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Finding Dollars That Disappear:
Deferred Compensation Plan Audits
March 2011 • Lockton Companies
L O C K T O N C O M P A N I E S
Jason MaplesExecutive Vice President,
Producer303.414.6101
WHY ANNUAL AUDITS OF YOUR COMPANY’S NQDC PLAN CAN HELP YOUR BOTTOM LINE Even in a stuttering economy, the process of obtaining, retaining, and rewarding top executive talent is daunting. Executive talent is often one of the few sustainable differentiators that organizations possess, so developing and retaining that talent is critical. Competition is fierce among companies seeking leaders who will not only help define the company’s vision, but also motivate employees to deliver that vision. Even if you can recruit great leaders, you may not be able to keep them. According to Right Management Consulting, 56 percent of employees with management level or higher titles have reported being contacted in the last year by another company regarding a job opportunity.
EFFECTIVE PLANS AID RECRUITING AND RETENTION
As a result of this challenge, 85 percent of U.S. Fortune 1000 companies have established nonqualified deferred compensation plans (NQDC plans), also referred to as “top hat plans,” to provide highly-compensated employees with pre-tax savings opportunities proportional to their income. This enables them to avoid the “reverse discrimination” effect of the Employee Retirement Income Security Act of 1974 (ERISA), which limits tax-deferred retirement savings contributions to $16,500/year (2011 limit) or $22,000 for executives above age 50. This is a very low limit for highly compensated employees.
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Conversely, NQDC plans enable participants to contribute up to 100 percent of their income, and distributions and allocations are more flexible than under formally funded programs, such as 401(k) plans.
EFFECTIVE PLANS PROVIDE BENEFITS FOR EMPLOYERS
NQDC plans provide desirable benefits for executive candidates, but they also offer several benefits to the employer providing the plan. For instance, employers that include corporate-owned life insurance (COLI) products in the NQDC plan portfolios are entitled to insurance benefits if the covered executives die. Such benefits can help employers defray the costs of recruiting new executive talent. In addition, because the plans cannot be formally funded according to IRS rules, the balances remain on the company’s books (unlike formally funded 401(k) plans) and are therefore available to creditors should the company become insolvent.
Given the benefits of these plans, companies often rightly seek expert counsel to ensure they set up a plan that provides the best benefits for participants and for the employer.
Beware: Setting Up a Good NQDC Plan is Only Half the Battle
Top hat plans are popular and have been in existence for decades. As a result, they have been subject to many regulatory changes over the years. The last major change to the non-qualified planning world was Internal Revenue Code section 409A, which was added as a result of section 885 of the American Jobs Creation Act of 2004. Section 409A states that a nonqualified deferred compensation plan must comply with various rules regarding the timing of deferrals and distributions. In response to 409A, companies were required to bring their documents and plans into compliance.
Unfortunately, regulatory changes often provide the only impetus for companies to proactively review the plans to ensure that they are still adequate and competitive. Most companies decide whether to offer a nonqualified deferred compensation plan and determine how to informally fund it when the plan is established. However, once this decision has been made, few companies ever conduct a thorough review of the plan documents or investment choices, nor do they market-test the plan fees. This can be an expensive mistake.
Regular NQDC Plan Reviews are Often—Wrongly—at the Bottom of the “To Do” List
NQDC plan oversight “falls off the radar” for a couple of reasons. First, these plans garner less attention than the other welfare benefit plans in the company (such as the 401(k) plan) because they tend to be smaller in size. Second, although NQDC plans are technically subject to ERISA, these plans are exempt from four of the major ERISA requirements:
Fiduciary duty Participation
Reporting Funding requirements
For both of the above reasons, regular reviews of NQDC plans—although important—are seldom conducted.
NQDC PLAN AUDITS CAN BE PAINLESS AND ENLIGHTENING—A CASE IN POINT
Lockton Companies’ Executive Benefits Practice was hired by a major Midwestern manufacturer to conduct an insurance audit of its NQDC plan.
Lockton launched the audit with a discussion with the CFO to understand the plan and his concerns. Next the team worked with the firm to gather data needed for the review. During the ensuing weeks, the Lockton team reviewed the data offsite, and within six weeks prepared
Month Year • Lockton Companies
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The firm was paying $82,000/year for $24 million of death
benefits–well above market rates.
a written summary for the CFO, the board of directors, and the board’s compensation committee. With just a few hours of the CFO’s time and a thorough review and analysis of the firm’s NQDC plan documents, Lockton discovered the following:
ONE: THE PLAN’S COLI WAS TOO EXPENSIVE.
The firm used COLI to informally fund the liabilities of its NQDC plan. Although the COLI selected when the plan was established may have been appropriate, due to the commoditization of COLI products and changes in life insurance mortality tables in recent years, newer COLI products are far now more cost-effective than the original COLI that was used. The firm was paying $82,000/year for $24,000,000 of death benefits vs. current market rates of $30,000 for the same coverage. (See Figure 1.)
TWO: THE PLAN HAD TOO MUCH COLI.
The economic recession meant that executives were not deferring as much compensation as they were when the plan was established. As a result, the firm needed less insurance—probably only $15–$20 million of death benefits instead of $24 million. Reducing the COLI coverage to a more appropriate amount further reduced the firm’s cost for this plan by another 15% – 30%.
THREE: THE PLAN HAD NOT CHANGED SINCE 2006.
As illustrated above, companies that do not periodically review their NQDC plan frequently pay more for a less effective plan, in part because of changes in the marketplace that affect prices, coverage needs, and options, but also because of changes at the company. In this example, the COLI was still in place for ten executives who were no longer with the company, and it was not in place for newly eligible individuals who joined the firm after the plan was established.
As a result of Lockton’s audit, the firm reduced its coverage from $24 million to $15 million, removed coverage for the ten departed executives, added coverage for the new executives, and saved more than $60,000 annually in COLI premiums by obtaining more competitive rates.
How an Audit Provides Additional Benefits for the Bottom Line
In addition to the above benefits, Lockton has conducted insurance audits of NQDC plans for other firms nationwide, and we have found the following in many cases:
INCREASING MUTUAL FUND FEES.
Mutual funds are another option for informally funding NQDC plans. We have found that—as with COLI products—mutual funds are also often commoditized over time, meaning that funds selected at the time of plan establishment are no longer the best options because fund prices have decreased over time. With mutual funds, as the income and dividend gains add to the value of the funds, the tax liability also increases. There are opportunities to offset this, however, by using more tax-efficient funds or exchange-traded funds to reduce tax liabilities.
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HIGH ADMINISTRATION EXPENSES.
Plan administration expenses are often a percentage of plan flows. Plans that are not monitored and submitted for market testing often have expenses out of line with current market rates. Over time, these fees can become a big drag on the plan assets. In many cases (such as mutual fund expenses) administrative fees can be negotiated.
LACK OF INVESTMENT REVIEW.
Because NQDC plans are not subject to ERISA fiduciary requirements, the plans receive little attention after they have been established. As a result, investment options that were once ideal may now be overpriced or even nonexistent.
REACTIVE, INSTEAD OF PROACTIVE, SERVICE.
This is a double-edged sword. First, because of the recession, executive compensation is lower, thus decreasing the flow of funds into the plan. Second, firms that are using the larger, publicly traded companies to manage their NQDC plan assets are finding reduced customer service, just at the time when they may need service most. Because those brokers face intense pressure from shareholders to cut expenses and increase profits, they are reducing service to these plans. Clients may
have trouble scheduling education and enrollment meetings and quarterly investment due diligence meetings at the time when they need to focus more attention on investment options, plan expenses, and levels of coverage.
UNBALANCED ASSETS AND LIABILITIES.
Without regular reviews of your NQDC plan, the cost of insurance, mutual fund fees, and administrative expenses can quickly get out of alignment and create a wide gap between your plan assets and plan liabilities, ultimately negatively affecting your company’s bottom line.
What Can You Do?
If you think your NQDC plan could use a review, contact Lockton’s Executive Benefits Practice, led by Jason Maples. We will meet with you and other executives as needed, review plan documentation, and provide a written summary of our suggestions. The entire process may take six to eight weeks (depending on the availability of executives and plan documents). Lockton can help get you and your NQDC plan back on track to ensure you are offering competitive and beneficial products to obtain, retain, and reward your executive talent.
About LocktonMore than 3,800 professionals at Lockton provide more than 15,000
clients around the world with insurance, benefits, executive benefits, and
risk management services, offering an uncommon level of client service.
From its founding in 1966 in Kansas City, Missouri, Lockton has grown to
become the largest privately held insurance broker in the world and the
9th largest overall. Business Insurance magazine recognized Lockton as
a “Best Place to Work in Insurance” two years in a row.
www.lockton.com
About Jason Maples, CLU, ChFC, CFP™An executive vice president with Lockton Companies since June 2009,
Jason was previously the founder and manager of Strategic Financial
Partners, a Denver executive benefits consulting firm. Jason has served
on the board of advisors for the Better Business Bureau, Entrepreneur’s
Organization and United Way Tocqueville Society. In addition, he’s an
Alumnus of Leadership Denver and has been a recipient of the Denver
Business Journal’s “Forty under 40” award and the Denver Foundation’s
Philanthropic Leadership Award.
Securities and investment advisory services offered through NFP Securities, Inc., Member FINRA/SIPC
NFP Securities, Inc. is not affiliated with Lockton Companies or its subsidiaries
www.lockton.com© 2013 Lockton, Inc. All rights reserved. Images © 2013 Thinkstock. All rights reserved.
