View Points March 12, 2013

Tax Legislation + Trends = Deferred Comp Sales Opportunities

The American Taxpayer Relief Act of 2012, otherwise known as the “fiscal cliff” tax legislation, had no direct impact on the tax treatment of nonqualified deferred compensation (NQDC) plans. But the tax implications for an employer’s highly compensated key employees create big potential for financial professionals to add value to their clients and prospects.
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The key legislative provisions, effective January 1, 2013 (see box: “Key Provisions of American Taxpayer Relief Act of 2012”), appear to have only personal tax implications for higher-income individuals, not the companies they work for. In addition to this legislation, higher-income employees were also impacted by increased Medicare taxes and taxes on net investment income (including dividends and capital gains) as a result of provisions of previous health care legislation.

But as the adage goes, “All business is personal.” The tax environment created by these changes has implications for organizations and their key employees. And that translates to a renewed interest in new and existing nonqualified deferred compensation plans. 

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There are five considerations that the new tax legislation creates for NQDC plan participants:

1. Higher marginal tax rates encourage deferrals into NQDC plans. By reducing current taxable income, deferrals reduce a participant’s taxable income at their highest marginal rate. The participant can pay taxes at a lower rate by taking installment payments after retirement in many circumstances.

2. Deferrals into a NQDC plan offer the potential to reduce or eliminate the impact of the tax changes for participants who are close to certain income thresholds. By deferring income, individuals could fall below the thresholds triggering additional taxes.

3. Higher marginal income tax rates and higher capital gains rates make pre-tax deferrals more attractive vs. after-tax investing. Investment gains in deferred compensation accounts are not currently taxed, and also compound on a tax-deferred basis. Compare this to the situation for after-tax investing. Income from interest, dividends and realized capital gains for highly compensated employees will be taxed at the corresponding increased ordinary income tax or capital gains rates depending on the nature of the income under the new legislation.

4. Reduced uncertainty over the future taxation of NQDC plan distributions. The tax rates made “permanent” in this legislation offer participants more clarity on receiving future plan distributions. With effective planning of deferred compensation distributions, key employees can potentially reduce their tax burden by spreading out distributions at retirement (as allowed by plan design) and coordinating with qualified plan distributions and Social Security.

5. NQDC plan deferrals offer more control over taxation timing. Although some control may be exercised over when realized gains are triggered, paying taxes inthe current year on dividends, interest and some capital gains will almost always occur. NQDC plan participants have flexibility to elect when to receive distributions based on the options outlined in the plan documents. This flexibility provides greater control over the timing of whenincome is actually received and taxes paid on it. IRS guidelines for NQDC plans provide plan participants the flexibility of delaying distributions beyond the original scheduled timing.

Some disincentives existed to participating in deferred compensation plans prior to the passage of this legislation. First, tax rates on high-income earners were at historic lows. Second, taxes on capital gains and dividends were also quite low (maximum 15% at the federal level). And finally, due to the “temporary” nature of the soon to expire tax rates, individuals were somewhat reluctant to defer current income into a very uncertain and potentially rising tax environment.

 

(Cont’d…)

According to research with NQDC plan participants in late summer of 2012(see chart–“Participants Planning to Increase Their NQDC Plan Contributions…” Source: 2012 Survey of NQDC Plan Sponsors & Participants, Principal Financial Group), 35% of participants expected to increase their deferrals in the coming year and 60% planned to maintain the same contribution amount.  Nearly 2 out of 3 who planned to increase contributions identified the expected increase in tax rates as the reason. So, regarding tax legislation, it seems NQDC plan participants were very accurate in their collective predictive skills.

An uncertain tax environment, coupled with a difficult economic environment, made nonqualified deferred compensation a tough topic for advisers to discuss with clients and prospects. Many plan participants clearly saw value in the benefits provided, and many plan sponsors chose to continue offering NQDC plans, new sales were tough to come by.

With the economy improving, companies returning to long-term profitability, and the tax environment for higher income taxpayers settled (at least for the time being), it’s a good time to approach clients and prospects regarding the benefits of nonqualified deferred compensation plans.

For employers:

·         The ability to recruit, retain, reward and retire their most key employees

·         The ability to provide discretionary employer contributions to retain and reward key employees in a competitive environment

·         The ability to control compensation through vesting and payment timing

For participants:

·         The ability to save on a tax-deferred basis in excess of qualified plan limits

·         The ability to better control the timing and rate of taxation

·         With proper plan design, the ability to design an individual investment strategy

For you as an adviser, the ability to provide value to your clients and prospects by offering them your expertise to take advantage of the benefits of nonqualified deferred compensation.

--Andy Dalgliesh, CPA*, MBA, CLU®, ChFC® - Director, Nonqualified

*CPA does not provide accounting or tax services on behalf of the companies of the Principal Financial Group®.  

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. Clients should consult with appropriate counsel or other advisers on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance issued and plan administrative services provided by Principal Life Insurance Company. Securities offered through Princor Financial Services Corporation, 800/247-1737, member SIPC and/or independent broker/dealers.  Securities sold by a Princor Registered Representative are offered through Princor®. Principal Life and Princor® are members of the Principal Financial Groupâ, Des Moines, IA50392.

The Markets March 12, 2013

Tell the Truth About Savings Rates, Putnam CEO Says

Address market challenges, embrace innovation and take the lead in improving retirement policy, said Robert L. Reynolds, president and chief executive of Putnam Investments.
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Speaking Tuesday at a conference in Florida, Reynolds called on the investment industry to usher in a new era of helping investors address a dynamic set of ongoing market challenges by breaking down the barriers of conventional wisdom and embracing a range of needed innovations to the marketplace.

Five years after the worst economic crisis to hit global capitalism in several generations and with investors still feeling the aftershocks, Reynolds urged asset managers, financial advisers and their clients to consider and apply a new set of investment strategies, driven by a modern view of portfolio construction, risk management and diversification. 

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“We find ourselves moving, ever so tentatively, into a financial future with seemingly only one certainty: it will likely be very different than the investment world in which we all grew up,” Reynolds said. “This suggests that conventional wisdom shaped by decades of high-return investing—first in equities from 1982 to 2000, then in fixed-income markets over most of this young century—needs to be re-examined, revised or even scrapped.”

Reynolds noted that over the last several years, Putnam has developed and introduced a series of investment offerings that seek to create a “shock-absorber effect” to help fulfill a diverse range of client financial goals – including accumulating and withdrawing income for retirement, and preparing for higher education costs. In many of its products, according to Reynolds, Putnam has sought to manage multiple risk factors that investors need to balance, including unprecedented market volatility, inflation, taxes, increasing longevity and lifelong income shortfalls.

 

(Cont’d…)

Reynolds called on the financial services industry to take the lead on three key retirement policy changes that could dramatically lift America’s retirement readiness by strengthening the workplace savings system:

Make the “full-auto” best practices endorsed by the Pension Protection Act of 2006 standard—perhaps even mandatory—for every workplace savings plan in America, featuring: auto-enrollment, annual re-enrollment, auto escalation, and automatic default to qualified target-date or balanced funds;

Support the extension of workplace savings coverage to all working Americans—so that everyone who pays mandated Social Security taxes also has an option to save for their own retirement; and

Lift the industry average of a 7% participant savings rate in today’s workplace plans by 50% or more—to a new baseline of 10% plus—the level that Putnam’s Lifetime Income Score shows is key to retirement readiness. “We don’t serve anyone well, “Reynolds explained, “by allowing them to believe that saving 3%, or 5%, or even 7% is enough to ensure retirement readiness. Let’s tell people the truth.”

Reynolds’ comments followed Putnam’s recently launched awareness building campaign, “New Ways of Thinking,” that emphasizes the importance for financial advisers and investors to continually anticipate the evolution of the investment markets – and then act to seize new opportunities and mitigate unforeseen challenges. (See “Putnam Campaign Advises Anticipating, Not Reacting.”)

 

 

(Cont’d…)

Reynolds pointed to the lower returns and increased volatility of core equity and bond markets over the past decade as the deepest sources of investor angst. He stressed some new directions in investment thinking that could help asset managers and advisers serve clients trying to navigate an era of constrained fixed-income returns and geopolitically driven anxiety that often roils global equities.

In this often daunting environment, Reynolds suggested investment providers and advisers could offer tremendous value to their clients by: 

  • Seeking value beyond mainstream indices (in both equity and fixed income markets)
  • Looking beyond bonds to dividend stocks as a key source for income
  • Adopting strategies that may help curb volatility and deliver a smoother, more reliable sequence of returns
  • Pursuing “diversification of investment philosophy” by incorporating absolute-return strategies in portfolios along with traditional benchmark-driven investments
  • Applying a stringent risk-allocation lens to assess the real “balance” in investment portfolios
  • Investing in low-beta stocks to seek less volatile, more precisely risk-adjusted returns
  • Applying Sharpe-ratio, or “high efficiency” metrics to judge securities and strategies

“The old conventions and rules of thumb we’ve learned to live by may no longer serve to position investors for longer-term success.” Reynolds noted. “Amid higher volatility, rising tax rates, political uncertainties and near-zero interest rates, Abraham Lincoln’s great adage, ‘We need to think anew – and act anew,’ is more relevant than ever. Investors, advisers and asset management providers all should consider a new blend of traditional and alternative strategies to help reach critical financial goals in this new investment era.”    

In summing up the necessity of innovation and policy reform to strengthen the long-term prospects of the modern-day investor, Reynolds said, “None of these changes—of mindset or approach—will be easy, but I believe that if we embrace new thinking and new solutions, we’ll find it exciting, liberating —and rewarding.”

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