Human Resources Chapter 11 Nonqualified Deferred Compensation Plans For Executives Nonqualified Deferred Compensation Plans

Chapter 11 – Nonqualified Deferred Compensation Plans for Executives

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Chapter 11 Nonqualified Deferred Compensation Plans for Executives

I. Learning Objectives (use PP 11.2)

2. Various nonqualified retirement plans for executives

4. Stock options and stock plans

6. Reporting requirements for nonqualified plans

II. Defining Executive Employment Status

A. Who are Executives? (use PP 11.3)

1. From a tax regulation perspective, the Internal Revenue Service (IRS) recognizes two

2. The IRS uses the term “key employees” to determine the necessity of top-heavy

3. The IRS uses the term “highly compensated employees” for nondiscrimination rules

in employer-sponsored health insurance benefits

B. Key Employees (use PP 11.4)

1. The term key employee means any employee who at any time during the year is either

of the following:

a. An officer having annual pay of more than $165,000

C. Highly Compensated Employees (use PP 11.5)

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

a. An officer

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III. Objectives of Nonqualified Plans (use PP 11.6)

1. Nonqualified plans are established to serve employer and employee interests

2. Employees recognize that nonqualified plans allow them to accumulate substantially

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

4. Restoration addresses the gap between the maximum retirement benefits allowed by

6. In general, all annual earnings above this level cannot be included in defined benefit

plan formulas or in the calculation of annual additions to defined contribution plans

7. The IRS limits the annual benefit amounts for defined benefit plans to the lesser of

8. Limits on annual additions to defined contribution plans were the lesser of $50,000 in

9. Annual additions refer to employer contributions allocated to the participant’s

10. Companies that pursue supplemental retirement benefits increase an executive’s total

11. Supplemental executive retirement plans (SERPs) generate higher retirement

benefits in a variety of ways: (use PP 11.7)

a. Nonexecutive employees earn an annual retirement benefit equal to 60 percent of

IV. Characteristics Distinguishing between Nonqualified Plans and Qualified Plans

A. Overview (use PP 11.8)

1. Nonqualified plans differ from qualified plans in four important ways:

a. ERISA qualification criteria,

b. Objectives,

B. ERISA Qualification Criteria (use PP 11.9 & 11.10)

1. Virtually every retirement program and deferred compensation plan for executives

2. Nonqualified plans do not meet all the ERISA criteria necessary to receive favorable

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nonqualified plans

3. In the case of qualified plans, employer and employee contributions are excluded

from taxable income in the same year the contributions were made

4. Nonqualified plans allow employees to contribute money on a tax-deferred basis, and

5. While employers may make contributions on behalf of employees and receive tax

6. Title I specifies a variety of protections for participants and beneficiaries:

a. Reporting and disclosure

7. Retirement programs designed exclusively for executives and additional groups of

highly paid management and professional employees who do not meet the IRS criteria

for key employees or highly compensated employees are nonqualified deferred

compensation plans for three main reasons

a. Those employees earn substantially more than the IRS limits for the maximum

annual benefit for qualified defined benefit plans

C. Funding Status (use PP 11.11)

1. Companies each make the decision about whether to establish executive retirement

programs as funded plans or unfunded plans

2. Funded plans allocate money or property (i.e., company stock, securities) to trust

4. Neither a company nor its creditors may withdraw from a trust fund or redeem an

insurance policy

6. Executives stand to lose retirement benefits following a change of company

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

ownership

7. Several factors in deciding whether to fund nonqualified pension plans:

9. Funding “forces” companies to set aside resources so that they will be able to meet

their financial obligations throughout an executive’s retirement

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a. Opportunity cost requirements

i. Funding nonqualified plans represents an opportunity cost. Companies decide

whether the investment in nonqualified plans promotes longer-term

D. Mandatory Retirement Age

1. Normal retirement age: Lowest age specified in a pension plan at which an employee

who retires may begin receiving retirement benefits

2. Upon attaining this age, an employee gains the right to retire without the consent of

3. The Age Discrimination in Employment Act forbids employers from setting a

mandatory retirement age for virtually all employees, except for:

5. An employee in a high policymaking position plays a significant role in the

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V. Nonqualified Retirement Plans for Executives (use PP 11.13)

A. Excess Benefit Plans

1. Companies usually create excess benefit plans by extending the provisions of existing

qualified plans

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

defined contribution plans

5. Funded excess benefit plans are subject to ERISA’s reporting and disclosure,

fiduciary requirements, and administration and enforcement

6. These ERISA requirements do not apply to unfunded plans

B. Supplemental Executive Retirement Plans (SERPs)

1. SERPs increase an executive’s total retirement benefits to a substantially greater sum

than do restoration plans

2. SERPs include a variety of different possible objectives that distinguishes them from

excess benefit plans: (use PP 11.14)

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

Qualified plans and excess plans use only base pay or salary to calculate

3. A well-known unfunded SERP is the top hat plan (use PP 11.15)

a. Companies maintain top hat plans “primarily for the purpose of providing deferred

compensation for a select group of management or highly compensated

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d. Exemption from these ERISA provisions requires that employers maintain top hat

plans as being unfunded and offer them exclusively to a “select group of

C. Contrasting Excess Benefits Plans and SERPs

1. Excess benefit plans and SERPs differ in two important ways besides the main

objectives set forth above

a. Companies choose to bestow vesting rights on participants of both types, but there

is a notable difference

VI. Funding Mechanisms and Tax Obligations

A. Overview

2. Overall, funding mechanisms vary according to the level of security, listed from the

least amount of security to the greatest amount: (use PP 11.16)

3. Funded and unfunded plans are subject to federal taxes from both employees and

employers

5. Specifically, tax regulations require that: Income although not actually reduced to a

taxpayer’s possession is constructively received by him in the taxable year during

6. For funded plans, executives pay federal income taxes each year based on

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

contributions to and earnings from the trust

7. For unfunded plans, executives generally pay federal income taxes when they begin to

receive payments from these plans

8. Employers usually are responsible for federal taxes when executives actually receive

benefits

B. General Assets

1. Companies may fund nonqualified deferred compensation plans with general assets of

the company (cash, company stock)

2. This method provides the least amount of security to executives for two reasons:

a. Companies are typically required to turn assets over to creditors in the event of

bankruptcy or insolvency

b. The agreement to compensate executives from general assets is not protected by

ERISA

C. Corporate Owned Life Insurance

2. Whole life insurance policies pay a designated amount to the designated beneficiaries

of the deceased

3. Employers purchase whole life insurance policies on the lives of executives and they

4. Employers use the insurance benefit to recover the costs of nonqualified deferred

compensation

D. Split Dollar Life Insurance

2. The employer and executive share the premium payment

4. The designated owner usually pays the larger share of the premium cost

5. Benefits professionals use the term collateral approach when the executive maintains

ownership

6. The endorsement approach designates the employer as the owner

a. Under the endorsement approach, the employer pays for most or all of the

premium

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

e. The employee names a beneficiary to receive the difference—that is, the amount

that exceeds the policy’s cash value

E. Rabbi Trusts

2. In the field of finance, trusts are a way of holding assets with a specific objective

4. Companies establish rabbi trusts to provide executives and key employees or

5. Starting at the time of retirement, termination, or death, a company makes payments

to the employee or beneficiary directly from its general assets

7. Rabbi trusts are unfunded

F. Secular Trusts

2. As a result, secular trusts are funded plans that meet the provisions of ERISA

G. Employee Owned Annuities

2. An executive sets up annuity arrangements with a third-party vendor such as a mutual

fund company

4. An executive’s vested retirement benefit usually determines the amount of the annuity

6. Not subject to ERISA’s provisions

VII. Stock and Stock Option Plans for Incentive Compensation and Retirement

A. Overview

1. Stock option plans commonly used in nonqualified deferred compensation plans: (use

PP 11.17)

a. Incentive stock options

b. Nonstatutory stock options

B. Basic Terminology (use PP 11.18)

2. Company stock shares represent equity segments of equal value

4. Stocks are bought and sold every business day in public stock exchanges; the New

York Stock Exchange is the best-known stock exchange

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

6. Stock grant: A company’s offering of stock to an employee

8. Disposition: Sale of stock by the stockholder

9. Fair market value: The average value between the highest and lowest reported sales

price of a stock on the New York Stock Exchange on any given date

C. Incentive Stock Options (use PP 11.19)

2. Usually, the predetermined price equals the stock price at the time an executive

receives the stock option

4. The IRS applies a minimum holding period to executives during

which they do not receive any tax benefits for the disposition of stock

6. Executives receive income tax benefits by participating in incentive stock options

8. Employers do not receive any tax deductions unless the executive disposes of the

stock prior to satisfying the requirements of the holding period

D. Nonstatutory Stock Options (use PP 11.20)

1. Awarded by companies to executives at discounted prices

3. Executives pay income taxes on the difference between the discounted price and

4. IRS classifies stock options as having ascertainable fair market value when stocks are

traded on established stock exchanges

6. Paying taxes when receiving the nanstatutory stock grant may be more advantageous

than paying taxes in the future when exercising the right to receive the grant

7. Stock prices are anticipated to increase over time. As a result, the capital gains will

likely be much greater in the future

E. Restricted Stock Plans (use PP 11.21)

2. Executives do not have any ownership control over the disposition of the stock for a

predetermined period, often 5 to 10 years

3. Executives must sell the stock back to the company for exactly the same discounted

5. Executives do not pay tax on any income resulting from an increase in stock price

until after the restriction period ends

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6. Employers receive a tax deduction in the same amount when the restriction period

comes to an end

F. Phantom Stock Plans (use PP 11.22)

1. A phantom stock plan is a compensation arrangement whereby boards of directors

2. Executives must meet specific conditions before they can convert these phantom

shares into real shares of company stock

3. Two conditions generally must be adhered to:

5. Executives pay taxes on the capital gains after they convert their phantom shares to

real shares of company stock during retirement

7. Thus, these retirees’ income tax rates will be lower

8. Employers receive a tax deduction in the same amount when employees pay taxes on

the capital gains

G. Discount Stock Options (use PP 11.23)

1. Similar to nonstatutory stock option plans with one exception

a. Companies grant stock options at rates far below the stock’s fair market value on

the date the option is granted

H. Stock Appreciation Rights (use PP 11.24)

2. Executives never have to exercise their stock rights to receive income

3. The company simply awards payment to executives based on the difference in stock

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VIII. Executive Severance Plans (use PP 11.25)

A. Overview

1. A common provision of executive plans is severance compensation

3. Severance compensation is negotiated during the hiring process, approved by the

board of directors, and subsequently documented by written contract

B. Golden Parachutes (use PP 11.26)

1. Provide pay and benefits to executives after a termination that results from a change

2. Golden parachutes extend pay and benefits from one to five years, depending on the

agreement

3. Boards of directors include golden parachute clauses for two reasons:

4. Companies benefit from golden parachute payments because they can treat these

5. Companies may now generally receive tax deductions on golden parachutes that

amount to less than several times an executive’s average annual compensation for the

preceding five years

C. Platinum Parachutes (use PP 11.27)

1. After a period of unsatisfactory performance as determined by shareholders and other

3. Platinum parachutes are lucrative awards that compensate departing executives with

severance pay, continuation of company benefits, and even stock options

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

publicity essentially by paying off a CEO to give up his or her post

IX. Regulatory Requirements (use PP 11.28)

A. Overview

1. Publicly held companies must make annual reports to the Securities and Exchange

Commission

B. U.S. Department of Labor

2. Companies must specify the number of current top hat plans and the number of

participants in each plan

3. Companies must include a declaration of purpose: The employer maintains the plan

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C. The Internal Revenue Service

2. Since 2005, the IRS has instituted additional rules that changed the long-standing tax

treatment of NQDC plans and created myriad additional rules

3. These rules impose more restrictions on employees’ elections to defer compensation,

benefit payment elections, and the timing of distributions

D. Securities and Exchange Commission (use PP 11.29 & 11.30)

1. Companies that sell and exchange securities (e.g., company stocks and bonds) on

3. Securities Exchange Act of 1934 applies to the disclosure of executive compensation

pay

5. The SEC rulings had two objectives:

a. To clarify the presentation of the compensation paid to a company’s CEO and the

6. Companies’ board members may be subject to personal liability for paying excessive

compensation

8. Well-publicized corporate accounting scandals have led to tighter accounting

standards

9. New corporate tax law puts tighter restrictions on deferred compensation payouts to

11. In 2002, the oversight of the SEC was strengthened when President George W. Bush

signed the Sarbanes-Oxley Act of 2002 into law

12. The act mandated a number of reforms to enhance corporate responsibility, enhance

14. In 2008, the SEC unveiled additional rules for disclosing executive compensation

15. In 2010, President Barack Obama signed the Wall Street Reform and Consumer

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Protection Act of 2010 to further enhance the transparency of executive

compensation practices

a. Also commonly referred to as the Dodd-Frank Act

2. Some of the leading and most well-respected firms in this area include the following:

a. Buck Consultants (www.buckconsultants.com)

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Summary

Nonqualified plan arrangements enable companies to award retirement benefits commensurately

Discussion Questions

1. What are the main objectives of nonqualified plans?

Chapter 11 – Nonqualified Deferred Compensation Plans for Executives

2. Why are unfunded plans the riskiest from an executive’s perspective? How can companies

justify the use of unfunded plans?

3. Discuss the differences between the general asset approach and secular trusts for funding

nonqualified plans.

Main Points

• General assets

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4. Describe the reporting requirements for nonqualified plans.

Main Points

• Top hat plans are exempt from the reporting and disclosure requirements of ERISA.

However, employers offering these plans are obligated to comply with Department of

Labor requests for information. In addition, publicly held companies must make annual

of executive pay.

• The Sarbanes–Oxley Act of 2002 is perhaps the most significant legislation governing

companies’ accounting standards because it imposes rigorous requirements for

companies’ financial disclosure so as to limit the chances that covert misuses of corporate

funds will occur.

5. Having studied employee-benefit practices in this book, do you believe that treatment of

executives is fair compared to that of employees of lesser ranks? Explain your answer.

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Cases

Understanding Your Benefits

Executive Compensation in a Corporation

1. What is the purpose of the platinum parachute? Why would the company provide this

benefit? How does it compare to the golden parachute?

2. Why does the company offer an incentive stock option plan?

3. What other protections are in place for the shareholders and employees relative to

executive compensation in organizations?

1. What is the purpose of the platinum parachute? Why would the company provide this

benefit? How does it compare to the golden parachute?

2. Why does the company offer an incentive stock option plan?

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3. What other protections are in place for the shareholders and employees relative to

executive compensation in organizations?

1. How does a stock option plan provide an incentive for executives?

2. Which plan would be better for Safeguard, the incentive stock option plan or the phantom

stock plan?

1. How does a stock option plan provide an incentive for executives?

2. Which plan would be better for Safeguard, the incentive stock option plan or the phantom

stock plan?

Chapter 11 – Nonqualified Deferred Compensation Plans for Executives

Incentive stock options allow executives to purchase their company’s stock in the future at a

predetermined price, typically the price on the date the option is granted. Executives will often