In the past few years, Congress has passed numerous laws that restrict the benefits that can be provided to highly compensated employees in a qualified retirement plan. These include a $200,000 compensation cap, a $30,000 maximum contribution to a Defined Contribution Plan, a Defined Benefit maximum benefit of $98,064, and the broad coverage requirements of Sec. 410(b). In order to provide these employees with an adequate level of benefits, employers must look to other strategies. As a result, an increasing number of employers are adopting nonqualified deferred compensation plans as a way to provide an appropriate level of retirement income to their highly compensated group.

Who Should Benefit From a

Nonqualified Plan of Deferred

Compensation?

Nonqualified plans are not, and in fact, may not be for all employees. The Employee Retirement Income Security Act (ERISA) exempts certain "unfunded" plans benefiting "a select group of management or highly compensated employees" from most of its requirements except reporting and disclosure. The plan will not have to meet the participation, funding, vesting and fiduciary requirements. The Department of Labor (DOL) has not yet issued regulations defining either "management" or "highly compensated employee." An indication of the DOL's position was suggested by David Walker, Assistant Secretary for Pension and Welfare Benefits, who suggested a definition of a highly compensated employee as someone earning three times the Social Security wage base. A plan, even if it is limited to a "select group of management or highly compensated employees," will generally be subject to ERISA's participation, funding, vesting and fiduciary requirements if it is "funded." A "funded" plan is one in which plan assets are set aside for the benefit of employees, and employees have secured rights to the assets. Nonqualified plans are generally "unfunded" in this sense.

ERISA also specifically exempts Excess Benefit Plans from most of its requirements except reporting and disclosure. An Excess Benefit Plan is a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by Sec. 415 of the IRC.

Why Use a Nonqualified Plan?

There are many reasons why an employer might want to consider using a nonqualified benefit plan. Some of the most common reasons are:

* As a way to exceed the various limitations imposed by Sec. 415 on qualified pension plan benefits and contributions;

* As an additional method of rewarding key employees for their contribution to the success of the company;

* As a means of imposing "golden handcuffs" upon the key employees of the company;

* As a means of providing additional death and disability benefits (beyond the company's group insurance programs) to select employees; and

* As a means of reducing the current tax liability and "crediting" tax deferred earnings for selected employees (via a deferred compensation program).

"Funding" Considerations

In order to be exempt from most ERISA requirements, nonqualified plans must be unfunded. This does not mean that an employer cannot do anything to prefund for future benefit obligations. What it does mean is that plan assets must not be irrevocably set aside for the future obligation to make benefit payments. A plan is considered unfunded as long as plan assets, if any, are available to meet the employer's obligation to its general creditors, and plan participants have no greater security than that of any other general creditor of the employer.

"Funding" Vehicles

Several vehicles are available for prefunding benefit obligations under a nonqualified plan. The various funding strategies are as follows:

Pay-As-You-Go-Strategy. There is no prefunding of the future benefit liability. All benefits are paid out of current cash flow as they become due.

Sinking Fund. The employer sets aside assets into an account earmarked for the payment of future plan benefits.

Annuity Contracts. The employer purchases annuity contracts on the plan participants and uses the contracts to fund future benefits. The employer would be the annuity contract's owner, premium payer and beneficiary.

Corporate Owned Life Insurance (COLI). The employer purchases life insurance policies on the lives of some or all of the plan participants. The employer is the policy owner, premium payer and beneficiary. Benefits, when payable, are usually paid out of employer cash flow, although loans from policy cash values could be used for this purpose. The life insurance face amount selected will ideally, upon the ultimate death of the covered plan participant, reimburse the employer for all premiums and benefits paid, and the loss of use of the funds.

Tax Considerations

Of major concern to employers and plan participants is the income tax treatment on nonqualified plans. If the plan is unfunded, then the following tax results would apply:

1. Employer's Tax Results:

* Plan benefits are deductible when paid or made available to plan participants;

* Any current "funding" of future benefit obligations would be nondeductible; and

* Earnings on plan "assets" would be currently taxable to the employer. If plan "assets" are invested in tax free or tax deferred vehicles, these tax benefits would be passed through to the employer.

2. Employee's Tax Results:

* Benefits are taxable at the earlier of when actually paid or made available;

* Employer contributions and plan earnings are not currently taxable to plan participants as long as there is no constructive receipt; and

* Any secured interest in plan "assets" will result in current taxation for the participant.

Security Considerations

It is natural for plan participants to be concerned with the security of their future benefit promises. Since plan participants are unsecured creditors of the employer, there is no guarantee that the employer will have the ability or desire to make the benefit payments as promised. Unfortunately, a secure interest can result in the loss of tax deferrals; however, there are other methods available to provide increased security for plan participants.

Rabbi Trust. A Rabbi Trust is an irrevocable trust established to pay promised benefits. As long as the trust assets are available to pay the general creditors of the employer in the event of a bankruptcy, the IRS has ruled that the trust beneficiary is not subject to taxation prior to receipt of the benefits. The major advantages of a Rabbi Trust arrangement are:

* Benefits are secured for all eventualities except employer bankruptcy. In particular, benefits are secured when there is a change in ownership or control of the employer; and

* Provides plan participants with a high level of security since trust assets can only be used for the payment of benefits. The use of an independent trustee protects against a change of heart by future management (or new current management, in the case of a takeover).

A Rabbi Trust must meet the following requirements:

* The trust account must be segregated from the employer's general funds. Nonetheless, since the trust is a grantor trust, its earnings are included in the employer's taxable income; and

* The trust funds must be subject to the claims of the employer's general creditors and the employer must notify the trustee of pending insolvency;

* The plan participants' current claim to plan assets is subject to a substantial risk of forfeiture;

* The plan participants cannot alienate or assign plan benefits; and

* The plan participants have no discretion as to time or manner of benefit payments. However, hardship withdrawals may be allowed.

Conclusion

Nonqualified plans provide an employer with significant flexibility in the design of benefit programs for a select group of key, highly paid employees. If the plan is carefully designed, both the employer and the plan participants will realize significant benefits from such an arrangement. Current income can be deferred to a later date, additional retirement benefits can be provided, and welfare benefits can be improved for the benefit of those employees who are most responsible for the success of the business. These plans should be carefully designed to promise competitive, yet reasonable, benefits. The employer needs to project the cost of the promised benefits, using reasonable actuarial assumptions, and be comfortable with both the cash flow requirements and the financial reporting implications before adopting any plan.

Nonqualified plans are common at Fortune 500 companies and with smaller employers as well. The current Congressional thrust to limit deductions to and benefits from qualified plans and welfare plans will make such arrangements even more attractive in order to adequately reward and retain top management talent.