Understanding Deferred Compensation

Understanding Deferred Compensation

Deferred compensation refers to a plan that allows an employee to set aside part of their income, which is deposited into an account and whose withdrawal is done at a later date. The funds contributed are held in the retirement account tax-free until such a time that they are ready for withdrawal. However, the tax regime under these plans is structured in a way that ensures that persons who hold the money in their accounts until retirement are taxed at a lower rate.

There are two main types of deferred compensation plans, namely qualified and non-qualified plans. Examples of qualified plans include 457, 401 (K), and 403 (b) plans. These plans are usually offered to all employees, but these are taxed before being deposited into retirement accounts.

Non-qualified Deferred Compensation Plans (409 a) – are plans that are typically offered to high-earning executives and selected employees considered as highly valuable to the institutions employing them.  

These plans are structured in a way that permits companies to defer paying part of the beneficiaries’ salaries while at the same time enabling them to contribute to other retirement plans. Under these plans, there are no limits put to the amount of money that can be contributed to the 409 (a) account.

Supplemental Executive Retirement Plan (SERP) –  these plans are packaged in a way that bears close semblance to defined-benefit plans. SERPs are almost exclusively given to top executives, and they guarantee them a specific amount of money to be paid to them upon retirement.

The SERP payments can be calculated as either a percentage of the executive’s salary or a fixed amount of money to be channeled to the account for a specific number of years. Alternatively, the company can fund a life insurance package worth an agreed amount to be paid upon the retirement of the executive.

How does deferred compensation work?

Once you get an offer for a deferred compensation plan, you will agree with the company work, the amount you are supposed to contribute, and the length of time you should contribute. The contribution period can range from five years to until retirement. You will also define the payment terms, which may be a lump sum or spread out over a specified length of time.

How are funds in deferred compensation invested?

Non-qualified Deferred Compensation funds are, in actual terms, not invested but are a commitment by your employer that they will pay you the money deferred, together with the accrued yields of your chosen investment option. 

For example, if you had chosen the Nasdaq industrial index, the employer will be expected to pay you an equivalent of the amount that matches the performance of the index during the plan period. Note that NQDC plan payments are not a guarantee but a promise/commitment by your employer. 

Below are the key factors you should consider to ensure that your NQDC does not antagonize your broader financial security strategy.

The timeline of your financial plan: If you plan to withdraw your funds after a prolonged period of savings, say 20 years, you can choose high-growth investments. However, note that such investments have high volatility. The long period will provide adequate recovery time in case the market is turbulent during some years. On the other hand, if your plan period is short, you should go for less volatile options.

Your risk tolerance: You will have a choice of going for high-risk/high-reward investment and low-risk/low-reward options. It is therefore prudent to weigh these options and assess the historical performance of the options at your disposal. This will help you make a well-informed investment decision.

Beware of other risks: NQDC plans have other existential risks apart from investing in high-risk ventures. Key among these risks is the risk of default by the company. This may happen if the company becomes bankrupt. It is also worth noting that the NQDC funds are not protected from creditors. In addition, if the company’s revenue plummets, you may end up with only a fraction of what you expected.

Advantages

  1. There is no limit to the amount of money you can contribute to the fund.
  2.  If you wait for your savings to accumulate until retirement, you will qualify for a tax cut.
  3. Most deferred compensation plans offer employees flexible payment options to fit their financial capabilities.
  4. You can choose to withdraw your cash in case the company engages in an acquisition or merger that you think will put your savings at risk.
  5. In some instances, you may get rare investment opportunities that may not be available with other options.

Disadvantages

  1. In case the company runs into financial headwinds, you may lose your investment.
  2. You risk losing money if you go against the terms of the plan.
  3. In some instances, the 409(A) plan may not always offer you an investment option.
  4. You cannot retract your decision to go for a 409(A) plan. Therefore, in case you change your mind midway through the implementation period, you will not have a way out.
  5. Your employer is the one who takes control of your funds until they are due for withdrawal. This denies you the opportunity to manage your own funds.

Bottom line

It is not uncommon for expenditure needs to rise significantly in the first few years after retirement. You may want to visit places you never got to visit during your working years, you may incur increased medical expenditure, among other things. Deferred compensation allows you to save for your future needs by keeping a portion of your current earnings.

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