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May 6, 2021 Article 5 min read

Nonqualified deferred compensation plans can offer financial security for key employees, helping ensure your business continues and thrives. Clear goals and planning are critical. Our experts share six things to know when considering a plan and how to fund it.

Businessperson in casual clothes standing by a desk using a laptop computer.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 staff, and additional incentives can help reward key employees for 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 help ensure the business you worked so hard to build continues to thrive. Here are six things you should know when considering a deferred compensation plan:

1. A nonqualified deferred compensation plan isn’t your ordinary succession plan.

A nonqualified deferred compensation plan is often used as a retirement plan alternative, but it can also function as a succession planning tool designed to reward past performance, attract and retain key employees, or supplement other retirement savings.

2. 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 key executives and employees today and to ensure the succession of well-prepared leaders when you exit the business. A plan that keeps key team members in place helps the business you’ve built sustain its operations and success. If you participated in the plan throughout your career, you might also reap financial benefits that impact your family, as well as your retirement, philanthropic, and estate planning goals. Essentially, a nonqualified deferred compensation plan, enables you to create financial security for yourself and your employees, while gaining peace of mind that the business will continue on.

3. Nonqualified deferred compensation plans provide distinct advantages.

A great advantage of using a nonqualified deferred compensation plan as a component of your succession 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 many of 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 that covers key management team members 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 equity, and payouts can be timed to coincide with exit timelines.

4. Unlike the typical retirement plan, a nonqualified deferred compensation plan isn’t required to be formally funded.

Once the plan is established, you need to determine how, or if, you fund the plan. This can be a benefit to a company, particularly in years when cash flow is an issue. Nonetheless, many companies choose to set aside assets to fund all or a portion of the benefits accrued.

5. Several factors should be considered when selecting a funding option.

In some cases, the success of your business can’t be outperformed, and it’s more beneficial to leave assets in the company and earn a higher return. However, it’s also possible that funding the plan is more appropriate, given the business market and conditions at the time. Common funding methods include investing company assets in investment vehicles such as mutual funds, and the using life insurance.

Many factors determine the right decision for your business. When evaluating funding options, we counsel owners to consider the following:

  • 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 your goals and objectives 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 assets needed for the benefit payout. 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.
  • Administration. When establishing a plan, you need to consider the administrative responsibilities and requirements, since some funding options require more involved processes and ongoing attention than others.

6. You should aim to 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.

Final thoughts

To make the most of a nonqualified deferred compensation plan, design your plan 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 those of 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 help you rest assured your business, and its legacy, will continue and thrive.

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