When Savers Exceed the Limit

Art by Wenting Li

If a defined contribution (DC) retirement plan sponsor is aiming for every worker to reach a solid income replacement rate, it may face a challenge with its best-paid staff. Rank-and-file employees, with their qualified plan plus the help of Social Security, can conceivably save enough to replace 70% of their income in retirement. Not so for highly compensated employees (HCEs). Between statutory limits on their contributions, discrimination testing, and a lower percentage from Social Security, HCEs may save far less than what they need to approximate their current lifestyle.

“[The increasing] limits placed on savings aren’t large enough to keep pace with the compensation of senior executives,” says Kirk Penland, senior vice president, nonqualified markets, at Voya in San Francisco. With so much emphasis on retirement readiness in the industry, he says, if advisers are going to urge sponsors to adopt plan design to help employees save, they should also advocate to help the HCEs.

When discussing retirement readiness with a sponsor client, advisers should first maximize what participants and sponsors can save in their qualified plan. “This benefits all,” he says. “Creditors have no access to qualified plan assets, as they do to nonqualified plan assets, and employers get a current tax deduction on their contributions.

Qualified Retirement Plan Options

Plan sponsors can choose from several options, without the sponsor or the HCE needing to leave the safety of a qualified plan. With all of them, though, contributions remain subject to statutory limits, which HCEs may not save above, Penland notes. In addition, the options all require that the sponsor invest more money in the plan.

One option for employers is to use a permitted disparity formula to calculate employer profit-sharing contributions. Permitted disparity allows plan sponsors to allocate contributions by applying one percentage on employee salaries up to the Social Security taxable wage base (TWB)—$132,900 this year—and another on employee salaries above the TWB. This results in a higher contribution to HCEs.

Another option is a new comparability, or cross-tested, plan design. Here, participants are divided into groups, with each group receiving its own level of employer contributions. For example, says Tom Foster, national spokesperson for workplace solutions at MassMutual in Enfield, Connecticut, plan sponsors may make higher contributions to older vs. younger employees or to employees in executive vs. non-executive roles. The way this design may pass nondiscrimination testing is that cross-tested plans convert the contribution into a projected benefit, similar to benefit accrual rates for defined benefit (DB) plans.

According to Penland, cross-tested plans are most typically used by smaller organizations—i.e., those with up to $25 million in assets; there are relatively few large-market companies with cross-tested plans.

Chris Middleton, executive vice president, director of the retirement plan division—which oversees small and midsize plans—at Greenleaf Trust in Kalamazoo, Michigan, says a number of Greenleaf’s small-plan clients use permitted disparity. The cross-tested plan design is considered more advanced and especially beneficial for older HCEs. When structuring cross-tested plans, age and/or length of service are common grouping criteria. Cross-testing methodology allows for different levels of contributions to each group.

Another qualified plan option that can increase high earners’ savings is a cash balance plan. According to Middleton, HCEs, and many older employees, can achieve a greater dollar benefit in these plans as the annual employer contribution is based on a defined benefit formula—which can consider age and salary. The plans are often used in professional service organizations with higher ratios of HCEs such as medical groups and law firms. 

Foster gives an illustration in which the partners in such a  firm could accumulate 365% more for retirement per year, depending on their age, than with the firm’s DC plan alone.

Foster says if a plan sponsor is unwilling to commit the additional funds, or if the sponsoring entity lacks sustained profitability, the adviser should look to another plan type to help HCEs save more. The sponsor may also prefer to adopt a nonqualified plan, which is unencumbered with the compliance requirements that qualified plans have under the Employee Retirement Income Security Act (ERISA), he says.

Nonqualified Plans

There many types of nonqualified plans, the most common being nonqualified deferred compensation (NQDC). Other options include the defined contribution supplemental executive retirement plan (DC SERP), 401(k) restoration plan, defined benefit supplemental executive retirement plan (DB SERP) and 457(f) plan.

According to Jason Burlie, senior vice president and nonqualified practice leader at Prudential Financial in Dallas, DC SERPs, DB SERPs and 401(k) restoration plans tend to rely solely on employer contributions to remedy the savings limitations of qualified plans. The difference between DC SERPs and DB SERPs is the benefit design strategy—whether the plan is aligned with DB plan benefit design or DC plan design.

Under ERISA, nonqualified plans must limit eligibility to a select group of HCEs, executives, managers, directors and/or officers, as defined in the plan document. If not, the plan could become subject to ERISA requirements.

Of all the plan types, the most popular with sponsors is the NQDC plan, agrees Scott Holton, a principal at The Todd Organization, a 60-year-old firm that focuses exclusively on executive benefits, headquartered in Cleveland. These allow HCEs to defer, on a pre-tax basis, percentages of salary above what qualified plans allow—$19,000 this year.

Middleton notes there are no limits on how much may be contributed to a nonqualified plan, per Internal Revenue Code (IRC) Section 409A. Plan sponsors may choose to match contributions to an NQDC plan, as they do in their DC plan, but they also may choose not to, providing the additional savings opportunity without needing to commit money.

A restoration plan is most often used to restore dollars lost for savings due to contribution limits or compensation limits, or it can be used to restore amounts returned to executives due to failed nondiscrimination testing, Holton says.

For governmental and tax-exempt nonprofit organizations, nonqualified plans work differently. Penland explains that IRC Section 457(b) plans may be used as nonqualified plans; they look like 403(b) plans, with the same deferral and catch-up contribution limits, but these limits are in addition to what can be saved in a 403(b) or other DC plan. As with other nonqualified plans, the assets are subject to creditors if the sponsor goes bankrupt or becomes insolvent.

In addition, 457(f) plans have been used by tax-exempt nonprofit organizations as nonqualified plans for HCEs. However, says Penland, the substantial risk of forfeiture rule under Section 409A may discourage executive deferrals into this type of plan. Substantial risk of forfeiture is the standard that the regulations apply to determine when an employee’s deferred compensation vests and, therefore, may be includable in income for the individual or deductible for the employer. He says both for-profit and nonprofit nonqualified plans are subject to this rule.

Yet, with nonprofit plans, IRC Section 83 says executives have a legal, binding right to the compensation provided by the 457(f) whether they defer into it or not; there would have to be a rigorous vesting schedule for HCEs to defer their own money and not have to recognize it as taxable income until it is vested—meaning they could lose their money if the sponsor went bankrupt or became insolvent. In fact, Voya has no clients whose HCEs currently defer into 457(f) plans. “All we’re seeing now in the 457(f) market is company contributions going into plans with a vesting schedule. As money vests, it is paid to the executive as compensation,” he says.

Penland says nonprofits have gotten creative with after-tax programs. He says these programs are paired with a 457(f); the sponsor makes contributions for HCEs, subject to a vesting schedule, and, when the money vests, participants have a choice to take the money or put it into an institutionally priced insurance contract. The type of insurance contract used produces a life insurance benefit, but also a tax-deferred growth account. Participants may take a distribution of their basis—what they put into the program—tax-free or they may borrow from the life insurance, tax-free.

Penland says nonqualified plans are a great supplement to qualified plans for many reasons, but, for one, they make a smart distribution strategy. An HCE may be able to take Social Security at age 62, but if he waits until 70, he will get a bigger benefit. To fill the gap of time, the executive may take distributions from his nonqualified plan—he has an incentive to use this money soon, as it would be subject to company creditors.

Stock options, restricted stock and restricted stock units, stock appreciation rights, phantom stock, and employee stock purchase plans are other ways companies can help executives and HCEs accumulate more for retirement. These plans may also provide assets to be used to fill a time gap between when the person retires and takes Social Security.

The Benefits to Advisers

Middleton says most plan sponsors appreciate options for how to allocate benefit dollars. Providing them with the most flexibility permitted to allot that money between HCEs and non-HCEs helps them reach the goals for their retirement benefits.

Foster, like Penland, says advisers need to support retirement benefits for all of a client’s workers. Getting into the service of more plan types also increases potential compensation. But even if they focus on only one of a sponsor’s plans, it helps if they understand the sponsor’s entire retirement program and how the plans fit together.

Penland says, if an adviser has not become familiar with all of the ways HCEs can save more, he is making a mistake. For advisers wanting to get into the nonqualified plan business, he suggests, “The best way to learn about [these plans] is to be active in one. Partner with someone who has done [one] in the past. Go to conferences and get the basics, then bring in experts to help with the first couple of programs.”

First, advisers should be willing to accept the added complexity of these plans, translating that into simple explanations for their clients. He says IRC Section 409A provisions have become even more complex in recent years; it is now required that distributions be established before contributions are made. “Advisers need to know such things before trying to win clients and expand their business,” he says.

Most nonqualified plan providers offer education and products to help an adviser understand and explain these plans, says Foster. “We want to supply all of the necessary tools to help advisers serve sponsors.”