Today’s forward-thinking companies strategically use non-qualified deferred compensation plans as a way to pay top executives for performance. Almost 70% of CEO pay is delivered through annual and long-term incentives, according to the Conference Board. With such high value opportunities, many executives are seeking tax-efficient programs.
One solution is to use deferred compensation plans, which have several benefits. First, participants can defer the timing of receipt and therefore taxation of the incentive awards. Second, the incentive awards can accrue returns on a compounded tax-deferred basis until distribution. It’s no wonder that high net-worth executives find deferred compensation plans attractive.
There are many ways deferred compensation plans can be created to mimic bonus or long-term incentive plans. Performance features can be incorporated into the Company contribution, vesting, and crediting rate. For instance:
- Contributions to executives’ accounts can be based on either attaining specific performance goals, service requirements, or a combination of both
- Vesting of company contributions can be based on attaining specific performance goals
- Crediting rate can track company stock performance
One example is a retail client that underwent a spin-off and sought to motivate and retain its store managers. The Company wanted to offer a long-term incentive plan that had performance requirements and a retention hook. The Company implemented a two-pronged approach: 1) a retention bonus based on store performance and 2) a grant of phantom stock based on the enterprise-wide value.
- For the retention bonus, the Company contributed to each store manager’s deferred compensation account a percentage of the cumulative net cash flow of his/her store at the end of five years
- For the phantom stock plan, each store manager received a grant of phantom stock that tracked the value of the Company over time
- Upon termination, the value of the deferred compensation account and the phantom stock were distributed to the store manager based on his/her election preferences (at termination or at a future date).
In situations where equity-like incentives are desired, deferred compensation plans are an elegant way to provide such incentives without using real equity. For instance, privately held companies, publicly traded companies that need to conserve shares, or subsidiaries that wish to tie their executives to subsidiary value use can use deferred compensation as a way to provide phantom equity to their executives in a tax-efficient manner.
Deferred compensation plans have drawbacks, though. Deferred amounts (employee and company contributions) are subject to creditor claims in the event of company bankruptcy. Design and administration of such plans are subject to various regulations, including IRS Code Section 409A. Each company should evaluate the drawbacks and weigh them against the tax-efficiency and design features that make deferred compensation plans attractive.