Blog: Mitigating Creditor Risk with Flexible Savings Accounts

Non-qualified deferred compensation plans (NQDCPs) are typically offered by companies to attract, reward and retain their most critical employees, whose needs cannot be met by qualified plans alone. The most popular employer-sponsored qualified retirement savings plan is a 401(k), which has a 2024 contribution limit of $23,000 for employees under 50 years old, and $30,500 for employees 50 and older.

While the contribution limits of a 401(k) generally increase annually, they are usually too low to allow highly compensated employees to build adequate retirement savings to meet the 75% of final salary retirement income benchmark suggested by most financial professionals. Therefore, many highly compensated employees use NQDCPs to supplement their retirement savings because there is no limit to the amount of compensation that can be deferred in a non-qualified plan.

NQDCPs are subject to different rules than qualified plans. Qualified plans must adhere to requirements established under the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA). These requirements include, amongst other things, disclosure rules, minimum coverage standards, contribution limits, vesting rules, and participation tests. Conversely, NQDCPs are subject to Section 409A of the Internal Revenue Code, which stipulates that, for participants to enjoy favorable tax treatment like qualified plans, non-qualified benefits must be paid from general assets of the plan sponsor (the company) and therefore may be forfeited if the company becomes bankrupt. This concept is known as a “risk of forfeiture” or “creditor risk” and means that participants in NQDCPs will be considered general, unsecured creditors of their employer in the event of bankruptcy and thus, they could lose their benefits.

Mitigating Creditor Risk

By nature, retirement plans have a long time horizon because withdrawals are not taken until retirement. Although NQDCPs are often offered and promoted as “retirement plans,” one unique characteristic they possess is the flexibility to be structured into short-term specified date distribution accounts with re-deferral rights known as Flexible Distribution Accounts (FDAs). In addition to retirement or separation distribution accounts, NQDCP participants can establish multiple FDAs, and each one can have a different distribution date. Section 409A says that a NQDCP participant may change a previously established distribution election at least one year before the payment date as long as the new payment date is at least five years later (i.e., a “re-deferral). Therefore, a savvy NQDCP participant can establish a flexible distribution strategy by establishing five FDAs and lining up their distribution dates one year after another. This way, participants will always have an account coming up for distribution each year and they get to decide one year in advance of each payment whether to take the distribution or to re-defer for another five years. This flexible distribution strategy is sometimes thought of as “laddering” one’s accounts over five consecutive years.

Laddering FDAs is a strategic way to mitigate creditor risk because it doesn’t require NQDCP participants to defer all the way to retirement or separation from service, giving them an opportunity to withdraw a portion of their deferred compensation and any investment earnings on an annual basis. And with the re-deferral feature, participants can continue to defer in 5-year increments if they are comfortable with the bankruptcy risk of their employer.

NQDCPs may only be offered to a select group of management or highly compensated personnel within an organization – usually no more than the 10% highest paid employees. This means that participants are senior leaders of their organization and are likely in tune with the organization’s overall health and are likely aware of industry headwinds that may pose a risk to the stability of the organization. And through the use of short-term FDAs, participants can continue to lower their annual tax burden and potentially earn investment gains on their tax-advantaged deferrals without the risk of allocating their deferrals into a nearly inaccessible long-term retirement savings vehicle. This characteristic makes the use of FDAs incredibly popular in the plans in which they are offered.