Non-Qualified Executive Benefits By: Dana DeLucaACS, ALMI, Peter Skelton

The quit rate is a measure not many employers know much about or track.  Yet, the Department of Labor tracks and records the number of voluntary separations in the labor force.  With job demand high in recent years, the quit rate had steadily increased from September 2009 to August of 2019, the highest-ever recorded rate, with 4,478,000 people leaving their jobs that month.  Even amid a pandemic, in September 2020, 3 million workers quit their jobs. That amounts to roughly 2.1% of the U.S. workforce.

This underscores that the demand for key employees is great, and, with this demand, many companies are looking to poach the best and the brightest from their competitors.  This is a great way to strengthen their workforce and weaken the competition.

So, how certain are you that your benefits are designed to retain and reward your key employees, the ones who are driving profits and helping to make your organization run efficiently?

Most employers are familiar with the standard menu of “qualified” retirement plans — “qualified” meaning compliant with the requirements under the Employee Retirement Income Security Act of 1974 (ERISA).  And many employees have a goal to accumulate enough assets to retire at 80% of their income.  Fittingly, for many employees, this goal can be reached through qualified plans.  However, key and highly compensated employees often need to be setting aside more than what the qualified plan limits are to reach this goal.

As an employer, establishing a non-qualified plan may be a way you can help your key employees reach their goal and provide an additional incentive for them to remain loyal to your company.  Non-qualified plans are an unfunded, unsecured promise by the employer to the key employee of compensation at a specific time or event in the future.  

As a non-qualified plan, the employer has significant room for creativity and design flexibility.  A plan can be unique to an organization and their employees to accomplish several goals:

  • Retain key employees through “golden handcuffs” by offering deferred benefits that are subject to forfeiture unless certain conditions are met.  Since these plans are not vested, the employee does not recognize current taxation of the benefits and in the event that the agreed-on time period for employment are not met have no interest in the benefit.
  • Create benefits that cannot be provided under the limits of the law.  A non qualified plan can accumulate assets beyond the ERISA defined contribution limits.
  • Provide benefits to just a select group of employees.  This can also be a more cost-effective route than establishing a qualified plan that provides benefits to all employees.
  • Provide incentives for key employees without creating an immediate corresponding tax burden to the individual.

Advantages to the Employee:

Non-qualified plans are attractive to key employees due to their favorable tax treatment.  These plans avoid current taxation.  In addition, they would avoid current taxation on any growth of the account.  

Non-qualified plans may be funded through employer dollars, employee deferrals or a combination of the two.  If an employee defers income. If an employee defers income, s/he can avoid an income-tax bracket creep by deferring enough income to stay in a lower marginal tax rate.
Disadvantages to the Employee:

The amounts deferred are unsecured contractual obligations by the employer.  These amounts are not protected from the claims of the business creditors.  In the event of a corporate bankruptcy, the employee would become one of the general creditors of the company.  This also means employees are depending on the likelihood the company will be solvent when they want to receive the deferred compensation and that it will have the funds to pay what’s owed.

There are rules for the timing of the decision to defer either compensation or bonus income.  The ability to change deferral rates is less flexible than what an employee can expect under a 401(k) plan.  The primary guideline for deferred compensation plans is 409(A).  Section 409A applies to compensation that workers earn in one year, but that is paid in a future year.  This regulation limits the ability of an employee to change his/her deferral election during the year.  This means that an employee needs to plan for the amount of deferral that makes sense for his/her cash flow.

Employees typically elect to receive their deferred compensation at major life events, such as retirement.  Other triggers include a specified date, change in ownership of the business, death or disability.  The election and timing of these payments are made in advance; therefore, the financial and other circumstances may change during the period of deferral (such as a change in the financial condition of the company).  There are limited ways that the deferral election can be changed.

Types of Plans:

Typically, there are two classes of deferred compensation, and they have similarities to their qualified plan counterparts.

  1. A defined contribution deferred compensation plan — The benefits are in the form of a contribution to an account accumulating investment earnings.  There is an unknown end benefit value.  Often these plans are called 401(k) mirror or look-a-like plans.

  2. A defined benefit deferred compensation plan — There is a formula or fixed dollar amount of income that will be provided if the agreed-on events (time of service) are met.

Characteristics of a Non-Qualified Plan:

Non-qualified plans are unfunded, and as long as the employee does not have either constructive receipt or any current economic benefit from the plan or accumulated contributions, there would not be any federal or state income tax payable.  At the time the employee begins to receive the benefits, those will be taxed at ordinary income tax rates.  Generally, benefits will be subject to FICA and Medicare payroll taxes.

Contributions by the employer are not deductible, and deductions would not be recognized by the employer until the benefits are paid out to the employee.  If contributions are set aside, the employer would be subject to taxation on those investment earnings.  Often, employers select life insurance as an asset to informally hold the contributions.  The cash values grow tax-deferred and the death benefit protects the employer from a premature death of the key employee.  

By using life insurance, employers have the flexibility to determine if the cash values of the policy should be used to pay out the deferred compensation benefits or to retain the policy and use the death benefit as a reimbursement for the deferred compensation plan.  By retaining the policy, the return on the policy improves significantly and is often not taxable as income when received. 
In conclusion, deferred compensation plans are a flexible plan designed exclusively for your key employees.  These plans are cost-effective, flexible and an ideal tool to provide meaningful incentives and benefits to encourage the retention of participants.  With the right plan design, you can avoid increasing your quit rate.

Dana C. DeLuca

Ms. DeLuca began her insurance career at Northwestern Mutual. Prior to that, Dana had traveled the country with a career in corporate project management and advertising.

Dana began her career at KAFL in 2008. Originally serving as a Case Manager at KAFL, Dana developed a collaborative approach to...

More about Dana DeLuca
Peter R. Skelton

Mr. Skelton came to KAFL Insurance Resources in 1992 serving as a Brokerage Manager. In January 2011, he was appointed as President.

Currently, Peter is the CEO of KAFL. His responsibilities include developing relationships with strategic partner accounts in targeted growth markets. He also analyzes...

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