NQDC Guidance
Art by Franco Zacharzewski
Nonqualified deferred compensation (NQDC) plans are an important way to help highly paid employees save more annually for retirement than is permitted in a qualified retirement plan. NQDCs can also help employers meet other goals—e.g., serving as a key incentive in recruiting and retaining top talent and as a vehicle for providing performance-based rewards.
Despite the clear distinction in the names, plan sponsors often mistakenly believe that NQDCs operate like qualified retirement plans, says Kathleen Souhrada, vice president of nonqualified and life administration at Principal Financial Group in Des Moines, Iowa. This highlights the value a skilled and educated plan adviser can provide, she says.
An NQDC plan is exempt from the provisions of the Employee Retirement Income Security Act (ERISA) that govern qualified retirement plans, says Phillip L. Currie Jr., managing director of Fulcrum Partners in Newport Beach, California. Plan sponsors do set up the plan document to define the provisions of the plan, but the only filing requirement is that the plan sponsor must notify the DOL, by letter, of the plan’s establishement within 120 days of that event. “There are no Form 5500s,” Currie says, “and the plans don’t have to be funded—there doesn’t have to be a trust associated with them.”
Funding
NQDC plans are, in actuality, a “promise to pay,” Currie says. If a sponsor chooses to fund the NQDC liability, best practice would be to allow participants to self-direct their account balance within a menu of investment options, which are notional. The employer then purchases assets that mirror the participants’ notional investments to hedge the liability. Unlike with a 401(k), which is an ERISA plan, NQDC plans do not require establishing a trust to hold their assets; doing so is optional. If the sponsor wants to increase the benefit security for participants, it would not only fund the liability but would hold the assets in a rabbi trust—a type of grantor trust.
Typically, NQDC plan sponsors purchase corporate-owned mutual funds or corporation-owned life insurance (COLI) to fund their plan, Souhrada notes. Whatever their method, sponsors commonly fail to understand that benefits payable under an NQDC plan are a liability on their balance sheet, she says. And if they informally finance their NQDC plan by purchasing some kind of asset, this asset needs to be recorded on their balance sheet, as well.
“Because NQDC plans are unfunded obligations, participants have a substantial risk of forfeiture should any type of insolvency event occur to the plan sponsor prior to benefits having been distributed,” she says. The role for advisers and plan sponsors is to ensure “participants understand the benefits, and the risks, associated with NQDC plans prior to a participant enrolling.”
Oftentimes, the adviser is providing education to current and newly eligible participants during initial and ongoing enrollment events, she points out. “The adviser can be the face of education with participants, which can also open doors to additional business for the adviser.”
Rules for NQDC Plans
According to Currie, the DOL has basically two rules that NQDC plans must follow. As previously mentioned, the agency requires that the sponsor of a new NQDC provide notification of its adoption. The second rule is that plan eligibility be limited to a select group of management and highly compensated employees (HCEs). “The DOL has never defined what that [latter requirement] means, so all we have to rely on is results of court cases,” Currie observes. NQDC plans must meet this “top-hat plan” exemption to be free from the eligibility, vesting, funding and fiduciary requirements of ERISA. If a court or the DOL finds that the plan covers more than that specified group, it can determine the plan is an ERISA plan, not an NQDC. A true NQDC plan is never ERISA governed.
There are also two doctrines in NQDC plans’ regulatory landscape, Currie says: constructive receipt and economic benefit. With constructive receipt, if the plan document allows a participant to access his money at a certain predetermined time—e.g., when he turns 59 1/2—the IRS considers the money taxable at that time, whether he takes a distribution or not. To avoid constructive receipt, advisers can help plan sponsors set provisions of the nonqualified plan in such a way that distributions will be made only upon a participant’s retirement, termination from employment or death.
The economic benefit doctrine is more difficult to understand. Under that, if an individual receives any economic or financial benefit or property as compensation for services, its value is currently includible in the individual’s gross income, Currie explains. “To keep a plan in compliance, we can establish a substantial risk of forfeiture by having a participant’s account balance subject to the claims of creditors in the event of an insolvency.”
The final, and most consequential regulatory element affecting NQDC plans is Internal Revenue Code (IRC) Section 409A, Currie says.
Only corporate NQDC plans fall under Section 409A’s governance. Other types of nonqualified plans are subject to other regulations, Souhrada notes. Those established by for-profit plan sponsors will generally be subject to 409A. Not-for-profit and governmental plan sponsors fall under IRC Section 457—their nonqualified plan is a 457(f) plan—and they are not subject to 409A.
The basic rules under Section 409A are that the plan must be in writing; it must specify how much compensation will be deferred; and it must state when distributions will be made and the form of payment, says Will Fogleman, an associate at Groom Law Group Chartered in Washington, D.C.
“Basically, under 409A, an NQDC plan is defined broadly as compensation or a legally binding right to compensation that is promised to be paid to participants in a subsequent plan year,” Fogelman says. “If a plan fails to comply with 409A, the assets are subject to immediate income tax at the time of failure. All assets are accelerated at the same time, and a 20% additional penalty tax applies—as well as an interest penalty on the tax that would have been paid if the participants had claimed the compensation as income when it was originally deferred.”
Advising for an NQDC Plan
Besides educating plan sponsors and plan participants about the differences between nonqualified and qualified plans, advisers can be a valuable support in setting up a nonqualified deferred compensation (NQDC) plan and finding the right provider for recordkeeping.
“I describe nonqualified plans as a process rather than a product,” says Phillip L. Currie Jr. of Fulcrum Partners. “We have 300 clients, and no two plans are identical.” Plan advisers should ask the plan sponsor what it is trying to accomplish with the plan, which group of employees is most limited by the employer’s qualified plan, to what sources of compensation can participants defer, and does the sponsor want to fund the plan or not?
The next key thing an adviser can do is help the sponsor find a quality recordkeeper for the plan, Currie says. Corporate plan sponsors, for instance, need a recordkeeper with a system built to comply with Internal Revenue Code (IRC) Section 409A, including controls that will prevent a 409A violation, he says. “If a plan sponsor uses one of the major recordkeepers, it is more likely to stay in compliance, and, if there’s a mistake, a correction gets done quickly,” he says. “Where there’s a potential for violations is when a sponsor works with an outside law firm to set up the plan and the chief financial officer [CFO] is administering the plan on an Excel spreadsheet—which is actually a common occurrence.”
A strong recordkeeper has not only the proper systems and technology to support regulations, but the expertise among its staff to guide the adviser and plan sponsor through the life of the benefit program, says Kathleen Souhrada of Principal Financial Group.
She says a plan’s adviser will also want to conduct periodic reviews with the sponsor, in concert with the recordkeeper. This way, he can ensure that the plan, and any funding, is continuing to meet the sponsor’s and participants’ needs and that it is adhering to the pertinent rules and regulations.