Pay Me Now, or Pay Me Later: The Truth behind Deferred Compensation
by Rob Mason of FutureSense, Inc.
For those senior executives out there with a non-qualified deferred compensation plan (“NQDC”), it is time to ask a fundamental question: why?
Yes, I know it is the end of the year and you are swamped trying to keep your “eye on the ball” and “head above water,” while “putting out the occasional fire.” Business-ese always seems to flourish this time of year. I realize you are busy, but it is time to readdress some taken-for-granted truths – this year it is deferred compensation.
NQDC plans are not for everyone. They are designed for the highly-compensated; otherwise, a company runs the risk of it becoming a “qualified plan.” According to Hewitt Associates, 71% of companies offer their highly paid executives a NQDC plan – that is the withholding of a percentage of salary which is not taxed until received at some later date.1 The goal of such plans is to compound earnings tax free until the money is withdrawn, typically at retirement. Given that 401(k) plans are capped at $13,000 a year (plus another $3,000 for those older than 50), NQDC offer another retirement vehicle.2 NQDCs can be voluntary with elective deferrals or involuntary, which requires no decision by the executive but is inherent in the understanding of his/her agreement.
The catch, for both voluntary and involuntary NQDCs, is that these funds are at risk; companies do not put money aside in a special pool. Thus, if the company goes belly-up at some future date, you have to stand in line with the rest of the creditors. For those who have faith that their employers will be around for some time, this plan may not be such a big risk. In this light, NQDC plans are quite innocuous – essentially “forced savings” for when you actually retire. You can pay taxes now or pay taxes later, in the end it is a wash.
Yet, somehow I get the feeling that not all use NQDC plans in this way. To those who are using these plans as a form of, a) intermediate capital accumulation or b) tax avoidance, then you may be playing the game for the wrong reasons and putting your retirement at risk.
One detour on the road to retirement is “intermediate capital accumulation” – the use or leveraging of retirement vehicles (NQDCs and 401(k)s) for purposes other than retirement. This trend has become quite prevalent as more men and women have chosen to postpone marriage and family until later in life.
According to the most recent US Census Survey, the percentage of men 30-34 who have never been married has quadrupled since 1970 – now accounting for about a third of men in that age group. Similarly, about a fourth of women 30-34 have never married – also a fourfold increase since 1970.3 Not surprisingly, these people are focusing more on their education and jobs than raising a family.
The net result of this demographic shift is that these “late marry-ers” are often using their retirement plans to fund their current living. In order to pay for that new “family” house when they finally settle down and college tuition later on, these individuals are withdrawing from their NQDC plans or taking out loans against their 401(k)s. Assuming they can make up the difference or “live on less” in retirement, executives are often left scrambling when that retirement age does come up.
Then there is tax avoidance. Let’s assume you are making $250,000 in total cash compensation (base salary and bonus) each year. You feel that you can live your current lifestyle with $200,000, so you decide to put $50,000 into a NQDC plan. The idea is to pay fewer taxes, on that deferred $50,000, when you are taking home a smaller paycheck at retirement (from your 401(k), pension plans, social security, etc.). While logical, this thinking assumes that you will be in a lower tax bracket at retirement; plausible, but highly unlikely. While I am certain that you can live on $120k a year after the kids are out of college, but many will find that $80,000 gap quite difficult to bear – particularly if you are still paying off college loans and mortgages as explained above. Downsizing, while pragmatic, is always easier said than done.
Moreover, I would not bet on taxes being lower in the future if the US keeps spending and borrowing at its present pace. The OECD’s latest Economic Outlook predicts that the current-account deficit will rise to $825 billion by 2006 (6.4% of America’s GDP) – clearly uncharted territory, both as a share of the economy and in terms of the share of foreign savings it soaks up.4 Economists squabble over how this imbalance will be corrected (i.e. greater demand outside of the US vs. higher US saving vs. declining value of the dollar), but most agree that it must, at some point, be corrected. If you think higher taxes are not going to be a part of that adjustment, then you can roll the dice and take your chances. In reality, those making over $200,000 dollars a year should pay taxes under the current Bush tax plan, because they are not going to be lower anytime soon.
Thanks in large part to the boys at Enron; the IRS has closed a few other loopholes with the “American Job Creation Act of 2004.” In general, this new legislation makes deferred compensation plans (as well as stock appreciation rights, phantom stock plans, and some severance agreements) less flexible with high penalties for non-compliance. In the past, executives were able to change their election schedule for a small “haircut” penalty (typically 10%); thus, Enron execs accelerated their NQDC payment schedules when they realized the company was going bankrupt. The American Job Creation Act essentially closed that loophole so that there is now a real risk of forfeiture – which, of course, was the intention of the plan in the first place.
Is it worth it…?
When used as a “forced savings” vehicle for retirement, NQDCs do make sense for the highly-compensated. But, these plans are a risk and you should be clear as to why you have it in the first place because they are not for everyone. NQDCs, as a vehicle for intermediate capital accumulation, may be a short-term necessity if bills need to be paid; however, be sure to consider the long-term consequences and adjust your retirement plans accordingly. As for tax scheming, be warned that the IRS is on the hunt – albeit slowly. While you should not abandon NQDCs out of fear of the “taxman,” all should ask…is it worth it?
1 Simon, Ruth. “Tax Bill Targets Executive Pay Perk,” The Wall Street Journal. August 13, 2004: page D1.
2 Katzeff, Paul. “Rules Make NQDC Plan Less Flexible,” Investor’s Business Daily, November 15, 2004: page A14.
3 U.S. Census Bureau < http://www.census.gov/population/www/socdemo/hh-fam.html >.
4 “The Disappearing Dollar,” The Economist, December 4, 2004: page 9.