Nonqualified plans - Executive Decision

Executive compensation has been under a lot of scrutiny lately. Most importantly, the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” which became law in July 2010, requires public companies subject to the federal proxy rules to hold shareholder “say on pay” votes on executive compensation at least once every three years. In October 2010, the U.S. Securities and Exchange Commission (SEC) released proposed rules for companies subject to the new law’s requirements.

Despite the heightened attention­ paid to executive compensation, 97% of employers with nonqualified deferred compensation (NQDC) plans say they intend to continue those benefits next year, according to a survey released by Principal Financial Group in March. With the job market improving, employers “are looking for ways to recruit key people and retain them and incent them,” says Gary Dorton, Vice President of Nonqualified Benefits at Principal.

However, nonqualified plans have their challenges. “When the economy goes through a downturn and people are worried about whether they have a job, participation goes down,” says Geoff Gottlieb, Senior Managing Director at Executive Wealth Management Ltd. (EWM), which designs, implements, and administers executive investment and compensation plans and has offices in New Canaan, Connecticut, London, and Zurich. “Most people try to preserve their 401(k) contribution, because there is no risk of losing that but, in a nonqualified plan, there is some risk of losing it: If the employer goes belly-up, you are a creditor and stand in line.” So, some people want to hold onto their money rather than contribute. The renewal of Bush-era tax cuts also may have discouraged a comeback in contributions to these plans.

Advisers can help sponsors think about these five NQDC issues.

The Need for More Scrutiny 

Many employers have decided to step up their reviews of their nonqualified plans in general, to see if they should change to reflect the employer’s current needs and realities. “They want to maximize the value of the plan, but minimize the complexity,” Dorton says. Some employers have frozen their defined benefit plan in the past couple of years, and want to figure out whether the nonqualified plan should change as a result. The broader issues in executive compensation focus on lengthening the time horizon and deferring compensation into equity, which has left executives increasingly long in company stock, says Scott Olsen, a Pricewaterhouse-Coopers LLP Principal.

“Sponsors are looking at the plans to see if there are ways to streamline or simplify them,” says Donn Hess, J.P. Morgan Retirement Plan Services’ Head of Product Development. “Nonqualified plans have tended to not get the same level of scrutiny (from sponsors) that qualified plans do.”

That is changing. “There is emphasis on greater governance of just about every kind of compensation plan,” Olsen says. “It is getting the attention of the board, the compensation committee, or the audit committee, as these obligations get greater and become more important to executive-compensation disclosure.”

Plan-Design Changes 

A lot of employers want to reevaluate nonqualified plan eligibility, Dorton says. The Principal study found a large increase in the number of middle managers participating in these plans, at 36% versus 17% previously. “They are the ones who have the gap where they cannot quite save enough in the 401(k),” he says, adding that the past few years have made them more aware of their potential retirement shortfalls. More employers have evaluated whether to let nonqualified-plan participants do in-service distributions, he says, so they can get a payout at a pre-determined date before retirement. “That gives people more ability to do financial planning,” he says. “It is a way for them to take advantage of the tax-deferred nature of a pre-tax plan, and save for material events in their lives.” In 2010, Principal and the Boston Research Group found that 21% of employers had fewer than 10 employees eligible to participate in their nonqualified plan, while 24% said 10 to 24 were eligible, and 56% said 25 or more.

Deciding To Mirror

“Some employers are deciding whether they want the plan to mirror the qualified plan,” Hess says. “What is driving the conversation is that, if you are offering it to a broader swath of employees, you probably need to simplify the plan.”

The trickiest issue: deciding whether to use the same investment options. Mirroring “always has been the easiest way to handle plans from a communication point of view, and a rationale point of view,” Olsen says. “Otherwise, it can look like just an executive perk.” Inevitably, some executives want more options, he says, but “adding additional things does not always enhance the value of the benefit. A lot of things are temporal and do not stand up to hindsight.”

Nonqualified investments increasingly need to pass muster with plan sponsors. “There is a lot more scrutiny on the investment lineups of these plans,” Dorton says. “Now, there is more of the investment oversight that we see in qualified plans.” Companies are more likely to have a committee overseeing the plan and evaluating it regularly; sometimes that committee also handles the qualified plan, and sometimes not. He does not have statistics on that, but says Principal has had increased requests for formal investment-review information supplied to a committee.

However, there is an argument for not mirroring investments. The choice of nonqualified plan investments “tends to be fairly anemic and of marginal value,” Gottlieb says. “Sometimes it is the same as the 401(k), which is doing a disservice to the higher earners. Nonqualified plans should be a real, true value, a wealth-creation value.” Many of these plans need investments not available through the 401(k), he thinks: higher-quality investments and more diversification into areas such as emerging markets and alternative investments. “Alternative investments are probably the best thing to put in a nonqualified plan,” he says. “The best alternative investments can outperform just about everything else, and they are geared toward long-term investments.”

Using Corporate-Owned Life Insurance

NQDCs are unfunded plans, but 60% of Principal’s sponsors completely or partially finance them, Dorton says. As for financing method, 47% use corporate-owned life insurance (COLI), and 28% use mutual funds.

Ten or more years ago, employers did not use COLI much in these plans, since the market lacked enough high-quality products and many sponsors did not fully understand them, Dorton says. However, the products improved in subsequent years, and more CFOs and financial departments got familiar with them, he adds.

“We saw a swing from employers using almost no corporate-owned life insurance to using a whole lot,” Hess says. However, some have since deemphasized COLI, Olsen says, “because, in many cases, it did not work out as people hoped.”

Now, employers carefully evaluate the use of mutual funds or COLI, Dorton says, and one size seldom fits all employers. Sponsors want to figure out if their current strategy makes sense. “They might have too much, or they might not have enough [COLI],” he says.

“They are making sure that they understand that investment vehicle,” Hess says, “and they are making sure they are using the right amount.”

Beefing Up Education

Employers have started questioning their previous assumption that people do not need much nonqualified-plan education because these high-ranking executives have lots of investment savvy. “A high level of compensation does not necessarily equate to a high level of knowledge about investment matters,” Hess says. “They may not be making the most optimal choices.”

Focus has increased on participant behavior in these plans. For instance, some executives contribute to an NQDC plan and set it for distributing money when their children reach college age, to pay for their higher education. While some like the flexibility, this does not help them with their long-term retirement­ savings, Hess says, and drawing the money out pre-retirement also effectively erases the tax benefits. Or executives may contribute to their nonqualified plan before their qualified plan, a questionable decision since that balance is less secure if the employer subsequently fails.

These key employees tend to keep very busy, Dorton says, so Webinars and online tools they can access at any time work well as educational approaches. Advisers also have a good opportunity to offer one-on-one help to executives to come up with their nonqualified-plan strategy. “Then, we suggest that participants follow up each year,” he says, “and see if this is still the track they want to be on.”

—Judy Ward

Survey Finds NQDC Plans Valued

Nonqualified deferred compensation (NQDC) solutions continue to be viewed by employers and participants as a valuable benefit, according to a survey from Principal Financial Group.

Employers sponsoring these plans gave five primary reasons for offering them:

• The plans allow participants to save for retirement in excess of qualified plan limits (86%).
• They help comprise a competitive­ benefit package for recruited employees (86%).
• They can be used as retention tools for key employees (81%).
• They help replace benefits lost by Internal Revenue Service restrictions on qualified plans (69%).
• They can assist in motivating employees to meet performance goals (46%).

Nearly all (97%) NQDC plan sponsors plan to continue to offer their plans, with only 7% planning to make changes in the next 12 months.

Participants still place the highest priority on NQDC plans’ ability to assist with retirement and influence a prospective employee’s decision to accept a new job. While difficult economic conditions may have contributed to a reduction in the median annual plan contributions—from $22,000 in 2007 to $18,000 in 2009—more than nine of 10 participants (91%) said they plan to maintain or increase their deferral contributions in the subsequent 12 months.

External Recordkeeper Usage

The Principal’s study found nearly eight in 10 plan sponsors (79%) use the services of an external plan recordkeeper. Plan sponsors look to their plan providers for support and resources, valuing the following services and expertise:

• Information regarding employee current deferral and investment elections (93%)
• General education about NQDC plans (92%)
• Investment option performance information (92%)
• Information about investment options available in the plan (90%)
• Tools and calculators to help determine how much to defer (88%)
• Face-to-face meetings with someone knowledgeable about the plan (82%).

The study shows plan sponsors’ satisfaction with their recordkeepers remains high. Ninety-six percent of current NQDC plan sponsors are either satisfied or very satisfied with their recordkeepers. Factors that drive their satisfaction with recordkeepers include whether the recordkeeper: “Is easy to do business with” (29%); “Understands the needs of your company”

(24%); “Is a thought leader” (24%); “Partners effectively to meet nonqualified administration challenges” (23%).

Participants’ satisfaction with nonqualified deferred compensation recordkeeping remains high at 81%, with access to plan benefit and other information serving as the leading drivers of this satisfaction. The results also show that approximately half (49%) of plan participants currently are using additional products and services provided by the recordkeeper, and a little more than half (53%) are likely to consider the recordkeeper for a new product and/or service.

Plan sponsors surveyed finance their NQDC plans using a diverse set of financing methods. Use of general corporate assets, mutual funds, and corporate-owned life insurance (COLI) are the top three financing methods identified in the survey.

More than three-quarters of plan sponsors who do not have their financing through their recordkeeper are satisfied with their financing methods, and only 7% indicate a likelihood to change financing in the next 12 months.

Nearly four of 10 plan sponsors (38%) require participants to enroll annually in the NQDC plans they offer, and 89% report satisfaction with the enrollment process.

—Rebecca Moore