Retaining Discretion Over Early Retirement Benefits

[401 Chaos]

Would appreciate thoughts on 409A legality of the following. Company has established deferred comp plan that is intended to operate as a true defined benefit type supplemental retirement plan. Benefits equate to payment of a percentage of final compensation for a period of 10 years following separation from service. There are no elective deferrals, etc. under the plan. Document has always provided that benefits will basically only be paid if employee remains continuously employed with employer through age 65. (There are benefits in the case of in-service death or disability prior to age 65.) Notwithstanding the age 65 retirement date requirement, however, the plan provides that if a participant "retires" between ages 60 and 65 the Company may, in its sole discretion, provide the participant a reduced benefit. The plan then goes on to spell out the reduced benefits that will be provided upon early retirement (i.e., basically reduced percentage of final year's compensation compared to the larger percentage paid for retirement at or after 65). The time and form of early retirement payments (if approved) by the company are the same as for regular retirement. Company owners generally anticipate honoring early retirement provisions if situations arise but very much which to retain ability to decide that on a case by case basis.

Question is whether it is possible to be 409A compliant and retain company's sole discretion to pay out upon early retirement. My initial thought was that such discretion could raise concerns over having established a fixed time and form of payment under the arrangement; however, it seems to me that arguably should not be the result. In this case, a participant separating prior to age 65 should have no legally binding right to any benefits unless and until the company has decided that the individual should receive some early retirement benefit. In essence, it is as if the company simply provides a brand new benefit upon the early retiree and so long as the terms of the benefit are fixed in a 409A compliant way at the time the company chooses to bestow such a benefit, the fact that the company exercised discretion should not be a problem.

Seems like this is a fairly typical arrangement for deferred comp purposes but I have not previously had to address. All thoughts appreciated.

[J Simmons]

Does the ER only make its decision after the EE has in fact retired early (<65)?

[401 Chaos]

Yes, that is the intent and how the plan is currently drafted.

Of course, it seems very possible (likely) to me that an employee would broach the subject (and the company might be inclined to give an answer) in advance of actual separation. We have not had anybody leave early so the issue has not come up but that sort of scenario where the employee knows whether or not they will get the benefit before leaving is part of the concern. I'm not really sure how to guard against that sort of thing happening in practice though. Another somewhat related aspect that gives me pause is the fact that the employer is likely to approve such early retirement benefits in most if not all situations--no guarantees of course--but it would not surprise me if everyone seeking early retirement benefits did not receive them. I wonder if that sort of pattern (if it did develop) might doom the discretionary approach as well. Thanks.

[J Simmons]

It seems to me that short of a pattern, if it happens with even just one EE that the early retirement deal is cut before employment ends, you have a de facto acceleration contrary to 409A. Discretion re timing are the red death under 409A.

[401 Chaos]

Thanks John. I do not really disagree and certainly think it pays to take the conservative approach on these things. Just trying to figure out where to draw the line and not be unreasonably conservative on some of these points. It does seem to me that you might have some reasonable argument though that the early retirement benefits are a new benefit and the fact that the employee and employer strike a deal for such benefits at some point prior to age 65 should arguably not be construed an acceleration of the regular benefits.

Contrast that to situation where the company decides to go with a strict age 65 requirement and not provide for nondiscretionary early retirement benefits in the revised 409A agreement. In other words, the revised agreement simply says the employee must work until age 65 to get anything and there is no mention of any possible early retirement benefits at all. A few years go by and there is a very sympathetic early retirement situation. Employer decides to provide some supplemental retirement benefits that just happen to mirror the reduced percentage of regular retirement benefits that were provided for early retirement benefits provided under the prior-409A plan. Is everybody 409A safe there since this is a whole new benefit to which there was no legal right and no hint of in the existing agreement? 409A should not prohibit parties from striking new deals for new benefits at any time so long as those new benefits are structured to comply with 409A.

[J Simmons]

Your contrasting situation certainly sits much better in the 409A framework. If the ER so decides after the EE has terminated and thus forfeited any legal right or claim to the age 65 benefit, then the argument of a de facto acceleration fades. While the benefits "just happen to mirror the reduced percentage of regular retirement benefits that were provided for early retirement benefits provided under the prior-409A plan" does provide some nexus between the age 65 benefit and the new benefit, I think the real key is no decision before the EE actually terminated, forfeiting the age 65 benefit. However, that nexus might give rise to suspicions and that might put the ER in the awkward position of proving a negative: there was no decision/side agreement before the EE actually terminated, forfeiting the age 65 benefit.

[401 Chaos]

Not to belabor this too much but wonder if there is any possible argument or way to creatively draft so that you could argue that change in benefit amount (if any) paid upon early retirement arises from a change in the vesting schedule applicable to plan benefits. In that case, the company's exercise of discretion, if any, following early retirement would arguably only work to accelerate the vesting percentage and would not change the time and form of benefit payments. So, the benefits (i.e., certain percentage of annual comp at separation) would always be paid for a fixed period of time commencing upon separation from service. For an extreme example, vested percentage for somebody terminating at ages 61, 62, 63, or 64 would be 0% whereas vested percentage for termination after age 65 would be 30%. In all cases, benefits (if any) would be paid in a series of equal monthly installments for a fixed period commencing with the month following separation from service.

If employer excercised discretion to accelerate vesting, could you argue that 409A should not care since discretion is only a vesting change that determies amount of benefits and not time or form of payment? (Of course, i realize here it's all or nothing so there is a big difference in the amount . . .)

[J Simmons]

It looks to me like the substance of the transaction would yet be retained discretion over timing of payment, just as to a different amount rather than all of the deferred compensation.

If the decision to pay an amount equal to what the employee has forfeited due to early retirement is made only after the early retirement and the forfeiture has occurred, and the employer is at the time of so deciding under no legal compunction to pay any part of the deferred compensation, then I think the employer's deciding to make a payment would be a 'new' benefit.

[Guest steverino]

Isn't there a legally binding right for anyone eligible for the plan even if they have not vested yet? If so, wouldn't there be a 409A violation if vesting and payment were permitted earlier? What about a long term incentive plan that provides for payment over three years but permits discretionary acceleration for a termination without cause. Does exercise of that discetion constituite a 409A violation? I certainly think the IRS could take that view.

[401 Chaos]

Steverino,

Thanks, I think that's a good question and points up some of the issues involved. I guess I would argue in our case that there really may not have been a legally binding right to benefits prior to age 65 since it was completely discretionary and in the control of the company whether or not to make an exception in the case of an early retirement. As J Simmons noted, however, I think the actual facts could color that a good bit depending on what the employer did. Seems as if the final 409A regulations talk about an example of an employer establishing a discretionary bonus for the upcoming year but retaining discretion as to who may get that bonus and in what amount. In that case, I think they basically said there was no legally binding right to the bonus before specific person / amount was named. Also, they seem to carve out from legally binding right those rights which are subject to unilateral reduction or elimination by the service recipient. This isn't exactly the same situation they envision but I think you might could make an argument that there was no legally binding right--i.e., that basically the employer just said that it retained the power to do some different if and when they elected to do that but didn't promise anything. Certainly I don't think an early retiree likely could prevail in court based solely on the language in the plan if they did not receive a reduced benefit. Not sure it is a winning argument but I do think one could be made.

FWIW, the employer in this case ultimately decided to revise the plan to remove the early retirement reference. That was not popular with the employees as most felt that they really did have an expectation (if not a clear legal right) to early benefits which is, of course, the very reason for the concern.