, San Diego, suggested these could include a Section 162 bonus plan or secular trust.

The last, an irrevocable life insurance trust in which all benefits are funded and immediately vested in the executive, separates the deferred compensation from the employer’s assets. The contributions, though taxable to the executive, are tax-deductible for the employer. And contributions are not subject to claims of the employer’s creditors.

Another ILIT, the rabbi trust, also can prove valuable in protecting executives against the six-month delay following their separation from service, during which time the company (whether under old or new management) might think twice about making payments. The trust should be fully funded and managed by an independent trustee, said Clary.

“The rabbi trust will provide the executive with sufficient security so that, absent a legitimate reason in the plan document as to why the company shouldn’t pay, then the trustee will pay,” he said.

Michael Goldstein, president and general counsel of BenefitsGroupWorldWide, Los Angeles, added that recent court decisions have affirmed that trust assets are protected against claims by secured (e.g., bank) creditors. Only general (unsecured) creditors can collect from the trust, including the executive seeking payment under the deferred compensation plan.

Clary said he expects companies will opt to use more frequently scheduled distribution accounts under 409A. So, a client who wants to retire at 62 may, for example, set up a scheduled distribution at age 57, with payments to be made in installments over 15 years.

Also to be considered seriously, he noted, are “rolling” three- and five-year distributions, wherein the plan comprises five accounts that pay on a staggered basis. So, the first year’s compensation is deferred into account one, which pays in year six. The second year’s compensation is deferred into account two, which pays in year seven, and so on.

“One advantage of this strategy is that, at any point in time, you have a five-year risk on your money,” said Clary. “Over the five years, you can take all their money out, stop deferring and take distributions as they occur. That reduces risk from a benefits security standpoint while maintaining flexibility going forward.”

Clary cautioned, however, that the IRS has yet to issue guidelines on such rolling deferrals. Still to be resolved is whether a change to any account alters the timing of distributions only for that account or for all accounts.

Given the added complexity of plan design mandated by 409A, advisors would do well to explore areas left untouched by the rule that could be simplified. One place to look, said Clary, is plan funding.

Companies desiring to insulate deferred assets from market volatility might consider a fixed-rate plan that is funded using 10-year Treasury notes. Clary observed that such fixed-rates plans actually have performed better than variable rate allocations tied to equities indexes, such as the S&P 500 and Russell 2000.

Advisors also should recommend establishing a new 409A-compliant plan, Goldstein insisted, because of the difficulties encountered in interpreting amendments to existing plans.

“Every time you amend, someone administering the plan several years later won’t understand the amendments and the grandfathering [of the plan] will die right there,” said Goldstein. “When you amend and restate, therefore, you’re causing clients significant problems.”

Advisors also can distinguish themselves under the new regime, said Clary, by enhancing communications with clients who might otherwise find 409A-compliant plans too daunting to implement.

“It won’t do us much good to put into these plans bells and whistles like rolling five-year deferrals and scheduled distribution accounts if we then don’t do more on the communication side,” Clary said. “We [Mullin Consulting] are ramping up to provide more robust communications and advisory services that our clients need to understand these plans.”

Goldstein added that advisors must also tailor presentations to decision-makers in four departments: human resources, treasury, finance and legal. These individuals will want to learn about plan benefits, funding mechanisms, how the plan will be reflected on the balance sheet, and IRS compliance.

If they also ask the advisor to justify being so well compensated for his or her services, the advisor should not convey shame when responding, said Goldstein.

“Like the investment banker, the advisor is helping the company to deal with debt liability–in this case deferred compensation–and to preserve human capital,” he said. “So, when a company exec says, ‘You’re making a big commission on this,’ you say, ‘You’re damn right I am! And let me explain why.’”

‘We’re moving into a world where non-qualified plans look a lot like qualified plans in terms of the governing regulations’

So, when a company exec says, ‘You’re making a big commission on this,’ you say, ‘You’re damn right I am! And let me explain why’