Lemonade Stand

Investors are demanding increased scrutiny of every aspect of C-suite executives’ compensation packages. Drawn into the line of fire is deferred compensation. “Deferred compensation is part of the executive compensation package, and executive compensation and anything attached to it is being demonized now,” says Richard Smith, a Senior Vice President and Executive Compensation Practice Leader at Sibson Consulting, a division of Segal. Legislators, regulators, activist groups, and the public all blame executive compensation for corporate ills, he says.

Since deferred comp is a component of “executive pay,” it becomes eligible for criticism, says Smith. Opponents feel it is an unnecessary perk and that all employees should be limited to the same plans, he says, so opponents push for lower and lower caps with more tax triggers that make deferred compensation unattractive for companies. Opponents of deferred compensation often think that deferred compensation only benefits C-suite executives with multimillion-dollar incomes, and that those “rich executives” are avoiding paying income taxes, which is false, says Michael Kozemchak, Managing Director for Institutional Investment Consulting, a member of NRP in Bloomfield Hills, Michigan.

The outrage over deferred compensation is misplaced, argue proponents. Deferred compensation is already under pressure. Companies are not offering deferred compensation as much because the 409A regulation, enacted as part of the American Jobs Creation Act of 2004, makes it unattractive to employees, says Smith. Since the cost of administration of a plan is high with low participation, it also becomes unattractive for the employer.

The general public, notes Smith, does not understand that deferred compensation is not an additional bonus. Executives are not earning additional money, but simply deferring money they already earned until a future time. Deferred compensation acts like a 401(k) for executives whose contributions to 401(k)s, limited by Internal Revenue Service rules, mean they will not be able to save enough to accumulate a proper replacement rate, explains Smith.

However, that link to 401(k)s also causes problems. Businesses are cutting back on workers’ salaries across the board, including reducing or stopping 401(k) matching contributions, says Darrell Alford, Founder and President of Alford-Jungers Financial & Insurance Services Inc., a retirement and consulting firm in San Diego, California. Employers are reducing workforces and salaries and eliminating matching 401(k) contributions, so, if executives receive large company contributions into a nonqualified plan, it looks bad to rank-and-file employees, explains Kozemchak. Even though most executive compensation plans are deferral-only plans with no additional company match or contribution, he says, it looks bad if the company reduces or eliminates qualified plan benefits for the rank and file but then retains “key employee” benefit plans that look generous.

The focus has led to firms being gun-shy about instituting new deferred compensation plans. Companies that do not have deferred compensation plans are not putting them in right now, says Smith. Companies that did have them in place have frozen them under the old, pre-section 409A rules, and generally have not put in new plans, he adds. There is a lot of interest in deferred compensation plans in small to mid-size firms, says Alford, but no one is willing to pull the trigger and implement plans until they get through with layoffs and salary reductions.

Further clouding the immediate future of deferred compensation plans is an administrative proposal that will indirectly tax a popular financing vehicle for these plans, corporate owned life insurance (COLI), which is used to shelter the gains in the plan from taxation. COLI’s primary use, explains Kozemchak, is to allow companies to set aside contributions that then can grow with investment gains tax deferred. COLI also helps offset long-term costs and provides the company with key-person death benefit coverage, he adds.

Revenue-raising provisions of the Obama Administration’s proposed budget for fiscal year 2010 propose denying a pro-rata portion of the interest deduction based on insurance held on any individual other than a 20% owner of the business. The proposal would apply prospectively, so no current COLI policies would be affected.

If the provision passes, it would disallow otherwise deductible interest by businesses by the ratio of the value of such life insurance contracts to the business’ total assets. For example, if an entity had 10% of its assets in life insurance, 10% of otherwise deductible interest would be disallowed. It is estimated that the proposal would raise approximately $8.5 billion from 2010-2019, and is part of a package of proposed tax changes intended to generate revenue to fund health-care delivery system changes.

The main reason for the administration pushing this measure is not to restrict deferred compensation, but to raise revenues, says Alford. However, he expects it would have the effect of restricting deferred compensation. Reducing the tax deduction for other interest paid by businesses would severely diminish the tax and economic benefits of purchasing life insurance on employees. This would mean that firms probably would be less likely to use COLI to finance nonqualified deferred compensation, preferring to use mutual funds or not to finance the plan at all.

However, James Clary, President of MullenTBG, a Prudential Company, in Chicago, Illinois, would be surprised if Congress enacts this provision. Congress recently addressed COLI in August of 2006 with the enactment of the Pension Protection Act of 2006, which contained the COLI best practices provision, he says. Generally, when Congress legislates in an area, it tends to not revisit that same issue so soon. “We’re cautiously optimistic that we’ll have a good outcome,” says Clary.

Nonqualified Plans of the Future

Once the market settles and firms can restore 401(k) matches, firms once again will look to deferred compensation plans to equalize retirement replacement income ratios for executives, predicts Alford. The PPA codified deferred compensation plans, says Kozemchak, and made it very black and white as to what can and cannot be done in all areas, including funding. The industry probably will not see individual annual deferrals in the millions, he says, but more highly paid employees will likely be taking advantage of deferred compensation at companies that offer it as a way to make up for restrictive 401(k) contribution limits as well as taking advantage of tax-deferred growth.

Partly driving the popularity will be the administration’s willingness to tax upper-income people, notes Clary. Since highly compensated employees are prohibited from saving enough in a qualified tax-deferred plan to generate sufficient retirement replacement income, he says, they are likely to turn to deferred compensation. Eventually, deferred compensation will become more of a mainstream benefit as the qualified plan restrictions affect not just the C-suite but any highly compensated employee, he predicts.

Deferred compensation will also become more of a recruiting and retention tool as companies deal with a shrinking work force, adds Kozemchak. Sponsors may use deferred compensation as a tool to incent employers to delay retirement using employer contributions and date-specific distributions combined with roll-forward vesting.

However when these plans are instituted, notes Kozemchak, they will be somewhat different from pre-409A plans. Among the changes he predicts are:

• The participant experience will be more like a 401(k) with Web-based deliverables, investment services, etc.
• Participants and sponsors will demand more integration with other benefit plans and assets. More emphasis will be on “what is my total retirement benefit” as opposed to fragmented pieces. Future administrative platforms could easily consolidate the 401(k), nonqualified deferred compensation, defined benefit, nonqualified defined benefit, brokerage account, and other liquid assets, all in one place.
• Participants may be able to ladder the taxation of future income effectively as the popularity of date-specific distributions increases.
  

Additionally, further legislative actions may have an impact on the design of deferred compensation plans. Kozemchak expects a $1 million cap on contributions to pass this year, as well as more sponsor reporting requirements in the future. “There is a great deal of money in these plans, especially when you consider the private sector, and no one knows for sure how much it is,” he says.

Deferred compensation is a good benefit that gets a bad rap, says Alford. The focus in the public is on the executive making $20 million who defers millions, he says, but it is also a great benefit for middle management unable to save enough under 401(k) programs to fund their retirements adequately.

In addition, says Clary, deferred compensation can provide an opportunity for advisers to expand their revenue stream. Right now, says Clary, advisers are being squeezed on their traditional revenue streams, and are looking for new ones. Revenue streams are being squeezed, he says, because of market performance, fee disclosure that puts downward pressure on fees, and some funds that are no longer paying commissions on money market funds. The nonqualified deferred compensation market, he says, has been largely underserved and is one area where an adviser can create new revenue streams and add value to clients. Advisers, he says, can add value to sponsors by educating workers on how to use the deferred compensation plan, such as saving for college costs or buying a home.

Good Time To Defer?

With the possibility of tax rates going up, or employers going belly up, some question whether now is a good time to defer income. Executives become unsecured creditors to the company if it goes bankrupt, and the Obama administration seems intent on raising taxes on high-income individuals.

Yet, experts are still bullish on deferring. While one’s employer obviously needs to be in sound financial shape prior to deferring, says Clary, there are still many tax advantages to deferring, even if tax rates do increase in the future. “It’s always the right time to defer compensation,” agrees Alford.

For example, says Clary, suppose an executive has the option of deferring $10,000 into a plan with an earnings rate of 10%, or taking the money and investing it after taxes and earning 10%. If the money is deferred for five years, tax rates would have to jump from 35% to 42% to negate the advantages of being in the deferred compensation plan. If the money is deferred for 10 years, then tax rates have to jump to 48%. Future tax rates on distributions would have to rise dramatically to outweigh the benefits of tax-deferred growth, he says.

This is an area where plan advisers can educate sponsors and participants as to the benefits of deferring income into a deferred compensation plan even in an era of increasing tax rates, says Clary.