Despite limitations added by new Code Section 409A, nonqualified deferred compensation plans still have a vital role in executive compensation planning for key executives.
They provide benefits beyond those offered by qualified plans that rarely meet retirement savings needs for top executives. Qualified plans have restrictions on withdrawals during employment, while scheduled in-service withdrawals (such as for college tuition or the purchase of a retirement home) are allowed without penalty from nonqualified plans.
Nonqualified plans can provide “golden handcuffs” that encourage loyalty as well as a parachute for executives in the event of a change in control. Most importantly, nonqualified plans are discriminatory. Only a select group of key management should be eligible, so employers can provide tailored incentives to key employees without having to do the same for all.
Once a company has identified a need for a nonqualified plan, the next step is to determine the best plan type to use. A defined benefit structure often is wrapped around a pension plan to pay executives benefits that exceed qualified pension plan limits, when the sole purpose of the plan is to provide supplemental retirement benefits. Given the increasing obsolescence of pension plans, other plan designs may be more useful.
A nonqualified defined contribution plan can provide contributions based on compensation over the qualified plan limit. It also can allow executives to defer significant amounts of income to later years. However, Section 409A limits the employer’s and executive’s flexibility.
Equity-based compensations, such as incentive stock options and nonqualified stock options, are popular forms of executive compensation because they tie executive compensation to stock price increases. As long as the option exercise price is equal to or above market value on the grant date and the option does not allow the executive to extend the option’s life or otherwise defer receipt of income after exercise, options are exempt from 409A.
The same rules apply to stock appreciation rights, whether they are settled in cash or employer stock. Options or stock appreciation rights based on below-market value, as of the grant date, must comply with 409A.