NQDC Investment Menus
Art by Harry Campbell
With the U.S. seeing its tightest labor market since World War II, reports Goldman Sachs, competition for attracting and retaining key employees is fierce. Nonqualified deferred compensation plans have been invaluable for both, experts say, as the plans can help highly paid executives save for retirement on a tax-deferred basis when their income exceeds the IRS limit for a 401(k).
The unfunded type of NQDC plan—and also the most common, according to wealth management firm Henssler Financial—is intended for top earners and allows the employer to create a competitive compensation package. Also called executive, or top hat, plans, they are technically agreements saying the company will pay an NQDC plan participant tax-deferred compensation at some point in the future, typically at retirement—although it can be timed to pay for college tuition funding or other large expense.
Unlike with a qualified plan—or a funded NQDC—the company assumes a contractual obligation to pay the benefit; no contributions must be “irrevocably and unconditionally set aside with a third party” to ensure the agreement is kept, as Henssler explains it. And, because no earnings are set aside, the participant pays no tax until the benefit is in hand.
The plans are also exempt from requirements pertaining to participation, vesting, funding and fiduciary responsibilities under the Employee Retirement Income Security Act, Sections 201(2), 301(a)(3) and 401(a)(1).
“[NQDCs] can help participants accomplish all of their financial goals, and [they’re] a great tool for plan sponsors,” says Kevin Mitchell, vice president, workplace consulting, at Fidelity Investments in Deerfield, Illinois.
Funding an Unfunded Plan Via COLI
While employers are not required to accumulate assets to ensure they will be able to meet their obligation, many in fact do, says Henssler Financial, noting, “This is commonly referred to as ‘informally funding’ an NQDC plan.”
One of the standard tools for such funding is corporate-owned life insurance. COLI insures the lives of the plan participants; yet, the policies are owned by the plan sponsor, which pays the premiums and is the beneficiary. An advantage of COLI is that it can be used as a tax-efficient way to offset some of the costs of nonqualified executive benefits.
“Life insurance shields the employer from having to pay corporate taxes on that money each year,” says Matt Compton, managing director retirement solutions at Brio Benefit Consulting in New York City. “But [the employer] is responsible for paying the insurance premiums that are associated with the corporate-owned policies.”
Compton says when he has cross-compared the expenses involved in funding an NQDC plan via insurance vs. via mutual funds, life insurance wins. “Normally, the cost of the insurance is not nearly as significant as what the taxes would be in a mutual fund investment vehicle.” Ideally, he adds, companies should model out the two strategies, to gain a clearer picture of which would be the better approach.
For NQDC plans that use COLI, one of the main reasons is flexibility with investments, says Mike Shannon, senior vice president, nonqualified consulting at Newport Group in Lake Mary, Florida. The sponsor and its advisers have fewer constraints than with mutual funds or exchange-traded funds when recommending and making plan investment menu changes.
“Consequences can sometimes hamstring a potential menu change when the funding is mutual funds,” Shannon says. There, a change in fund managers will trigger realized gains, and the sponsor will get taxed on the income. “COLI obviously doesn’t have that same consideration, since fund reallocations don’t trigger taxable income,” he says.
On the con side, Mitchell says, there are generally higher fund manager fees associated with an insurance-based investment lineup than with an investment approach containing mutual funds. He has seen a shift among plan sponsors in recent years away from the insurance-based approach for this reason, he says.
Still, it is not necessarily an either-or situation, and many providers find they are best-suited in funding an NQDC with a combination of COLI and mutual funds, Compton says.
“If an adviser or recordkeeper is doing the proper modeling, that will show you what the better route is,” he says. “And, in split-funded situations, it can show you what percentage should be going to the mutual-fund-based investments vs. what percentage should be going to COLI-based investments.”
Mirroring a 401(k) plan has become the most prevalent investment menu approach among NQDC plan sponsors.
Qualifications and Stipulations
Top hat plans typically benefit executives whose annual salary exceeds the annual limit for compensation that may be taken into account under a qualified plan for purposes of computing the employee’s contributions and benefits. According to the IRS, the maximum annual compensation this year is $305,000.
“An investment menu designed for a nonqualified plan has the benefit and flexibility of focusing specifically on the different demographics, time horizons and financial objectives of the senior management NQDC participants,” says Shannon. “In addition, there’s a great chance to create diversification and alternative investment opportunities in these plans that is not typically available in a qualified plan.”
There are possible negatives for the potential sponsor to consider, though, and advisers can help clients sort through them.
One minor drawback can be the additional oversight the plan’s investment menu demands, Shannon says. But “that is easily handled by the plan adviser as an add-on to his or her qualified plan responsibilities.”
Additionally, Compton notes certain sometimes vague stipulations. The plan’s participants must be highly compensated and represent no more than 10% of the company’s workforce. ERISA, however, provides no clear definition of what else constitutes a top hat group.
According to a report from executive benefits consulting firm Fulcrum Partners, recent case law also speaks to the lack of clear guidance when it comes to identifying a company’s top-hat vs. rank-and-file employees, who sometimes, mistakenly, get enrolled in the plan. The firm recommends plan sponsors “work with experienced executive benefits consultants who have traditionally used conservative definitions of top hat plan guidelines” to avoid significant litigation risk or ERISA fines.
Tried and True
Another common investment approach for sponsors of NQDC plans is to simply mirror the investments in the company’s qualified 401(k) plan. In fact, Mitchell says, in recent years mirroring the 401(k)’s lineup has become “by far” the most prevalent investment strategy used by NQDC plan sponsors.
Earlier in his career, Mitchell says, NQDC sponsors typically believed that executives needed and wanted a different investment lineup, with more exotic or sophisticated options. “But that has not proved to be the case.” Many sponsors have shifted to mirroring their defined contribution plan because those provide “simplicity, convenience and lower fees,” while still allowing for participants’ diversification needs, he says.
Shannon disagrees. “There is a huge, missed opportunity for participants to have additional diversification through the use of other fund families and more esoteric asset classes,” he says. He cites “fixed-rate options and REITs [real estate investment trusts] or alternative investment styles such as international fixed income that might not typically be utilized in a broader DC plan.”