The pros and cons of nonqualified deferred compensation
4 min read
Your company’s leadership team includes some of the most critical hires your organization can make. For employers— attracting, retaining and incentivizing these top employees is often a top priority. Nonqualified deferred compensation (NQDC) plans provide a competitive benefit for top talent. In fact, one study shows that 92% of companies offer such plans.1
Beyond benefits such as qualified 401(k) or other retirement savings plans, NQDC plans allow employers to create enticing compensation packages aligned with individual and company values. For example, the plans can be customized to each executive, providing compensation in a variety of ways from performance-related bonuses to equity. At the same time, NQDC plans give the organization the ability to spread out the compensation expense, often over the span of years.
In short: NQDC plans are a great tool in your compensation and benefits toolbox. By understanding the advantages and risks of these plans, you can ensure that you’re putting them to the best use for your company.
NQDC plans explained
Nonqualified deferred compensation plans refer to a range of incentive plans, offered to executive-level employees. Broadly, the plans allow employees to defer compensation to a specified point in the future. Employees also defer paying taxes on that compensation until they receive it—typically years down the road and often post-retirement. However, unlike 401(k)s, NQDCs don’t have contribution limits, which make them even more enticing to high-earning employees, who may easily max out an employer-sponsored qualified retirement plan.
Employers can create these plans at any time, and usually include them as part of a job offer or as a retention or performance incentive. NQDCs can also help restore benefits that have been diminished or lost due to IRS regulations and limitations.
Plan distributions can be structured in various ways, from payments over a specific time period to one-time lump sum payments. Customization isn't only applicable to salary but also equity and bonuses. If properly designed, non-qualified plans are not required to follow ERISA based participation rules. In fact, an employer can create a plan for a single individual.
Deferred compensation advantages
The plans provide employers—as well as employees—with some distinct advantages. A significant advantage is providing companies with a vehicle for recruiting and retaining the most competitive employees. Employers can tailor plans for individual employees, and in doing so, differentiate their compensation offer from competitors. Because the plans can be configured in multiple ways, they also offer employers an opportunity to align company and executive goals—and reward executives for achieving highly desired milestones.
For example, employers can connect bonuses to broad performance metrics such as revenue increases or improvements in the stock share price or individual performance metrics such as the creation of a strategic plan or restructuring of a specific division. NQDC plans provide flexibility to employers as well, especially for high-growth companies. In these cases, cash may be at a premium and better used to fuel growth (instead of paid out in compensation). An NQDC plan can entice executives to take a lower salary in the present day for the promise of additional compensation later, when the company may be in a better cash position.
While NQDC plans provide a host of distinct advantages, they also come with some considerations. The biggest is that any contributions the company makes to a plan aren’t deductible until the employee receives the compensation. That may affect some tax planning for companies.
The plans carry some inherent risk for the employees in that the deferred payments are unsecured and not guaranteed. So if the organization faces bankruptcy and creditor claims, the employees may not receive their promised funds. (In contrast, qualified plans such as 401(k)s are protected from bankruptcy creditors). That said, employers can help mitigate some of this risk by establishing thoughtful plan designs and implement the use of trusts to hold plan assets.
Employers do need to pay close attention to the structure of their NQDC plans including the timing of payments, and the number of plan recipients. With multiple executives, it’s possible that your organization could be making multiple deferred payments at one time—and planning for that outflow of cash is critical.
Both employers and employees should understand the ins and outs of any nonqualified deferred compensation offering. Organizations can help ensure their employees understand the plans by providing some additional education around the offering.
- Helping employees determine when and how to take their deferred compensation.
- Educating employees on the risk of participating in such plans.
- Providing access to financial planning resources so that employees can determine how nonqualified compensation fits into their broader financial planning goals.
- Exploring how nonqualified investments may range from investments in qualified retirement plans.
- Providing annual updates and online resources to ensure that employees remain educated and engaged with their NQDC plans.
Nonqualified deferred compensation provides an excellent way to offer executives additional benefits beyond what's provided for the general employee base. Putting these plans into play may increase your ability to attract and retain top employee talent.
1 Current Practices in Non-Qualified Deferred Compensation. Newport Group, 2019
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