Requirements of Nonqualified Deferred Compensation

Cash value life insurance is an attractive vehicle for financing an employer’s obligations under a nonqualified deferred compensation plan. There are essentially six steps necessary to implement a nonqualified deferred compensation plan financed by a company-owned life insurance policy.

  1. The employer adopts a corporate resolution authorizing an agreement between the corporation and the employee (or independent contractor) to be covered, promising to make specified benefit payments upon the occurrence of certain triggering events, (e.g., retirement, death and, in some cases, disability) in return for the continuing services of the employee. The resolution usually will note the importance of the employee to the firm and the recruitment, retention, retirement, or reward benefits to be gained by implementing the plan.
  2. A second and separate corporate resolution is adopted, authorizing the purchase of life insurance to indemnify the employer for the significant expenses it is likely to incur and the loss it is likely to realize at the death before retirement of the covered employee (or independent contractor).
  3. The appropriate amount of life insurance is purchased by and made payable to the employer. The employer is the owner, and no interest in the policy is given to the employee. The policy remains on the employer’s books as a corporate asset, subject to the claims of the employer’s creditors.
  4. The employer’s attorney drafts a nonqualified deferred compensation agreement, to be signed by an authorized officer of the employer and the covered employee. The plan should not mention how the employer will meet its obligations. In particular, when life insurance is used, the plan should contain no reference to or incorporation of the life insurance.
  5. A rabbi trust may also be established to hold the life insurance.

ERISA Requirements

ERISA’s requirements can be quite burdensome.6 However, a properly designed unfunded top hat nonqualified deferred compensation plan can escape all or most of the requirements applicable to qualified plans.

  • A plan is considered unfunded as long as the contributions are not held in trust for the exclusive benefit of paying out benefits, as is the case for qualified plans. The assets that are accumulated must be subject to the claims of the business’ creditors. This does not prevent the employer from informally accumulating assets for the purpose of paying benefits, such as purchasing mutual funds, corporate owned life insurance, or any other accumulation vehicle, as long as such assets are subject to the claims of the business’ creditors.
  • A top hat plan is a plan that is limited to a select group of management or highly compensated employees. There is no clear definition of management, select group, or highly compensated. As a general rule of thumb, a plan should limit participation to a small group of highly paid executives, relative to the employee population—not to exceed 10 to 15 percent of the employees of an organization. To qualify as highly compensated, their compensation should also be in the top 10 to 15 percent of overall employee compensation. In addition, a participant should have definitive management responsibilities and duties to be considered as management.

For example, an unfunded excess benefit plan is freed from satisfying all of ERISA’s reporting, disclosure, participation, vesting, funding, fiduciary responsibility, administrative enforcement and plan termination insurance requirements.7 Also, if a plan is an unfunded top hat plan, it will be exempt from ERISA’s participation, vesting, funding, fiduciary responsibility, and plan termination insurance requirements.8 However, such a plan will be subject to streamlined reporting and disclosure requirements, recordkeeping requirements and at least some of ERISA’s administration and enforcement requirements (including the requirement that a claims procedure be established).

The streamlined reporting and disclosure rules require that a short statement be filed with the Secretary of Labor. A one-page ERISA notice should be completed and filed with the Department of Labor. The statement must include:

  • the name and address of the employer
  • the employer’s tax identification number
  • a declaration that the employer maintains a plan (or plans) primarily for the purposes of providing deferred compensation to a select group of management or highly compensated employees
  • a statement of the number of such plans maintained and the number of employees participating in each such plan.

The streamlined reporting and disclosure rules also require that plan documents be provided to the Secretary of Labor upon request.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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