Bankruptcy risk in NQ Deferred Compensation plan just a fact of life?

[Guest Rdubs]

Our Benefits Dept is looking to set up an NQ deferred comp plan that 'mirrors' the investments in the 401k plan.

The biggest concerns raised by eligible employees is the bankruptcy risk (i.e. assets are not protected in that event is my understanding). Is there ANYTHING that can be put in place to offset the bankruptcy risk? Or is this just the basic feature of NQ plans?

[Alf]

It is the ultimate trade-off to avoid tax. There is no legitimate way around it, but a Rabbi trust will get you some security for things other than bankruptcy.

[Guest Rdubs]

Thanks. Our VP keeps saying 'theres got to be some type of insurance or funding feature for these things' but all I see is what you refer to - a rabbi trust for change of control scenarios.

[david rigby]

Insurance? Is this VP saying that there is insurance against bankruptcy?

Funding? Qualified plan!

[mbozek]

The VP should speak to his advisors, e.g. counsel or accountants about why there is no insurance against default of nqdc plans. Under the IRC NQDC is not taxed to the employee as long as the benefits are subject to a subsantial risk of forefeiture, eg, a creditor can take possesson of the plan assets before they are paid to the employee. This is why the benefits are not taxed even if thy are vested. If the employers buys ins to protect the nqdc against default risk the NQDC would be taxed as income because there is no risk of forfeiture. At one time AIG sold an ins. policy to executives to protect them from default risk on their nqdc. But there was catch- only employees of very credit worthy co.(AA) were eligible for the ins since these co were least likely to default. AIG no longer sells this ins. and based on other messages on this board no other ins sells this product. The use of rabbi trusts to avoid creditors claims has been prohibited under the new bankruptcy act. Under current bankruptcy law transfers of corporate assets to executives in anticipation of bankruptcy are considered voidable preferences subject to reversion to the corp.

[Mark Whitelaw]

At the risk of being considered a heretic, this is a mostly a NQDC forum, why not offer something better than NQDC.

Some of the leading COLI/BOLI providers now permit their institutionally priced policy to be owned by the qualifying employee (top 35% by compensation in a white-collar role). Think of this as an employer sponsored after-tax voluntary institutional life insurance program—ILI is designed to maximize cash accumulation. Compared to 401(k) or NQDC the participant has (1) greater immediate emergency value, (2) greater spendable income during retirement and (3) lifelong life insurance protection. Why? Institutional life insurance costs are less than the cost of taxes on 401(k) or NQDC. The participant owns the contract – no creditor issues, no distribution issues, no asset allocation issues, no portability issues, etc. Doesn’t matter if the employee has 30 days or 30 years of future employment—this is a lifelong value. It’s an after-tax participant contribution – no employer costs, no administration, no accruals, no 409A, no Sarbanes-Oxley, no plan documents (sorry guys and gals), etc.

We live in a new era of selective benefits and economic value is driven by the superior longevity of the institutional risk pool, not tax deferral. Anyone believe a middle to upper income individual isn’t deferring into a higher tax rate, especially in NQDC when you get a lump-sum if you don’t stay to retirement? Anyone believe medical advancements won't continue to extend longevity, especially for upper income individuals with the greater ability to pay resulting in lower costs of insurance. Even at today’s tax rates and ILI mortality rates, NQDC doesn’t cut it anymore, especially for older employees. How well is the program received? Over 85% enrollment in a 100% employee paid program of those earning $40,000 or more. Higher if the employer chips in a few bucks. Very simple, very effective and a much better value to the individual with none of the employer hassles. It's also employer structure neutral (C-corp, partnership, S-corp, etc.) That’s why I stopped selling and administering NQDC plans in 2001—it no longer provides the superior value opportunity. That’s why employees in NQDC are cashing out during this “transition year” and converting to this program.

Just something else to think about. Enjoy. Mark

[mbozek]

Without getting into the investment merits of using LI to fund retirement benefits, The bkcy reform act provides for a 2 year look back for transfers to corporate insiders by a bankrupt corp to be considered a fraudlent transfer. The employee would be required to return the amount of the premium applied to the policy.

[Mark Whitelaw]

Yes - Just as they would have to return all paychecks received in the prior two years.

[TCWalker]

There have been and will be a variety of "solutions" out there to avoid creditor risk. These solutions usually present new practical problems or legal risks. Maybe some work, I suspect most don't; qualified plans certainly work assuming you can afford the contributions cost. Life Ins. has a significant market presence, no doubt.

Creditor risk is part of the bargain to defer employer compensation outside 401(a)/501(a); be prepared to weave a tangled web in an attempt to avoid it.

[vebaguru]

A response to Mark Whitelaw's comments:

I don't consider you a heretic; I consider you another insurance peddler.

The entire premium under the approach you describe will be taxed to the employee immediately, making it a fairly expensive benefit. The employee must pay tax on a benefit with funds from his own pocket, or the employer must also bonus the employee enough additional funds to pay the taxes. This is an inefficient delivery system.

Once the premiums and bonus are paid, the employer has no golden handcuffs and no loyalto to the employer.

I dispute that there are no written agreements applicable to such arrangement. Most executive compensation is pursuant to contract, and this must be a part of the agreement.

"No employer costs"? The entire payment is a significant cost to the employer with no real return except for a temporarily happy (if the employer reimburses the taxes) executive.

If the employee purchases it himself with after-tax funds, it is simply an investment that must compete with other investments available. Yes, it is tax sheltered, but so are many other investments. Yes, it includes a death benefit, but does he really need it and is this the best way to purchase it? Wouldn't the executive rather have a tax deduction for needed insurance purchased?

[Mark Whitelaw]

“… another insurance peddler” I can live with that. For 20 years I was “another NQDC plan design and administration geek.”

I agree with many of your comments if we were discussing a SERP vs a Bonus 162 plan, company funded/provided benefits, but we weren’t.

This thread started with (1) the simple accommodation of permitting pre-tax deferral with accounts indexed / “mirroring” the 401(k) and (2) concern over the unsecured creditor risk. While on the surface a simple accommodation, the solution is very complicated and can be very costly for the employer.

Do employers want to go through all those costs and administrative headaches, or should they investigate employer-sponsored alternatives for the participant’s after-tax paycheck? Yes, with the latter we’re now in the world of after-tax, but also talking about a level of contract the individual can’t buy in the retail marketplace. Isn’t one of the advantages of being employed the ability of the employer to utilize its clout to offer opportunities unavailable elsewhere? There is also the broader issue - reexamination of the value of pre-tax deferral and after-tax tax-advantaged.

Do employees want to save pre-tax subject to 409A and be unsecured creditors, or own an asset with 100% control that projects greater immediate value, greater spendable retirement income while also providing modest additional life insurance for their families? Our experience is they prefer the latter.

Employers adopting this solution like it because it requires them to do “virtually” nothing—only coordinating the after-tax payroll deduction.

Will this program replace NQDC? Of course not. But it is a viable alternative where NQDC does not fit and for employees concerned about having all their eggs in the pre-tax basket and want employer sponsored diversity. And just as 401(k) pushed the growth of NQDC, the Roth option to 401(k) will push the need for after-tax tax-advantaged employer-sponsored programs. Presently the adaptation of institutional life insurance from an employer-owned asset designed to improve the balance sheet while providing cost recovery, to an employee-owned asset designed to improve the personal financial statement while providing an additional legacy benefit, seems to be the leading alternative.

Our enrollment experience with this program is much higher than NQ elective deferral. My guess is the participants like it better, but that’s just a peddlers’ perspective.

[Locust]

Mark W - I think you're saying that the benefit of the COLI owned by the employee vs. regular life insurance is that the COLI is cheaper.

Why is COLI cheaper than regular life insurance?

What kind of percentage discount does COLI get over regular life insurance?

[Mark Whitelaw]

COLI is cheaper than retail life insurance, cheaper than capital gains rates on taxable investments, cheaper than ordinary income taxes on tax deferred vehicles. And the longer we live, the cheaper it will be. My money is on the physicians, not the politicians.

Why it’s cheaper is simple. The institutional risk pool is an upper income white-collar pool—the best risk group--those that live the longest and can best afford healthcare. One carrier told me last year that their institutional pool was running 23% better than their retail products pool. That’s one of the reasons why they can issue coverage guarantee issue through age 70 – no medical questions or exams – at rates better than retail.

How much cheaper is dependent upon age, smoker, etc. COLI is guaranteed issue through age 70, so the comparative varies depending upon which of the plethora of retail rates you are comparing against. A retail policy at select preferred nonsmoker, the best retail rate, may catch-up in value to a COLI policy when someone is in their late 70’s, early 80’s. Preferred nonsmoker and lesser classes will never catch up. The difference for smokers is more dramatic—not nearly the rate hit you take in a retail policy. In both situations you can take what someone is paying for retail term insurance and create equity.

While comparing rates helps understand the pricing difference, the purchase is different. Retail insurance is death benefit driven – I need $500,000 of death benefit to protect my family, what’s the cash value? Typically 20% - 30% of premium. COLI is contribution driven – I want to save $10,000 a year to age 65, what’s the death benefit? The amount of death benefit is the minimum that will accommodate the contribution. That may be $250,000 for a 50 year old, $800,000 for a 30 year old. The objective is to maximize cash value. COLI doesn’t have surrender charges so assuming an 8% fund rate of return, cash surrender values in year 1 of 106% to 107% is typical.

COLI is designed for life, not death. The longer we live the greater the tax advantages of life insurance and the low rates of the insitutional pool work to our advantage.

The program works whether the qualifying employee has 30 years or 30 days future employment—it’s a lifelong Appreciation Benefit—an employer using its purchasing influence to give qualifying employees access to a level of coverage they can’t get in the retail marketplace. Its a great compliment for someone about to retire and is taking a 10 year payout from a NQDC plan--10 year payout and 20-26 year life expectancy. Other than being a conduit and coordinating payroll deduction, the employer’s out of it. The only thing simpler is doing nothing.

[TCWalker]

nice post

[Kirk Maldonado]

Mark Whitelaw:

I second TC Walker's comment. Your post was very informative.

But I have a question for you. What do you mean by institutional risk pool? Is it the senior executives of a large corporation that would be insured by the COLI product?

[Mark Whitelaw]

The handful of carriers that offer institutional products run a separate risk pool, separate from retail products or group products. The product/pool is restricted to employees in the top 35% by income in white-collar roles. These are individuals with health insurance, low-risk jobs and the incomes to pay for any treatments. They also tend to be more fit, play sports, health clubs, etc. One carrier advised me their risk experience was running 23% better than their retail product pool.

In NQDC executive benefit plans these are the high-end COLI/BOLI products the company buys in their rabbi trust. But in an individually owned alternative, remove from your vocabulary "executives". This is not an "executive" benefit, but a program for the top 35%--"qualifying employees". We have employees making $40,000 as well as seven figures--contributing $100 a month and five figures a month. There are design alternatives for elective deferral, SERP and GTCO that generate much greater value for the same dollars than the plans of the past and none of the employer administrative hassle. The administrative hassle is transferred to the corporate specialty broker.

Kirk, you used the term "large corporation". This program is available to almost any size company--3 lives and $100,000 of contribution minimum. At 10-15 lives you have guarantee issue - no medical questions or exams.

NQDC was a program for top management--this is a voluntary alternative recognizing a broader group that have earned their entrance to a pool because of their career and life choices. No different than those that choose to be non-smokers. A simple employer sponsored program with extraordinary value.

[Guest Harry O]

"COLI is . . . cheaper than capital gains rates on taxable investments."

If COLI is such a great investment, publicly traded corps have a duty to their shareholders to sell all of their operating assets and invest the proceeds in COLI. COLI should be analyzed just like any other investment and when it beats investing in your own business, you should shut down your business. My inclination has been to not prefund NQDC and use the funds to invest in the business where I presumably generate a greater return for my shareholders. Better yet, don't even offer deferred comp at all since it is a very expensive form of corporate borrowing -- what idiot would freely borrow money and pay an equity rate of "interest" (e.g., "mirror" 401(k) plan returns)?

[Kirk Maldonado]

Mark Whitelaw:

Thanks again for your informative post.

You are providing a lot of useful information that I don't hear in the pitches that are being made to my clients. That is appropriate because the audience on the Message Board is more technically oriented than the general business community.

Also, I want to compliment you on tailoring your approach to your audience. Unfortunately, many in your industry (meaning those involved in executive benefit arrangements funded through life insurance) have one script that they use, regardless of who they are making the pitch to.

To say the very least, I am very turned off when I have someone start off their presentation to me by explaining tax principles on a very basic level. That person has proven to me that they are not terribly bright and that fact alone will kill the deal. I don't want to get my clients involved with a service provider who is that dense.

I've seen people make that same mistake in giving presentations to good-sized audiences of sophisticated employee benefits professionals.

By way of contrast, taking an approach like you are doing here, by focusing on facts and providing important information that we probably won't otherwise hear, is very effective. You are acting more like someone who is sharing specialized information with other benefits professionals, rather than being a sales person with a a hard-core pitch, which would not go over well on the Message Boards.

To analogize it to a car dealership, it is the difference between the way the sales people treat you at a Mercedes or BMW dealership v. the way the sales people treat you at a Ford or Chevy dealership. It is a completely different experience.

I sincerely hope that you keep posting messages on these boards.

[Mark Whitelaw]

I appreciate your compliment.

For over 20 years my partner and I have lived in on the institutional/selective benefits support side of the insurance business—mine as the technical voice in the decision process, his crafting the marketing/benefits communication messages. Where others would get a CEO interested in a NQ concept, our role was dealing with the CFO, VPHR and their advisors. Our standards have had to be high because we dealt with very informed clients and their advisors who buy life insurance on reason rather than emotion and seldom let themselves be sold. It becomes a consultative process and if the agent doesn’t sit on the clients’ side of the table, he gets nowhere.

The corporate specialty side of the business, those of us that only deal with institutional products and corporate benefits, is a very, very small club. I know exactly of what you speak—retail agents wandering outside their area of expertise and bringing an emotional retail pitch to a corporate finance decision-making process. Or, using words like “impartial” but not exploring with you the mutiple other ways to design and informally fund a compensation/benefits objective.

Sophisticated buyers and advisors want to see inside the engine and compare what it can do with what they know of other engine designs. Institutional life insurance (ILI) is one of multiple funding alternatives and has earned respect as a corporate finance tool, and transforming it for personal ownership doesn’t change the engine. The primary component of that engine for personal finance is the low-load design and cost advantage of the institutional risk pool resulting in the ability to better manage retirement security and risk management goals.

Having said all that, we have seen a distinctly emotional side to the decision in this personal application of ILI. Participants gain a greater sense of self-sufficiency and control over their retirement planning, while their employers get relief from the unreasonable responsibility put upon them to administer and guarantee retirement security. And aside from the economics, those aren’t bad reasons to explore this new era in benefits either.

I look forward to contributing to the Message Board as appropriate.