Deferred compensation: the pros and cons

Today 93% of public companies offer some sort of nonqualified deferred compensation plan (NQDC) and nearly half (44%) of eligible employees participate.^{Disclosure 1}  For a great many highly compensated executives, NQDCs will serve as a major source of retirement income. In fact, a 2018 study found that more than one in five NQDC participants expect their deferred compensation plan savings to provide more than 25% of their income throughout retirement.^{Disclosure 2}

In light of the marginal tax rates associated with the Tax Cuts and Jobs Act, however, the benefit of NQDC plan participation may not be quite as compelling as it once was—particularly for plans that don’t offer any company match provision.

The question you need to consider is whether it’s smart to be deferring compensation today with the promise of it being paid out to you 10 or 20 years down the road, when the top marginal income tax rates may potentially be much higher? Keep in mind that for many wealthy senior executives, the notion of dropping down into a lower tax bracket in retirement is a myth.

In order to more confidently make that determination, you need to take a closer look at the fundamental pros and cons of NQDC plan participation.

The Pros

For most highly compensated executives, the primary value of an NQDC plan is its ability to offer a much-needed additional opportunity to save for retirement. But there are also other benefits to consider, including:

✓  No contribution limits: If you earn a substantial income and you want to be able to save significantly more than your 401(k) limit, NQDCs offer that opportunity. Some participants opt to defer half or even their entire annual bonus.

✓  Retirement income bridge opportunity: An NQDC can be used to generate income during the early years of your retirement, allowing you to delay Social Security benefits and affording tax-deferred 401(k) assets an opportunity to continue growing until you reach age 72--when mandatory required minimum distributions must begin.

✓  Flexible payout options: Depending on the plan design, you can typically choose either a lump sum distribution or opt to take withdrawals over a period of 5-10 years. This offers far greater flexibility than 401(k) or IRA accounts, which require withdrawals to begin at age 72 and impose penalties on any funds withdrawals prior to age 59½.

✓  Current income tax mitigation: Depending on your personal spending habits, moving into a lower tax bracket in retirement is a possibility—even for higher earners. Deferring income to your post-work years may therefore offer some tax efficiencies.

The Cons

The rules governing when and how you may access the compensation you have deferred are unique to each specific NQDC plan. Some plans may permit short-term deferrals while others mandate that funds can’t be accessed until retirement. A plan may not allow assets to be rolled over or distributed if you change employers, or impose other “golden handcuffs.” Other potential participation concerns include:

✗  Reduced protections/greater risk: When you participate in an NQDC plan, you essentially become a creditor of the company. If the firm should ever become insolvent and declare bankruptcy, you could potentially lose part or all of your investment. Therefore, choosing a longer-term payout option (e.g., over a 10-year period) means you’ll be taking on an additional 10 years of credit risk to gain additional tax deferral. While you may be comfortable with deferring income now and putting it into the plan because you know exactly what's going on with the company, what happens when you retire and have a decade of exposure without knowledge as to how the firm is being run?

✗  Lack of investment diversification: As a senior executive, there’s a strong likelihood you may already be too heavily weighted in your own employer’s stock. If things go badly for the company and your NQDC assets are in jeopardy, you will already have experienced a significant loss of value in your company stock holdings. Essentially, it serves as a double-hit on your retirement savings.

✗  Unexpected payout acceleration: Even if you choose a flexible payout option over time, the company may have a right to accelerate your payout, should you unexpectedly leave. This means you could suddenly receive a large sum of money when you’re not expecting it, resulting in significant tax implications (especially if it’s in tandem with a severance package) and additional retirement income planning complications.

While high-income earners typically have a far greater opportunity to retire early if they choose to, it’s important to keep in mind that spending tends to be significantly higher during the first 5-10 years of retirement compared to later year expenses.

For someone retiring at age 62, a deferred compensation program can be an invaluable resource for filling the 10-year gap until qualified plan required minimum distributions kick in. It provides an opportunity for you to take your time in determining your future retirement income and liquidity strategies, while serving as a replacement for the monthly compensation you’ve grown accustomed to as your principal liquidity source.

No matter how much money is on your balance sheet, determining which assets to draw down and in what sequence to tax-efficiently access them can be a complex undertaking. An NQDC plan affords you time to thoughtfully make those determinations and plan out your financial future.