Of course you offer an
executive deferred compensation plan; it’s a given, right? Both the executives
you’re trying to recruit and your own staff expect you to have one. What’s
more, if you’re competing for talent with the company across town and it has a
deferred comp plan, you’d better have one, too. And what executive in his or
her right mind wouldn’t want one?
However, 2008 is here.
In this age of technology and rapid change, there are no “givens.”
It’s time to reexamine
the reasons you started and maintain your deferred compensation plan, says
Scott Hill, senior vice president and financial advisor for Kanaly Trust
Company. Hill regularly advises his executive clients on whether they should
enter a deferred compensation program when their employer offers one.
Automatically assuming it’s the best deal for executives or for the company may
be an outdated approach.
Plans May Be Less
Attractive
In times past, there was
good reason to offer a deferred comp plan, and there were great reasons for executives
to join them. “Historically, deferred comp programs were fairly flexible, in
that executives had more control over the timing of when they would pull out
their deferrals,” Hill explains.
Before 2001, company
executives could withdraw their deferred compensation funds early, paying only
a small penalty. “These executives were able to pull money out of these plans,
to the detriment of shareholders and other employees, taking a small, 10
percent ‘haircut’ on the funds,” says Hill. However, new rules made it
difficult for executives to withdraw funds early and only suffer a small
penalty.
That, says Hill, is just
one reason that deferred compensation programs have become less attractive over
time. Here are two more:
1. The convergence of
personal and corporate tax rates. “Many years ago, corporate tax rates were much
higher than personal tax rates,” says Hill. “So in an attempt to decrease
overall taxation, it made sense for companies to hold onto the funds longer,
and then pay them out to retiring executives. Then, back in the mid-1980s when
personal and corporate tax rates started coming closer together, that little
advantage started going away.”
2. The uncertainty of personal
income tax rates. “When money comes out of a deferred compensation plan, it is taxed
at ordinary income tax rates,” says Hill. “We’re in a situation now where those
rates are low from an historical perspective, so there is ample reason to
believe personal income tax rates could move higher in the future.” Many people
assume that they will enjoy a lower tax rate in their retirement years, but
that may not be true. “The executive needs to evaluate whether to defer the
money and pay later at ordinary income rates at that time, or invest in
something else—like a mutual fund—and be taxed at capital gains rates when he
or she withdraws the money.”
“The big consideration,
from an executive’s perspective, is the security of funds he or she defers into
a deferred comp program,” Hill continues. “Since [Internal Revenue Code Section
409(a)] has made it more difficult to access the funds once you’ve deferred
them, you have to really scrutinize the company as to its financial condition.
It may look great right now, but how is it going to look 10, 15, or 20 years
from now when you’re ready to retire and withdraw the funds? And keep in mind,
these assets, because they’re not part of a qualified plan, are subject to the general
creditors of the company. So while an executive may own a ton of company stock,
it may not be secure.”
Executives Face Several
Risks
Hill says executives
have greater exposure to the company’s ups and downs than do most employees. “Executives
have to decide how much exposure is enough,” he says. “First, you have exposure
simply because you work there; that’s where your paycheck comes from. Then, if
you own stock, you have exposure there through equity ownership. And third, if
you defer into a deferred comp plan, you’re taking assets you have earned and
putting them back into the pool in the name of tax deferral, and that is
subject to the general creditors of the company. So you can be at vocational
risk, equity risk, and deferral risk. It’s one of those things that creeps up
on you. Usually when people are first eligible for these plans, they look
great: who doesn’t want a tax deferral? Then one day you look, and you have
pretty big balances. That’s where it gets subjective: what exposure to this company
am I comfortable with?”
Hill says that offering
the services of a financial planner to executives can help everyone sleep
better at night. A qualified planner can examine each executive’s particular
circumstances and make recommendations.
That’s what Hill’s
company does and sometimes, depending on the individual’s circumstances, it
recommends not participating in a deferred comp plan: “Every individual
executive is going to have a different situation. If you have someone who is
two years out from retirement, their risk profile is going to be much different
than an executive who is 40 years old and has another 25 years to go. [The
latter] can accumulate more stock and really tie their fortunes to those of the
company, where someone who is getting ready to retire really needs to think
about retirement income and diversification and things like that.” Paying for a
set number of financial planning hours for executives could be an investment in
them that they will appreciate.
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Eliminating the Plan Is
an Option
Don’t be afraid to
consider eliminating the deferred compensation plan completely. “You can have
people take the compensation and pay their taxes now, and invest the extra
funds in an account outside a deferred compensation plan,” says Hill. “And keep
in mind there is a cost (to the company) of administering these plans. The
biggest cost is the loss of the company’s tax deduction; it’s not paying out
the compensation yet, so it loses that deduction.”
“But the cost of
compliance and administration is a hard-dollar cost. Nonqualified plans are
cheaper to administer, but you still have to have someone tracking it and
keeping up with the rules. And if the plan is out of compliance (with the law)
the penalties can be pretty stiff.”
Hill’s advice for
executives, if they decide to join your deferred compensation plan, is to be
fully aware of the implications of participating. “Go in eyes wide open,” he
says. “Understand the risks, the exposure that you have. Be aware that if you
make a deferral, you may not have access to the funds any time soon— you can’t
change your mind and get the money back without severe penalties.”
And for plan sponsors,
Hill says to be aware that, with its diminishing value, a deferred compensation
plan may no longer be a given.