Nonqualified retirement plans Featured

8:00pm EDT October 26, 2007

The dust is just settling after the first proxy season following the implementation of the SEC’s disclosure rules around executive compensation. The new policies demand greater candor and disclosure about executive earnings and compensation plans. If meeting the spirit and intent behind the SEC requirements wasn’t enough, now public companies must contend with meeting the final rules of IRS Section 409(A), and the Pension Protection Act, both of which take effect Jan. 1, 2008.

With the final regulations in place, companies need to revise their deferred compensation plans, including nonqualified retirement plans, before the deadline.

“Section 409(A) applies to every non-qualified retirement plan,” says Pete Neuwirth, senior consultant with the Retirement Practice at Watson Wyatt Worldwide. “All aspects of the plans are coming under review, including plan design, funding and administration.”

Smart Business spoke with Neuwirth about how CEOs can prepare for the upcoming changes in deferred compensation and nonqualified retirement plans required as a result of all the new rules.

How do the new proxy disclosure rules come into the picture when discussing the Section 409(A) requirements for nonqualified retirement plans?

The proxy filings represented the first time that we’ve seen many of these executive compensation numbers laid out in public. At Watson Wyatt, we conducted a survey of 690 proxy statements, specifically looking at the compensation that was associated with nonqualified retirement plans. In general, the pension portion of the executive compensation was equal to base pay and averaged about 10 percent of the total compensation the executive received, which also included performance-based compensation and bonuses. For some CEOs, however, the nonqualified retirement program represented a much larger component of compensation. One important component of the proxy statements is to explain the link between performance and pay for executives. This is difficult to do for a nonqualified retirement plan. Because the proxy statements must include the present value of any accumulated benefits, including deferred compensation, it brings forward the issue of explaining how performance is tied to deferred compensation and nonqualified pension plans. The proxy also requires a discussion of the rationale for adopting the retirement plan in the first place, something that most companies are not able to readily do.

What design changes to nonqualified pensions plans do you recommend to meet the new requirements?

First of all, one size does not fit all. It’s not necessarily the answer to eliminate all of your deferred compensation plans, including your nonqualified pension plans, to comply with the new rules. For example, the nonqualified plan may have been put in place for retention purposes or to augment succession planning goals by helping your company attract midcareer employees, so you still want to derive the benefits while complying with 409(A). You should think about the type of nonqualified retirement plan that will best meet your objectives and, in particular, review how your non-qualified plan dovetails with your qualified plan. You may, for example, find opportunities to achieve your goals through the qualified plan, i.e. QSERP. You may want to consider lowering your Supplemental Executive Retirement Plan formula and using total compensation in your benefit formulas as opposed to base pay only to better tie the plan to performance. Rather than throwing your SERP out the window, carefully consider the reasons for the plan and, where possible, tie the value of the plan back to performance. Doing this helps companies meet both the 409(A) and the SEC disclosure requirements.

How does 409(A) impact funding requirements?

While, historically, there’s been no formal way to fund nonqualified plans, executives want some type of security for their retirement funds. That security has generally been achieved by funding nonqualified plans through a ‘rabbi’ trust or allowing executives early access to their benefits through in-service distributions with a small reduction, or ‘haircut,’ applied. (The name comes from the first IRS private letter ruling approving such a trust, obtained by a synagogue on behalf of a rabbi.)

Unfortunately, 409(A) sharply curtails your ability to get at funds even if a haircut is applied. Rabbi trusts, however, are still viable. While securing against a ‘change of heart,’ rabbi trust assets are still accessible by creditors in the event of bankruptcy. Also, because earnings on trust assets are subject to income tax, many companies place the trust assets backing executive’s deferred compensation into Corporate Owned Life Insurance (COLI). This funding strategy provides positive tax consequences and security for the executive, but results in increased frictional costs and a lack of liquidity.

How does 409(A) change plan administration?

Certainly 409(A) has complicated plan administration considerably. In the past, the administration of nonqualified pension plans has tracked closely with requirements for 401(k) plans. You may want to consider outsourcing the plan administration since the complexity of 409(A) will require someone on the staff to be very attentive to the requirements and, given the number of people covered by the plans, it may not make financial sense to keep administration in house.

PETE NEUWIRTH is a senior consultant in the Retirement Practice for Watson Wyatt Worldwide. Reach him at (713) 733-4139 or peter.neuwirth@watsonwyatt.com.