Creative Solutions for HCEs

[ldr]

Good afternoon to all,

We have a prospect that has about 1800 employees, mostly in lower paid jobs, in the service industry (think restaurants as an example).  Of the 1800, only 600 would be eligible if we use 1 year of service, dual entry, age 21.  There are 12 HCE employees.  All these employees are spread out over several corporations, but they are all owned by one man, so it's a controlled group.

They have been presented a standard 401(k) plan with a safe harbor match to cover everyone and have rejected it.  What they say they want is a deferral-only 401(k) plan for the NHCEs and a separate "carve out" plan (their terminology, not mine) that benefits only the HCEs for which the company would be willing to provide a match.

We are somewhat aware of the existence of Non Qualified Deferred Compensation plans but our understanding of them is that they have so many drawbacks that they are not very popular anymore.  We don't really think that the 12 HCEs will appreciate their contributions being a general asset of the employer, being subject to taxation if they leave and take the funds, etc.  We understand that the contributions could be put into a Rabbi trust, but even then, they are still subject to the claims of creditors if the company experiences bankruptcy.  All that makes this look like a doubtful solution.

Are we missing some cutting edge, new plan design possibilities within the world of qualified plans?  How have you addressed such requests, if you can share?

As always, your comments and experiences are much appreciated.

[XTitan]

NQ plans not very popular?  Ok, I'm a little biased.  Maybe a lot.  NQ surveys I've seen say 80%-95% of respondents have NQ plans at their companies so one could say they are as popular as they've ever been; they haven't been legislated out of existence (yet).  It's true NQ plans have risks not found in qualified plans.  It's true the plans are unfunded and subject to a nonpayment risk.  It's also true that plans can be designed to provide deferral opportunities for the select group with creative match and vesting provisions.  But it does require expertise to design, implement and record keep. 

Based on the numbers of HCE, NHCE, and ineligibles, I'm guessing that if a 401(k) plan were implemented that the safe harbor contribution would be too expensive, but without it, the HCEs will be severely limited in their contributions.  If this is right, then a NQ plan can address the retirement needs for the HCEs.  But I'd prefer to see how the right qualified plan can address this first.

[jpod]

I agree that they are popular, but all of the risks which ldr outlined do often scare people away from contributing their own money to a NQ plan, and rightly so in my opinion.  Then again, the more generous the match, the more enticing it becomes and could convert someone from being risk-adverse to a risk-taker.  For example, if it's $.25 on the $1.00 subject to a vesting requirement, not so generous; but $1.00 on the $1.00 without a vesting requirement, maybe so.  Also, note that just because someone is an NHCE doesn't mean necessarily that he/she is a member of the requisite "top hat" group.     

[ldr]

Hi XTitan and jpod,

Thank you both for your observations.  I shouldn't have said that NQ plans are not popular without checking further.  We were just told this on the phone by an ERISA attorney who said he hasn't had to write a document for one in years and that they had fallen out of favor.  That's just one person's perspective and we should have looked further.

XTitan, can you explain more about what you mean when you say that you would prefer to see the right qualified plan address this first?  To our knowledge, what we have here is an employer who wants to offer everyone except the select group of 12 HCE employees a deferral-only plan (which will largely go unused but whatever).  The employer apparently wants to be able to say that he has a 401(k) plan when hiring people but doesn't want to make any employer contributions to it.  Then for the 12 HCE employees, he wants a separate plan, to which he will make a match of some sort but we don't yet know how much that will be.

jpod, I like your idea about a match so rich that the 12 HCEs could overlook the hazards of a NQ plan.

If you have a suggestion as to how to accomplish what they want using only qualified plans, we'd appreciate more details.

Thank you both in advance.

[Mr Bagwell]

ldr,

From a Qualified plan perspective,  IMO, the Safe Harbor Match is the only viable option that would even motivate me to want to have this plan.  (To each his own, I'm not judging)   A non safe harbor plan for the HCEs will be a disaster because the NHCE numbers will kill the potential for any substantial HCE deferrals.  So you would have HCEs not getting to defer much, and the NHCEs aren't deferring much.  Add on top of that 1800 employees to track for census. 

Any chance the one owner will defer to the plan?  I would hate for the plan to somehow go Top Heavy.

[jpod]

Also, some employers in your situation would consider implementing a 3% SH non-elective in conjunction with a 3% hourly wage rate reduction, or foregoing one year's worth of hourly wage increase, depending upon how easily that can be "sold" to the employees and/or it's impact on retention and hiring. 

[ldr]

Hi Mr. Bagwell,

We presented the Safe Harbor match plan to them and really tried our best to sell that idea.  My guess is that they perceive it as potentially being too expensive if enough people participate.  We really don't like the idea of a deferral-only plan even for the NHCE group without the HCEs because only a very few people will use it and as you say, we still have to process all those people for census purposes.  It seems like such a waste of resources.

We are not considering putting in a plan like you described, a non-Safe Harbor covering everybody.  For all the reasons you cited, that will not work.

My guess is that they are talking to multiple TPAs and someone else has suggested what they are now requesting, which appears to be the deferral plan for all but the HCEs and the NQ plan for the HCEs.

Our shop is small and we do not try to do all things for all people.  We don't do ESOPs for example, preferring to defer to the ESOP gurus on that.  We haven't been doing NQ plans but we are wondering if perhaps we should.  Meanwhile we are asking questions and researching the subject.

What I initially was asking was whether there is some new technique for manipulating qualified plans to produce the desired effect.  I don't see how that could possibly work with only using qualified plans.  However after doing more research and reading the responses here, I am inclined to think that the combination of the deferral-only plan for the NHCEs and the NQ plan for the HCEs could get the job done if they are amenable to all the drawbacks of the NQ plan and if we decide we want to jump into this arena.

Thanks!

[XTitan]

I actually didn't think there was a good alternative to SH, but I recognize I don't know what I don't know.  I'm not surprised an ERISA attorney would push back.  There is a lot of nuance to the NQ regs that specialists can understand, but it might be tough to fathom for an ERISA attorney who focuses only on qualified plans.

[ldr]

jpod, thank for the 3% ideas.  I doubt that the employees could afford a 3% pay cut, and I also doubt that the employer was planning a 3% pay raise for next year, but it certainly won't hurt to at least ask!

[C. B. Zeller]

Since the employees are spread out among different corporations, it might be possible, if they meet the other requirements, to disaggregate some of those corporations as a QSLOB. You would still have to include some of the NHCEs in the safe harbor plan, but potentially many fewer.

[david rigby]

49 minutes ago, XTitan said:

I'm not surprised an ERISA attorney would push back. 

I am surprised that an ERISA attorney would push back.  IMHO, you need to talk to (at least one) other ERISA attorney.  I can recommend several such individuals.

BTW, as stated, although a NQ plan (where the ER is putting up the money) is subject to creditors or other risk of loss, this is substantially more valuable than the current zero in those "accounts".

[XTitan]

12 minutes ago, david rigby said:

I am surprised that an ERISA attorney would push back.

I have had many wonderful conversations with ERISA attorneys who have zero NQ experience.  A suggestion to a client to find more experienced ERISA attorneys who are more familiar with NQ is generally met with great appreciation...

[jpod]

Another idea might be to experiment with auto-enrollment in the 401k plan and see how it goes.  I am pretty sure the statistics show that a high percentage of those auto-enrolled do not opt out. 

[ldr]

All interesting ideas!  Thank you all very much.  I will let you know the outcome. david rigby, thanks and we may very well need to get in touch for a recommendation if the other 2 local ERISA attorneys here are not experienced with NQ plans.

[Mike Preston]

2 hours ago, C. B. Zeller said:

Since the employees are spread out among different corporations, it might be possible, if they meet the other requirements, to disaggregate some of those corporations as a QSLOB. You would still have to include some of the NHCEs in the safe harbor plan, but potentially many fewer.

Combine the qslob with a qserp and many fewer becomes many many fewer. In addition, a few targeted nhce managers can help a lot. 

[ldr]

Mike and C.B., thanks for your ideas.  You are getting into pretty esoteric areas (for us) and we would need to do a lot of research on this.  Our general impression is that QSLOBS are supposed to be extremely unrelated businesses, like say, a gas station, a hair salon and a pizzeria under common ownership.  This prospect of ours has multiple corporations but they all do the same thing.  We didn't think that could qualify for QSLOB status.  As for a QSERP - we'd have to look into that.  

[Luke Bailey]

What Life insurance agents sometimes referred to as a “section 162 bonus plan”  has some of the characteristics of nonqualified deferred comp, but  is not unfunded and therefore doesn’t have the creditor risk.  It’s not a panacea, but you might look into it. You should be able to find some information about these by just googling the term “section 162 bonus plan,“ with and perhaps without the name of your favorite life insurance company. The ones active in the market use majestic animals, implying strength and stability, in their advertising. There are no  magic tax benefits for Section 162 bonus plans, but,  depending on the financial goals and  expected turnover of your HCE’s, they might be worth looking into. 

[FPGuy]

Let's start with the basic tax difference between qualified and non-qualified (outside of 457) plans: qualified plan contributions by the employer are deductible; non-qualified contributions are not except to the extent taxable to the participant (hence a "162 bonus"). Here, then, is how such a plan could work using a life insurance Policy (funded to the MEC threshold). A few comments on that term and Policy selection follow the sample outline of design.

For every dollar the HCE contributes to Policy, Employer will provide a {insert percentage} match.     -  HCE contribution is non-deductible (think of it as a Roth contribution);  -  Match is fully deductible but taxable to HCE, so -  Employer grosses up the match (also deductible).  Depending on the tax bracket assumed for the gross up payment, and the extent to which local taxes or the employer's share of SS taxes are taken into consideration, the non-qualified match will cost the employer 30 - 60% more net after tax than a qualified plan match (ex: employer TB = 21%; HCE TB for gross-up purposes = 28%; no local tax or SS adjustment. Cost of $10K QP match NAT = 7,900; gross up for $10K NQ match = $3,889; NAT for NQ contribution + gross-up = $10,972; Difference 38.89%). However, eventually the employer will receive a deduction for NQ payout. Deferred benefit, deferred offsetting deduction.

Vesting - what client wants it to be? If desired, design can include a forfeiture provision for some or all of the match (and earnings thereon?) to be pulled out of the Policy, but think it bad form (and never seen) forfeiture relative to the HCE contribution (and earnings thereon). "162 bonus plan" with forfeiture provisions often referred to as a "Restricted Employee Bonus Arrangement" (REBA).

HCE Benefits - In addition to insurance protection, cash values will grow tax deferred; HCE will be able to recover cumulative premiums (including match) tax free, and may be able to access additional cash value tax free through Policy loans.

Insurance Policy Considerations:  -  The MEC (Modified Endowment Contract) threshold separates the favorable tax treatment of life insurance proceeds and withdrawals from the less favorable tax treatment of annuities. Funding to MEC limits reduces internal Policy expenses and maximizes cash value build-up.  -  Variable Life allows the Policy owner to allocate cash values among a menu of 401(k) type sub-accounts (subject to any Employer mandated restrictions). No ceiling or floor on performance.  -  General Account Universal Life or Whole Life essentially passes on a return based on the performance of the insurer's reserves, which for a better rated company will be primarily investment grade bonds. Modest return expectations, with some performance guarantees.   -  Equity Indexed Life is a hybrid, with investment return based on the performance of a selected index (such as the S&P 500), generally exclusive of dividends. There are downside performance guarantees (such as 0% floor) and upside ceilings.

[Mr Bagwell]

Are Life Insurance Companies comfortable with policy just under the MEC?  I know "MEC'ing out" is really bad.

[FPGuy]

"Mec'ing out" means that any withdrawals from the policy, including loans, come out earnings first.  Issue for the policyowner, not the insurer. As "Mec'ing out" maximizes the premium relative to the death benefit, it gives the insurance company more money to invest with relatively little additional commission exposure, as commissions are heavily weighted toward a "target premium" that is a function of the death benefit. Note that once a MEC, always a MEC (although remediation possible if caught/addressed early). MEC status cannot be cured by 1035 exchange.

[loserson]

On 6/26/2019 at 4:21 PM, ldr said:

We don't really think that the 12 HCEs will appreciate their contributions being a general asset of the employer, being subject to taxation if they leave and take the funds, etc.  We understand that the contributions could be put into a Rabbi trust, but even then, they are still subject to the claims of creditors if the company experiences bankruptcy.  All that makes this look like a doubtful solution.

Are we missing some cutting edge, new plan design possibilities within the world of qualified plans?  How have you addressed such requests, if you can share?

Remember that the HCEs can still max their 401(k) accounts, so they are getting some 401(k) trust protection already.  The idea of a nonqual plan is to get them extra deferral beyond the qualified plan.

I agree that this is poor tax planning on the employer's part.  But the decision to use a rabbi trust as part of the overall comp strategy is a reasonable one.

I think you are being overly conservative about rabbi trusts.  Rabbi trusts are quite common and most executives are fine with it because the alternative is immediate taxation.  The bankruptcy risk over the time horizon of their deferral is usually not significant.  They can keep rolling it over in 5-year increments if they want (as long as they elect to re-defer at least 12 months in advance).  In exchange for deferring tax, and the opportunity to stretch out your distributions to reduce tax bunching, the bankruptcy risk is usually an acceptable trade-off.

There are other ways to deliver exec comp.

• You can do a 401(k) excess plan.  This is just a particular kind of NQDC or SERP, but it's designed to simplify the executive's elections and to cross over the limits and maximums of the 401(k) plan.  That might be what they meant by a "carve out" plan.
• With equity awards, like restricted stock or stock options, the equity gives some deferral until the equity is sold.  But that can bunch up employees' portfolios in one stock, which is bad, and it has lots of administrative and legal complications, and the ownership consequences need to be considered.
• You can do phantom equity and stock units, but all those non-equity awards are just different ways to tally what are ultimately just cash bonuses. 
• You can offer special perks, like travel and housing and transit, or reimburse things like car insurance or home insurance or gym memberships or mobile phone costs.  But many of these benefits will usually be structured to be taxable, so they are really just a fancy way to pay salary but in a way that is less flexible than salary.
• I really think a simple top hat nonqual is easier to explain and easier to administer.  For a small top hat group of 12, I think a simple NQDC works well.

other ideas-

The employer could offer HDHPs and HSAs so that HCEs get another opportunity at tax deferral.  HSAs are held in trust by a bank, so it avoids rabbi trust limitations.  It's not a costly benefit, but it tends to see disproportionate use by more sophisticated and higher-income employees.  If the participants do not spend the HSA money on their medical expenses, then they can reimburse themselves in later years, and the money is a tax-free savings vehicle.  And at age 65, it starts to work like a trad IRA, with no more penalties for voluntary non-medical distributions.  So it's a deferral chance without using a rabbi trust.

If you really want to remain in the qualified plan world, will you be offering the after-tax non-Roth contributions?  The folks who max out their $19k can keep contributing up to the annual additions limit, which is $56k now.  So if there are no employer contributions and no other allocations, an executive can contribute $19k pre-tax and then an additional $37k after-tax.  That's not a Roth contribution, but you can allow in-plan rollovers into Roth, or you can allow them to do in-service distributions of their after-tax amounts.  There is no tax on the rollover, except to the extent of gains, and after that it just becomes Roth.  It gives high-income people an extra bite at deferrals.

After-tax non-Roth is an easy benefit and most plans could offer it with little difficulty.  This is not really a special trick.  But not everybody is aware of it.  You can have the employer present it to executives as an extra chance at deferral - and the funds would be either in the 401(k) trust or their own IRAs, so that avoids the rabbi trust problems.

Maybe if you give the executives several opportunities to get deferral into secure trusts, you can be more comfortable with using a rabbi trust as one portion of the overall executive compensation strategy.

[jpod]

3 hours ago, loserson said:

Remember that the HCEs can still max their 401(k) accounts, so they are getting some 401(k) trust protection already. 

Huh?  That they won't be able to get anywhere NEAR maxing out is the entire point of this discussion!

[loserson]

21 minutes ago, jpod said:

Huh?  That they won't be able to get anywhere NEAR maxing out is the entire point of this discussion!

I think you're talking about annual additions max?  I was talking about annual deferrals max.  A highly compensated employee could very plausibly hit $19k in their own deferrals, and many of them do.

Though if the plan allows after-tax deferrals, then a highly compensated executive could potentially hit the annual additions max of $56k.

My point is that the rabbi trust is not so worrying, especially if HCEs have the chance to make 401(k) deferrals to move part of their retirement saving activity into qualified trusts instead of a rabbi trust.

[jpod]

18 minutes ago, loserson said:

I think you're talking about annual additions max?  I was talking about annual deferrals max.  A highly compensated employee could very plausibly hit $19k in their own deferrals, and many of them do.

Am I on Candid Camera?

[Mr Bagwell]

4 minutes ago, jpod said:

Am I on Candid Camera?

Yes.  :)