As a business owner, you want to ensure the growth, success, and sustainability of your company. Your best ally in pursuit of these goals is your employees, and additional incentives can help reward key staff for their performance and encourage their ongoing efforts as you plan for the future.
A nonqualified deferred compensation plan can be a highly effective way both to motivate critical employees and to lay a strong foundation that helps ensure the business you worked so hard to build continues to thrive. Here are six things you need to know:
- A nonqualified deferred compensation plan is not your ordinary succession plan. Generally used as a retirement plan alternative, it can also function as a succession planning tool designed to reward past performance, attract and retain key employees, and/or supplement other retirement savings.
- You can achieve two goals with one plan. A properly designed nonqualified deferred compensation plan allows you to accomplish two important goals: reward and retain your key executives and employees today and to make certain the succession of well-prepared leaders when you exit the business. A plan that keeps key team members in place means the business you have built can sustain its operations and success. If you participated in the plan throughout your career years, you may also see the financial benefits of the plan and the impact to you, your family, and the accomplishment of your retirement, philanthropic, and estate planning goals. Essentially, through the implementation of a nonqualified deferred compensation plan, you can create financial security for yourself and employees, while having peace of mind that the business you worked so hard to build will continue on.
- Nonqualified deferred compensation plans provide distinct advantages. A great advantage of using a nonqualified deferred compensation as a component of your transition plan is that it allows for a continued stream of income through retirement — some plans are even designed to provide a payout for life — without the typical rules and constraints, such as plan limits. This means a plan payout can usually be tailored to fit your cash needs in retirement. And, depending on plan design, you might be eligible for significant FICA tax savings compared to continuing to receive salary.
A well-designed nonqualified deferred compensation plan covering key management can also be used to fund the purchase of your business if transferring ownership to management is part of your exit strategy. Plan distributions can be made in company ownership, or payouts can be timed to coincide with exit timelines.
- To fund or not to fund. Once the plan is established, you need to determine how, or if, you fund the plan. Unlike the typical retirement plan, a nonqualified deferred compensation plan is not required to be formally funded. This can be a benefit to a company, particularly in years where cash flow is an issue. Nonetheless, many companies choose to set aside assets to fund all or a portion of the benefits accrued.
- Key factors play an important role in the funding option you select. In some cases, the success of your business cannot be outperformed, and it is more beneficial to leave assets in the company and earn a higher return. However, it is also possible that funding the plan is more appropriate, given the business market and conditions at that time. Common funding methods include investing company assets in investment vehicles such as mutual funds, and the use of life insurance.
Overall, many factors determine the right decision for your business. When evaluating funding options, we counsel owners to consider:
- Goals and objective of the plan. The funding mechanism should meet the goals of the plan and not drive the plan design. It's important to identify these before evaluating a funding mechanism.
- Timing, risk tolerance, and rate of return. The time horizon for when benefits will be paid can greatly impact your appetite for risk, which impacts your potential return on assets. If you have a shorter time frame, you may not be willing to take on much risk for the assets that are needed for the benefit pay out. It may also be easier to predict what company cash flow looks like over the next few years, allowing company assets to be used as the funding mechanism. On the other hand, a longer time horizon may provide greater opportunity to be more aggressive to try to achieve a higher return. Given that long-term company performance tends to be more uncertain, however, you might desire greater certainty that the funds will be available when the benefit is due.
- Taxation. The tax implications of nonqualified deferred compensation depend on the participation of the individuals in the plan, as well as the type of funding. Some vehicles, such as life insurance, may defer income taxes due, but owners and their advisors still need to carefully consider the timing and rate.
- Financial statement impact. It's important to consider the effect of an unfunded plan, or unfunded liability, on company financial statements and the possible impact on operations. For example, lending institution debt covenants or bonding companies may have requirements that conflict with an unfunded plan, which would affect your decisions about whether or how to fund the plan.
- Administration. When establishing a plan, you need to consider the administrative responsibilities and requirements. Some funding options require more involved processes and ongoing attention than others.
- Plan ahead. In order to achieve your desired objective and benefit targets, it’s important to plan early, rather than wait until the final years leading to retirement. To make the most of a nonqualified deferred compensation plan, we recommend the plan be designed to meet specific organizational or individual goals — there's no “one size fits all” approach. For example, if the purpose of the plan is to serve as a retention tool, vesting and distribution provisions would be different from a plan simply intended as an additional retirement benefit. With clear goals and sound planning, a nonqualified deferred compensation plan can create financial security for you and your key employees — and bring you peace of mind that your business, and its legacy, will continue and thrive.