More Than Golden Handcuffs

Until recently, an executive's retirement income package comprised qualified plan benefits, Social Security, income from personal investments and benefits from any nonqualified plans. Most packages were designed to provide benefits from the first two sources of between 50% and 75% of the executive's average final pay. Unfortunately, companies now find it increasingly difficult to achieve this objective using qualified plans because the compensation limit used to determine eligible contributions has been lowered (see the article on page 45), the definition of employee for coverage purposes has become more complicated and comprehensive and the amounts that can be contributed have been restricted. As a result, companies are using nonqualified deferred compensation plans to bridge the gap created by qualified plan restrictions and uncertainty over Social Security. In addition, many companies are finding that good communication between employer and employee will improve the effectiveness of all retirement benefit plans. This article gives companies information they need to develop retirement programs that are fair to both parties. MIXED APPEAL OF QUALIFIED PLANS Favorable tax and nontax benefits have led most companies to adopt some type of qualified plan as part of their executive retirement planning, including defined benefit and defined contribution plans. (See the glossary on page 40.) Under Internal Revenue Code sections 404 and 402 (a) (1), these plans provide significant tax benefits to both employer and employee. Amounts contributed are tax deductible by the employer, while the employee does not recognize any taxable income until distributions are made. Under IRC section 501 (a), earnings within the plan also are exempt from current taxation. Since qualified plan assets are held in trust, they are safe from the creditors of either the employer or the beneficiaries. In Patterson v. Shumate, 112 S.Ct. 2242 (1992), the U.S. Supreme Court held that not even the bankruptcy court could reach a bankrupt beneficiary's interest in a qualified retirement plan. Despite these advantages, a number of factors have diluted the appeal of qualified plans for highly compensated executives (HCEs): * In the past, key executives were more likely to stay with one company for most of their careers. Today, executives move freely from company to company. Since qualified plan benefits depend on years of service with the employer, the build-up of benefits is hampered by the limited number of years executives are able to accrue benefits. * Legislation in the 1980s and 1990s significantly restricted the usefulness of qualified plans by limiting contribution and benefit amounts. The Tax Reform Act of 1986, for example, reduced the maximum compensation that can be taken into account for qualified plan purposes to $200,000. The Omnibus Budget Reconciliation Act of 1993 reduced it further to $150,000. (Beginning in 1997, the compensation limit, which is indexed for inflation, increased to $160,000.) Exhibit 1, page 39, outlines other limitations for 1997. * Legislative activity in Congress has significantly increased the employer's cost of establishing and maintaining a qualified plan. To satisfy nondiscrimination requirements, plans must provide coverage, benefits and contributions to both HCEs and non-HCEs. The sheer complexity of qualifying under the Employee Retirement Income Security Act of 1974 (ERISA), as amended, and IRC administrative requirements greatly increases the burden of maintaining qualified plans, especially for small employers. * Limitations on the maximum benefits available under Social Security and qualified plans result in non-HCEs being able to retire at a higher percentage of their final compensation from these sources than HCEs. Exhibit 2, page 41, and exhibit 3, page 42, illustrate the restrictions on qualified plan benefits for HCEs, assuming an employee's bonus does and does not qualify -- respectively -- as part of the benefit formula. …