A non-qualified deferred compensation plan (NQDC plan) can be an attractive solution for a company that wants to provide an opportunity for executives and corporate directors to make pre-tax deferrals of compensation in excess of the limits imposed on qualified plans. These plans are an essential component of any competitive compensation and benefits offering.
NQDC plan design, funding strategy and administration are the key elements that must be coordinated for a plan to be successful. For nearly 50 years, Karr Barth Administrators has been recognized as a national leader for its sophisticated combination of experience, knowledge, and leading-edge technology that enables plan sponsors to offer effective plans that attract, reward and retain their most critical employees.
Funding of NQDC Plans
When an NQDC plan participant chooses to forgo receiving earned compensation and defers it via a NQDC plan, the deferred compensation becomes a liability of the participant’s employer, or the plan sponsor, and an investment account is opened on behalf of the plan participant to invest their deferred income. Plan sponsors have a few options to consider when deciding whether to establish an asset on their balance sheet to offset the liability.
NQDC plans are considered “funded" if assets are irrevocably set aside with a third party, off the balance sheet of the plan sponsor, and to be exclusively used for payment of participant NQDC plan benefits. This arrangement typically triggers a mandate to comply with ERISA regulations and immediate taxation to participants of their deferred amounts. For these reasons, this is not typically a viable option.
Informally Funded Plans
When assets are earmarked on the plan sponsor’s balance sheet, typically in a Rabbi Trust, the NQDC plan is considered “informally funded.” The majority of NQDC plan sponsors choose to informally fund their plans and the most popular methods of doing so are through corporate owned life insurance (COLI) or mutual funds.
Unfunded Plans
Properly designed NQDC plans are considered “unfunded,” even if the plan sponsor earmarks assets on its balance sheet to meet its NQDC plan obligations. Since those assets are available to the plan sponsor’s creditors in the event of bankruptcy, there exists a “risk of forfeiture” that prevents the IRS from taxing the participants on their deferred compensation. When assets are not set aside to pay plan benefits, plan participants rely on the agreement with the plan sponsor that the compensation they defer will be available when they have elected to collect distributions. In this instance, plan sponsors are essentially “borrowing” from their executives by reinvesting their deferred compensation back into the business. If the deferred compensation is “deemed” to be invested in a fund or a selection of funds, the plan sponsor may choose to mitigate the P&L impact by entering into a total return swap (TRS) arrangement with a counterparty, such as an investment bank.
Funding Explained
Plan sponsors may choose not to set aside assets if their NQDC plans are not large enough to merit an informal funding strategy or if the company has a high weighted average cost of capital (WACC) such that it would rather reinvest its employees deferred compensation back into the company. Companies that sponsor completely unfunded plans typically do not offer participants a selection of investment funds for determining the growth of their deferred compensation accounts. Rather, a modest fixed interest rate of return may be offered. For all plan sponsors, there are important factors that determine the appropriate funding strategy for their plan.
Corporate Owned Life Insurance (COLI)
COLI is a popular informal funding option for large tax-paying companies or companies that have stable or growing plan liabilities.
The insurance costs for COLI plans are borne by the company in exchange for the future receipt of tax-free death benefits. If the company intends to hold the policies until maturity (death), there are no current or deferred taxes on investment earnings generated by the investment portfolios.
Mutual Funds
Plan sponsors can informally fund NQDC plans using mutual funds by investing income deferred by plan participants in the same mutual funds that plan participants have selected for their account balances. This is a common approach used by companies that pay little or no taxes because realized gains, dividends and interest income generated by the mutual funds are taxed currently to company; unrealized gains require the company to book a deferred tax expense. Mutual fund plans are simple to administer, and the plan sponsor can typically rely on its 401(k) provider for administrative support.
Total Return Swaps (TRS)
These plans operate via a “futures” contract the company enters into with a counterparty, such as an investment bank, whereby the total return of a basket of securities similar to the plan’s investment profile is guaranteed by the counterparty in exchange for a floating interest rate – typically a spread above LIBOR/SOFR. Therefore, the TRS acts as a hedge against market-based changes in the plan liability, the TRS gain/loss is marked to market and can be reflected in compensation expense, where it can directly offset the market adjustment in the plan liability.
Additionally, taxes on TRS gains attributable to hedging a participant’s account are deferred until the participant receives a distribution, which is the same time the company gets to deduct the deferred compensation.
Side-by-Side Funding Comparison
For More Information
At Karr Barth Administrators, our team of experts provides end-to-end support for our clients by developing customized plan designs, determining appropriate funding strategies, effectively installing plans, and continuously administering the plan with white-glove service for their key executives.
Learn more about how you can implement a plan that attracts, rewards and helps retain top talent by contacting us at (800) 549-1989 or PlanAdmin@KBAdmin.com, or by visiting KBAdmin.com.