A recession, which economists forecast is on the horizon (if not already upon us) is normally associated with sweeping job cuts and business retrenchment. But for many highly valued executives, an economic downturn can actually be a good thing.

Business owners, fearing that a loss of, or inability to attract, top talent could threaten their competitiveness in a contracting market, will establish or enhance executive compensation plans to recruit and retain the people they need. The demand for high-skilled and high-priced human capital, sources tell National Underwriter, has been a boon for advisors who specialize in executive compensation planning. But observers have noted another trend: an increase in the number of plans that tie non-salary-based executive pay to performance.

“When the economy is on the ropes, it’s more important than ever to identify and appropriately compensate those executives who are your top performers,” says Jim Magner, an advanced markets attorney for the Business Resource Center at Guardian Life, New York. “These are the people who consistently drive top-line growth, hit their numbers and keep expenses in check.”

Richard Pope, a financial representative at Guardian Life agrees, adding: “In the past 18 months, I’ve seen a marked increase in interest [in performance-based executive compensation plans]. As the economy worsens, employers are looking at ways to reward and retain not only execs in upper management, but also those in middle management. We’ve never seen this before.”

How are companies linking executive pay to performance? A common technique, sources say, is to tie compensation to specific revenue targets, for example a 5% or 10% increase in year-over-year sales. Company objectives might, alternatively, require increasing customer satisfaction, reducing costs or surmounting product development hurdles.

Many plan packages tailor bonus pay to the individual performance or to that of a group of executives. But it’s also often the case that compensation will hinge on the overall performance of the firm.

“If employees are not performing, the employer has the option to say, ‘we’re not funding the retirement plan this year,’” says Pope. “That’s even true of defined benefit plans, though generally the plan document has to be amended to allow for a suspension. And the suspension cannot be done in perpetuity.”

The prospect of an all-or-nothing deal can apply to individual executives as well: If they don’t meet company targets, they don’t get a bonus, irrespective of how well the company does. But many firms, experts say, also ratchet up (or down) performance-based compensation in tandem with tiered benchmarks. Hence, the executive might receive supplementary pay of 10%, 20% or 30% above salary if he or she achieves year-over-year sales growth targets of 10%, 20% or 30%, respectively.

However structured, the executive compensation, must meet with the approval of the employees who stand to benefit, experts say. If the executives deem the plan incentives as insufficient or the company benchmarks as unattainable, then job performance and job satisfaction are likely to suffer, and executives may be inclined to bolt from the firm–the very outcome the plan was intended to prevent.

It is important, therefore, to have a meeting of minds among company owners and the executives for whom the plan was devised. To insure their buy-in, observers say, the executives should participate in the drafting of plan documents. And advisors should be prepared to help arbitrate differences among opposing parties.

“The advisor should be the one to quarterback the plan, especially when dealing with key employees who aren’t owners,” says Gary Underwood, a chartered financial consultant and advanced markets attorney for Genworth Financial, Lynchburg, Va. “When the different parties have vastly different interests, it’s a good idea to encourage execs to consult with an attorney when drafting a plan. By quarterbacking the effort, the advisor can come out looking like a white knight.”

To be sure, it’s not always the key employees who stand to lose from a poorly structured deal. If the plan comes without golden handcuffs, sources say, the executives may opt to leave the firm–and potentially put themselves in competition with their former employer–upon receiving the promised pay.

To guard against this eventuality, many companies restrict access to compensation previously awarded by establishing a vesting schedule. Popular among such arrangements, observers say, is the IRC Section 162 restricted executive bonus plan, funded with permanent life insurance. Under this arrangement, the key employee owns the policy and the business pays the premiums. The policy beneficiaries enjoy a pre-retirement death benefit, but access to the contract’s cash value is restricted pending the employee’s completion of certain objectives or years of service with the firm.

Marc Belletsky, an advanced sales consultant at Hartford Financial, Hartford, Conn., says he’s seeing a “significant up-tick” in demand for such plans among businesses. Typical of these arrangements, he says, is the franchise owner who restricts access to the bonus until such time as a key employee becomes franchisee and opens a predetermined number of stores. The owner thereby accomplishes two goals: keeping the employee loyal and expanding the franchise.

To sweeten the deal, business owners often will increase the bonus to cover any income tax the employee would otherwise have to pay. If, for example, the employee stands to pay $35,000 in tax on a $100,000 bonus (assuming a 35% tax bracket), then the employer will bonus up the payout to $135,000, netting $100,000 for the employee.

Sources say interest in executive bonus plans is now especially strong among small businesses, particularly those constituted as pass-through entities, including LLCs, limited partnerships and S corporations. Such arrangements, they note, are relatively simple and inexpensive to set up and administer.

Contrast this with non-qualified deferred compensation plans, which observers say tend to be cost-prohibitive for all but large, publicly held firms. Adding to the expense and complexity of these plans is IRC Section 409A, an outgrowth of the American Jobs Creation Act of 2004. While lending clarity to the rules governing deferred comp arrangements, 409A also imposed numerous restrictions on the timing of deferral elections, payment schedules and triggering events that will result in payouts.

Observers say the new regs, combined with the current high volatility in the equity markets, have also crimped demand for another component of performance-based pay: stock option plans. “We’re seeing less stock appreciation right plans due to the uncertainty of 409A,” says Belletsky. “I don’t feel comfortable with 409A because it has so many loopholes and minefields.”

If non-qualified deferred comp plans have fallen out of favor among some firms since the advent of 409A, the same cannot be said of their analog in the qualified plan arena. Guardian Life’s Pope observes that small and mid-size business have shown “extraordinary interest” in multi-tiered qualified deferred comp plans, of which the 401(k) is but one component.

As a “classic example,” Pope cites a 3-tiered plan he recently implemented for a company of 26 employees, including 3 principals, 8 senior managers, 5 middle managers and 10 rank-and-file employees. The package allocated $1.2 million to a defined benefit plan for the principals and senior managers, $500,000 to a profit-sharing plan for middle managers and select rank-and-file employees, and the balance to the 401(k) for all employees.

Making a comeback in the current economic environment are split-dollar life insurance plans: arrangements wherein the business owner and executive share the premium costs and policy benefits. Though less attractive since 2003, when new IRS restrictions on such plans went into effect, observers say that loan regime split-dollar plans (formerly collateral assignment split-dollar) are increasingly of interest to business executives. The reason: Loans extended against a policy’s cash value by the business owner to a key employee can be repaid at low interest cost–often at 3% per annum or less.

Low interest rates have, conversely, put a damper on current assumption universal life insurance as the funding vehicle of choice in executive comp plans. So long as interest rates remain in the low single digits, sources say, the potential for policy gains will also be low. As an alternative, many advisors recommend variable universal contracts that invest a portion of the policy’s cash value in the equity markets, as well as equity-index contracts that enjoy a percentage of market gains experienced by an index fund (such as the S&P 500) but also provide protection against market downturns.

“We don’t sell it, but we’ve observed a rise in sales of equity-indexed products,” says Belletsky.

Guardian Life’s Pope, however, sees more promise in traditional whole life insurance. Though premium payments cannot be adjusted over the life of the policy to accommodate a business’ changing cash flow requirements–a flexibility enjoyed by UL and VUL contracts–Pope says that whole life’s contract guarantees appeal to executives who seek to insulate their retirement plans from market gyrations.

“I’m finding there’s a flight to whole life when it comes to both qualified and non-qualified deferred compensation plans,” says Pope. “And that warms my heart, as I’m a strong believer in whole life.”