Employee Benefits & ERISA Legal Update - How to Battle the Great Resignation with Deferred Compensation Plans

This article is co-authored by Emily Langdon, Partner at Fraser Stryker PC LLO, and Jacob Bosacki, Senior Consultant at Mullin Barens Sanford Financial.

Executive Summary

This article explores how a company can use a deferred compensation plan (“DCP”) as a tool to overcome the executive recruitment and retention challenges produced by “The Great Resignation”. For more information, readers may connect with the authors directly.

What is the Great Resignation?

During April 2021, amid the COVID-19 pandemic, the number of employees who quit their jobs in just one month broke a previously unsurpassed record in the United States. Economists call this “The Great Resignation.”  April was only the beginning of this so-called “Great Resignation”. In July, even more employees quit. Yet again, the number of “quits” – the term coined by the Bureau of Labor Statistics – reached new record highs in August and again in November, and there is no expectation of a reversal in the near term. In fact, “[n]early a quarter of workers plan a job change or retirement in the next 12–18 months, and 81% of plan sponsors are concerned about increased competition for talent.”[1]

With a tightening labor market, employers are feeling the squeeze at all aptitude levels, especially in their battle to retain executive leadership and attract new executives. The question employers are left with is how to combat a workforce terminating voluntarily – with a tight labor-market, with supply-chain issues, and with a pandemic? An immediate tool: provide a DCP specifically designed to overcome recruitment and retention challenges. What is a DCP?

What is a Deferred Compensation Plan (DCP)?

In this context, a DCP is an agreement between or among an employer and one or more employees that permits an employee to delay receipt of compensation to a later year (e.g., short-term [2-10 years] or long-term [retirement]). The plan also permits the employer to make discretionary contributions to an employee’s account and dictate vesting requirements for these contributions (e.g., recruitment bonus with three-year cliff vesting). There are no statutory limitations on the amount a participant can defer, or an employer can contribute.[2] Participants are typically given the ability to direct which investments their deferrals or vested employer contributions track. The investment menu is created by the employer. Typically, a recordkeeper tracks and credits participant investment returns to their respective accounts daily.

Like qualified plans, DCPs are primarily used because of the tax preference received through the Internal Revenue Code (“Code”). Under a properly structured plan, employer contributions and employee deferrals are made tax-deferred.[3] Tax is also deferred on investment yield and investment reallocation[4] – resulting in a tax-preferred investment environment. Income tax is typically recognized when distributions are received by the participant.[5]

Permissible distributions from DCPs generally occur at separation from service, a specified date (including in-service), as a result of a change in control, the death or disability of a participant, or in the event of an unforeseeable emergency.[6] These distributions can be made as a lump sum or can be scheduled to occur as installments spanning several years.[7] There are no required minimum distributions or penalty for receiving distributions before age 59½.[8]

Rules governing DCPs require discrimination in favor of a select group of management or highly compensated employees.[9] As long as the plan is “a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees”, the plan is exempt from ERISA’s minimum participation and vesting rules, its funding rules, and its fiduciary responsibility rules (including the trust requirement).[10]

DCPs are a mechanism employers use to strategically meet compensation and benefits issues faced by their more highly compensated employee pool. These plans can and should be designed to meet the challenges created by changing economic and social issues. For example, “The Great Resignation” has created issues for employers seeking to recruit or retain top-level talent – and a properly designed DCP can meet these challenges regardless of how fluid the challenges are.

Can DCPs be designed to meet challenges posed by the “Great Resignation”?

  1. The plan should permit custom recruiting bonuses to be contributed to an employee’s DCP account. Custom, time-based vesting schedules could also be permitted to be tied to such bonuses. Using this feature, an employer can make tax-deferred recruiting bonuses as needed to attract select talent. A new employee sees the immediate – albeit, unvested – account balance allowing the employer to show the new employee immediate value with no current cash outlay from the employer. The custom vesting schedule provides the employer the latitude to determine its retention needs relating to each newly recruited key employee.
  2. The plan should permit custom retention contributions to be made to an employee’s DCP account. Again, custom, time-based vesting schedules should be permitted and tied to these contributions. Using this feature, an employer can make discretionary retention contributions as needed to retain select talent. Like recruiting or sign-on bonuses, an employee would see the tax-deferred value of this employer contribution in their DCP account without any required current cash outlay from the employer.
  3. The plan should permit an employee to defer their current compensation (salary, bonus, etc.). Permitting deferrals of compensation allows the employee to offset “separation from service distributions” the employee may have received as a result of leaving the previous employer to join the new company. A “separation from service distribution” comes from the previous employer’s DCP and are taxed as ordinary income to the employee. Permitting deferral of new compensation allows the newly recruited employee to neutralize the “separation from service distribution” income tax increase by deferring a like amount into the new employer’s plan. Without a DCP, the new employee’s ability to manage income and tax will be limited to whatever nominal qualified plan deferrals are available to the employee – this can be significantly less deferral capacity than what is needed. To be effective, a new highly compensated employee should be immediately eligible to defer his or her compensation.
  4. The plan should permit special contributions to be made to an employee’s account. Special contributions can be used to offset unvested benefits the employee lost as a result of leaving the previous employer to join the new employer. Lost benefits can range from lost DCP account balances or non-account balance benefits, equity compensation, qualified plan benefits, and so on. Permitting special contributions provides the recruiting employer a flexible mechanism with which it can restore the benefits an employee may lose as a result of joining the new company, thereby allowing the recruiting employer to overcome recruiting hurdle rates created by unvested benefits. The new employee sees the restored benefit immediately and individualized vesting can be tied to company objectives. Having a plan with this one-off flexibility can be key for the recruitment of highly talented employees.

How can DCPs create value beyond meeting the challenges of the “Great Resignation”?

Pre-tax retirement savings capacity is a critical component of the American retirement system. Without pre-tax deferral capacity, a key employee’s ability to accumulate assets for retirement is significantly damaged. The most common pre-tax savings plan in America is the 401(k) plan. A 401(k) plan exists to provide most employees with tax incentives to save for their own retirement. Unfortunately, the amount of compensation deferrable under a 401(k) plan is extremely limited by Code section 402(g) – $20,500 in 2022. The deferral limit is often further reduced for highly compensated employees when the ADP and ACP nondiscrimination tests are applied.

Layering a basic DCP into a highly compensated employee’s benefits may fully restore the deferral capacity the employee may have lost by virtue of being a key employee. Generally, a DCP is the only plan that provides high earners the ability to invest compensation in an unlimited amount on a tax-deferred basis. For that reason, DCPs are commonly used as a foundation of executive retirement programs, and when used as such, are an extremely powerful accumulation tool.

There is limited ability for highly compensated employees to provide themselves with a meaningful tax-deferred retirement investment platform outside of an employer-sponsored DCP. Non-highly compensated employees can defer a large percentage of their compensation under a 401(k) plan and have additional options outside of an employer-sponsored plan – such as using an IRA to make pre-tax or tax-deferred contributions. Not providing a basic DCP to highly compensated employees put those employees and the employer at an unnecessary disadvantage.

Final Thoughts

While it is clear that the American workforce is in a state of tremendous transition, it is also very clear that a primary factor driving those changes is that individuals do want to work for employers who can meet their needs. A company deploying strategic benefits packages is more capable of meeting the needs of individual executive employees.

The process of designing or assessing a DCP begins with the assistance of an experienced DCP consultant. By combining the skill of a DCP expert with the knowledge of an ERISA attorney, a plan sponsor can collaborate with an experienced team to successfully establish or amend a DCP to meet its corporate goals and needs – both short-term and long-term. Readers may reach out to the authors if interested in implementing a DCP or to request the review of a current plan.

Authors:

Emily R. Langdon, J.D.

elangdon@fraserstryker.com | (402) 978-5386

Emily focuses her practice on employee benefi­ts and ERISA. As part of this practice, Emily assists her clients with matters related to health and welfare benefi­ts, executive compensation, pension, and retirement plans, wellness plans, and life insurance law. Emily also has signi­ficant experience in the areas of health care law, corporate transactions, business formation and advising, and employment law, all of which compliment her bene­fits work.

Jacob Bosacki, JD, FSRI

jacob.bosacki@mbsfin.com | (920) 819-4365

Jacob has been a trusted partner to advisors and clients for many years. He has built his career on the pillars of integrity, dedication, and unbiased consultation. He has significant experience working with corporate clients on their executive benefit programs and corporate insurance solutions.

[1] Survey results show workers looking at changes, less confident in economy. Principal Financial Group. November 9, 2021.

[2] IRC Section 409A.

[3] Id.

[4] 26 CFR § 31.3121(v)(2)-1.

[5] Id.

[6] 26 USC Section 409A(a)(2)(A).

[7] See, e.g., 26 CFR Section 1.409A-3(b).

[8] 26 USC Section 72(t)(2)(A)(i).

[9] Sections 201, 301(a)(3), and 401(a)(1) of ERISA.

[10] Id.

This article has been prepared for general information purposes and (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal advice from a qualified attorney. Always seek professional counsel prior to taking action.