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Part Four: Extending Employee Benefits: Design and Global Issues

Chapter Eleven: Nonqualified Deferred Compensation Plans for Executives

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Learning Objectives

In this chapter, you will gain an understanding of:

who executive employees are and the characteristics of nonqualified deferred compensation (NQDC) plans.

examples of NQDC plans used for executives’ retirement.

funding mechanisms for NQDC plans.

stock-based compensation plans.

separation agreements for executives.

reporting and disclosure requirements.

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Overview

The chapter begins by defining executive employment status.

Then nonqualified deferred compensation plans (NQDC) are defined and discussed.

The chapter continues by discussing nonqualified retirement plans for executives.

A discussion of funding mechanisms follows.

Stock options and stock purchase plans are defined, as well as separation agreements.

The chapter ends with a discussion on reporting and disclosure requirements.

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Who are Executives?

The IRS notes two employees with a central role in a company’s competitive strategy:

highly compensated employees, and

key employees.

The IRS uses the term:

“key employees” to determine the necessity of top-heavy provisions in qualified retirement plans, and

“highly compensated employees” for nondiscrimination rules in employer benefits.

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Key Employees

Key employee means any employee who at any time during the year is either:

an officer with pay more than $175,000, or

an individual who was either a 5% owner or a 1% owner whose pay is more than $150,000.

Officer in this definition is:

an administrative executive in regular service,

who holds a title of officer, or the authority of an officer.

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Highly Compensated Employees

The IRS defines a highly compensated employee as one of the following:

a 5% owner during current or preceding year, or

for the preceding year:

had compensation in excess of $120.000, or

was in the top 20% of the most highly compensated employees.

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Defining Nonqualified Deferred Compensation Plans (NQDC)

NQDC plans allow executives to accumulate more money for retirement than allowed by qualified plan limits.

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Nonqualified deferred compensation (NQDC)

the IRS says this plan is an agreement between an employer an employee to pay compensation in the future

Defining Nonqualified Deferred Compensation Plans (NQDC)

Companies use nonqualified retirement plans to achieve one of two objectives:

restoration, and

supplemental retirement benefits.

Restoration

restores retirement income limited by qualified plans income limits.

Supplemental retirement benefits

increase retirement benefits more than restoration plans.

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Characteristics Distinguishing Nonqualified Plans

Nonqualified plans differ from qualified plans in three important ways:

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ERISA qualification criteria

Funding status

Mandatory retirement age

ERISA Qualification Criteria

NQDC plans fail to meet ERISA criteria.

Qualified plans meet all ERISA standards.

Some ERISA Title I and Title II provisions set minimums to qualify pension plans.

Title I specifies:

reporting and disclosure,

participation and vesting minimums,

funding,

fiduciary responsibilities,

administration,

continuation coverage,

portability, access, and renewability.

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ERISA Qualification Criteria

Which standards are not usually met?

Executives’ pay exceeds the IRC limits for qualified plans.

ERISA prohibit favoring highly compensated employees.

Executive plans violate nondiscrimination rules

which prohibits favoring highly compensated employees in contributions or benefits, availability, rights, or plan features.

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Funding Status

Each company decides whether to establish funded or unfunded plans.

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Funded plans

place money in trust funds or insurance contracts in an executive’s name, so no risk of forfeiture

Unfunded plans

only contain the promise to pay in the future with no designated funds to honor the promise

Funding Status

Companies consider several factors when deciding, we look at three.

Managing liabilities requires preparation and funding compels companies to set aside resources.

Funding NQDC plans is costly – does the investment promote profits or reputation?

Shareholders are sensitive to public debate about excessive executive pay and may view funding the plans as a detrimental cost.

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Mandatory Retirement Age

Normal retirement age is the lowest age when a retiree begins receiving benefits.

Employers may not set a mandatory retirement age, except for:

any employee 65 or older who, for two previous years, is employed in a bona fide executive or a high policymaking position, if

that employee is entitled to retirement benefits of at least $44,000.

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Nonqualified Retirement Plans for Executives

Four broad classes of plans:

excess benefit plans,

supplemental executive retirement plans (SERPs),

salary reduction arrangements, and

bonus deferral plans.

The focus here is on the first two.

Companies offer excess plans to restore retirement income disallowed by qualified rules, while SERPs award benefits at higher levels than restoration plans.

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Excess Benefit Plans

Excess benefit plans

increase retirement benefits by the amount lost due to limits set by the IRS.

Companies design excess benefits plans as extensions to qualified defined benefit or defined contribution plans.

Companies may offer these plans on a funded or unfunded basis.

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Supplemental Executive Retirement Plans (SERPs)

SERPs - supplemental benefits that increase total benefits to a greater sum than do restoration plans.

SERP objectives that differ from excess plans:

Inclusion of other types of monetary pay in the calculation of retirement benefits.

Use of SERPs as a tool in executive-level succession planning.

Rewarding substantially higher retirement benefits.

Compensating for short-term employment or older new hires.

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Supplemental Executive Retirement Plans (SERPs)

Companies may offer SERPs as funded or unfunded plans.

A common unfunded SERP – top hat plans.

Primary purpose is to provide deferred income for management and highly compensated employees.

Exempt from ERISA’s standards as long as unfunded and only for select employees.

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Contrasting Excess Benefits Plans and SERPs

They differ in two additional ways.

Companies bestow vesting rights for both types, but lengthier vesting schedules for SERPs.

Companies may include offset provisions to reduce

contributions to and benefits from SERPs when

executives participate in unrelated company-sponsored retirement programs.

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Funding Mechanisms

Funding mechanism is not synonymous with funded plans.

Funding mechanisms by security level:

general–asset approach,

corporate-owned life insurance,

split-dollar life insurance,

rabbi trusts,

secular trusts, and

employee-owned annuities.

Funded and unfunded plans are taxable

for both employees and employers.

Constructive receipt guides when executive’s tax obligations become due.

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Funding Mechanisms

Funding with general assets is the most risky.

Bankrupt companies use assets to pay creditors.

Not protected by ERISA.

Corporate-owned life insurance is only a bit less risky.

Companies take out whole life insurance policies, naming themselves as beneficiary.

Recovering the costs of nonqualified deferred compensation.

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Funding Mechanisms

Split-dollar life insurance.

The employer and executive share the premiums.

The collateral approach is when the executive maintains ownership.

The endorsement approach designates the employer as the owner.

Rabbi trusts is an irrevocable grantor trust.

The employer, as grantor, must still hand over the trust in the event of insolvency.

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Funding Mechanisms

Secular trusts are not subject to creditors in the event of a company bankruptcy.

They must meet ERISA provisions.

Employee-owned annuities offer the greatest degree of security as the employer pays for an annuity in the executive’s name.

Not subject to ERISA because the executive sets up the annuity, not the company.

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Stock Options and Stock Purchase Plans

Some basic terminology is followed by five commonly used alternative stock option plans:

stock options,

restricted stock plans and restricted stock units,

stock appreciation rights,

phantom stock plans, and

employee stock purchase plans.

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Basic Terminology

Company stock is equity in the company.

Company stock shares is equity segments of equal value.

Stock options is a right to buy shares of stock at a designated price.

Stock grants offers stock to employees.

Exercise of stock options is an options purchase.

Disposition is shareholder stock sale.

Fair market value is the average price.

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Restricted Stock Plans and Restricted Stock Units

Under restricted stock plans, a company may grant stock options at market value or discounted value, or provide stock.

Executives must pass through a vesting period before they receive ownership.

Under restricted stock units shares of stock are awarded at the end of the restriction period.

For either, a company may add performance criterion to the vesting period – known as a performance plan.

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Stock Options

Incentive stock options

Executives may purchase stock in the future at a predetermined price.

Capital gains or capital loss is the difference between stock price and stock option price.

Tax benefits are that capital gains is taxed at a lower capital gains rate.

Nonstatutory stock options

This option does not qualify for favorable tax rates.

Executives pay income tax when stock is granted.

However, the tax liability is lower over the long term.

Stock prices usually increases.

Capital gains will likely be much greater than current tax.

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Stock Appreciation Rights

Stock appreciation rights provide income at the end of a designated period.

Much like restricted stock options.

However, executives never have to exercise their stock rights to receive income.

Companies award payments based on fair market value.

Executives keep the stock.

Executives pay taxes when they exercise their stock rights, after retirement, at lower rates.

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Phantom Stock Plans

A phantom stock plan is when boards promise to pay a bonus in the form of the:

equivalent of either the value of company shares or the increase in value over a period of time.

Executives must meet conditions before they can convert phantom shares into real shares:

they must remain an employee for several years,

and they must retire from the company.

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Employee Stock Purchase Plan

A formal stock purchase plan allows workers to purchase stock after a set period of time.

Employees set aside money through payroll deductions during the offering period.

These plans may be qualified or nonqualified.

To qualify for favorable tax treatment, companies’ plans must meet several criteria.

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Separation Agreements

Separation agreements specify compensation and benefits an executive will receive after termination.

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Negotiated during hiring

Approved by the board

Documented in a contract

Golden parachutes

Platinum parachutes

Golden Parachutes

Golden parachutes provides pay and benefits to executives after a termination due to:

a change in ownership or corporate takeover.

Boards include these clauses because they:

limit executives’ risk due to unforeseen events,

promote recruitment and retention,

silence the executive who may resist a takeover which actually benefits the company, and

counts as a company business expense if paid.

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Platinum Parachutes

A platinum parachute may be awarded to a CEO terminated for poor performance.

These are lucrative awards that include severance pay, continuation of benefits, and stock options.

Companies use platinum parachutes to avoid long legal battles or negative publicity.

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Reporting and Disclosure Requirements

Two laws, in particular, are responsible for reporting and disclosure requirements:

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The Securities Exchange Act of 1934

The Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act)

Securities Exchange Act of 1934

Companies that trade on public exchanges are required to file information with the

Securities and Exchange Commission (SEC).

The Securities Exchange Act of 1934 applies to executive compensation practices.

Companies must complete a Definitive Proxy Statement which reveals information about the CEO and Named Executive Officers (NEOs).

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Exhibit 11.1

Securities and Exchange Commission Disclosure Requirements for Executive Compensation

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Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act)

The Wall Street Reform and Consumer Protection Act of 2010 enhanced the transparency of executive compensation.

Commonly called the Dodd-Frank Act.

Three provisions encompass benefits practices:

The say-on-pay gives shareholders a vote on executive compensation;

An independence requirement for compensation committee members and their advisors; and

Disclosure of golden parachute agreements.

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Summary

The chapter began by defining executive employment status.

Then nonqualified deferred compensation plans (NQDC) were defined and discussed.

The chapter continued by discussing nonqualified retirement plans for executives.

A discussion of funding mechanisms followed.

Stock options and stock purchase plans were defined, as well as separation agreements.

The chapter ended with a discussion on reporting and disclosure requirements.

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