Nonqualified deferred compensation programs: Good for now and later

Thought Leadership on Employee Benefits-Risk & Reward presented by TriBridge Partners.

When I was a kid, one of my favorite treats were Now & Laters. The candies came packaged together in a long tube that was filled with a seemingly endless amount of individually wrapped fruit chews. As I recall, the marketing behind the product promised enough chews that you could enjoy some now and some later. This makes sense in theory, but when left to my own devices, rarely did the discipline of a 10-year-old allow for me to practice any sort of delayed gratification.

While personal discipline and self control improve with age, in the financial planning world, we often see very successful individuals whose finances closely resemble that of an overzealous 10-year-old. They want too much now and not enough later.

When viewing this through the employer prism, encourage a culture in which key employees are very financially sound, as it can reduce their reliance on cash flows from the business late in their careers. This can also reduce conflict between the next generation in the business looking to move into leadership or ownership roles.

Fortunately, there are a number of effective deferred compensation strategies that can be implemented NOW. A nonqualified deferred compensation (NQDC) arrangement is simply a means of supplementing an executive’s retirement income and providing survivor benefits. It is a contractual, fringe-benefit arrangement under which an employer promises to pay specified benefits to an executive in the event of disability, retirement or other future separation from service.

In other words, NQDC is an arrangement where an employer promises to pay an employee in the future for services rendered currently. Should the executive die prior to retirement, specified amounts would be paid to the executive’s beneficiaries. The deferred benefits, instead of being paid and taxed now, are received after retirement. This maximizes the value of the executive’s chief asset — his or her earning power — and lessens the need to personally accumulate retirement funds.

Once an NQDC arrangement is adopted and implemented, the employer incurs a future liability to make specified payments. It is a sound business practice to hedge this liability by establishing some type of reserve fund from which the payments can be made.

Although they must be “unfunded,” and employees receive only an unsecured promise from the employer, the benefit obligation may be “financed” through a planned investment strategy. Life insurance is ideally suited for this purpose, and is recognized as one of the most practical and economical methods of ensuring the funds for such arrangements. Further, since they provide pre-retirement salary-continuation death benefits to the executive’s family, life insurance can fully and instantly create the funds necessary to complete the arrangement. The income tax-free death proceeds received by the corporation will offset after-tax cost of providing these benefits.

These types of programs have significant advantages to both the employer and the employee.

For an employer, an NQDC arrangement:

  • Attracts talented people.
  • Retains key employees. The payment of NQDC benefits is usually contingent upon performance. For example, the employee will receive the promised retirement and death benefits only if actively employed at the time payments commence;
  • Is a selective and flexible fringe benefit. The employer is not required to include all employees in this program and an NQDC arrangement can be individually tailored to complement other salary and benefit programs.
  • Has a cost that may be predictable.
  • Offers simple administration. These arrangements do not require Treasury Department approval. 
When established for select management or highly compensated employees, they are not subject to many of the requirements of the Employee Retirement Income Security Act of 1974 (ERISA).

For an employee, an NQDC arrangement offers:

  • Pre-retirement death benefits – An NQDC arrangement can be set up so that all or part of an employee’s salary will continue in the event of pre-retirement death.
  • Increased retirement income – The living benefits provided usually entail payments for a number of years after retirement, although it is possible to continue the payments for the lifetime of both the employee and the surviving spouse.
  • Greater net income – Net income from a deferred arrangement will often be greater than alternative planning methods.
  • Stable and consistent growth in cash value
  • Tax advantages and flexibility

It is important that a NQDC arrangement is structured appropriately; however, when implemented properly, a NQDC program can be a “yummy treat” enjoyed both now and later for employers and key employees alike.

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