Executive Compensation and Nonqualified Plans: What's Ahead?

Executive compensation is facing intense scrutiny today from all quarters: political, media, corporate boards and even executives themselves. Nonqualified deferred compensation (NQDC) plans are attracting a fair share of the attention, and on the political front, the Sarbanes-Oxley Act has disallowed the use of offshore trusts as a tax-efficient funding mechanism for nonqualified plans. It also eliminated direct or indirect loans to Section 16 executive officers, which probably precludes collateral split-dollar life insurance arrangements for top corporate executives. The American Competitiveness and Corporate Accountability Act (H.R.5095) proposes broad changes to deferred compensation arrangements, such as taxing "funded" nonqualified benefits, restricting benefit plan payouts and changing rabbi trust arrangements.

Corporate boards, executives and shareholders are rethinking the value, security and optimal execution of NQDC plans in the face of market doldrums, higher plan liabilities, steeper security risks and increasing demand for cost control and efficiency.

An effective NQDC plan can play an important dual role - satisfying stakeholders' demands for efficiency and effectiveness while offering attractive rewards to talented executives who will add value to the company. When the economy rebounds, it's a sure thing that having well-structured and administered nonqualified plans in place will be critical. What is less certain is exactly what form effective NQDC plans will take in tomorrow's reshaped corporate environment.

The 2002 Nonqualified Deferred Compensation Study

Watson Wyatt set out to understand the corporate perspective on when nonqualified plans met their goals and when - and why - they fell short. In Watson Wyatt's 2002 Nonqualified Deferred Compensation Study, we surveyed 169 firms, most of which were for-profit, public companies employing an average of 14,900 workers, 55 top executives and 468 other managers. Survey participants represented employers from a cross-section of industries, including manufacturing, health care, finance and insurance, wholesale and retail, and utilities. The survey captured and analyzed data on the prevalence, objectives, effectiveness and features of NQDC plans; determined prevalent management practices with a focus on those considered successful; and provided information on evolving practices, particularly in the areas of design, administration, funding/financing efficiency and return on investment, and communications. Figure 1 shows the prevalence of plans by type and target group.

Survey highlights include:

• Nine out of 10 companies with qualified plans also sponsor a nonqualified plan, and many sponsor more than one. The most common types are voluntary deferred compensation (74 percent), followed by defined benefit excess §401(a)(17) plans (58 percent) and defined benefit excess §415 plans (52 percent).
• The two primary purposes of nonqualified plans are retirement income security and wealth accumulation. However, specific objectives often vary by plan type and target group (top executives versus other management). Few supplemental plans were designed as one piece of an overall executive compensation strategy, but those that were tend to be successful.
• Perceptions of effectiveness in achieving objectives also vary by plan type and target group. Defined benefit Supplemental Executive Retirement Plans (SERPs) are more likely than other plans to meet objectives. Voluntary deferred compensation plans are the least effective.
• Most NQDC plans of all types are unfunded, meaning specific assets have not irrevocably been set aside to provide for future benefits. In companies that fund their plans, corporate-owned life insurance (COLI) and mutual funds are the most common funding vehicles. Many companies plan to review their funding/financing in the coming year.
• Almost three-quarters of companies that fund their plans have a security arrangement, the most common being a rabbi trust. Most plan participants (and even employers) do not seem to understand rabbi trusts, and companies should be prepared for questions about them.
• NQDCs are more likely to be administered externally than internally, but performance reviews are mixed. Higher administrative performance in qualified plans seems to be raising the bar for nonqualified plans as well. While most companies are at least somewhat satisfied with their arrangements, many cite plan administration as their reason to review their NQDC strategies.
• Companies that put more effort into communicating their plans achieve greater satisfaction. In many companies, there is still considerable room for improvement - nearly three out of 10 participants did not know whether their communication methods were effective.
• Future NQDC developments are likely to involve convergence, innovative designs linking plan benefits to company performance, integration, self-service and new funding/financing strategies.

Areas That Could Stand Improvement

While nonqualified plans appear to work well for many organizations, we found room for improvement in several areas of plan design, governance, funding/financing, administration and communications.

1. Nonqualified plans are too often designed as extensions of qualified plans. In failing to take advantage of the inherent flexibility in nonqualified plan design, many employers are not maximizing the potential of these plans for attraction/retention and wealth management, and are overlooking the role they could play in overall compensation strategy.
2. Governance is not done well. Nonqualified plans do not require the same level of governance and oversight as qualified plans - but perhaps they should. Applying the governance techniques applied to qualified plans to nonqualified plans would likely improve their effectiveness and efficiency.
3. Nonqualified plans tend to be fragmented. Nonqualified plans are often "owned" by several departments, and so have been designed by one department, financed by another and administered by a third.
4. Funding and financing for nonqualified plans are not well understood. Nonqualified plan financing is complex and rarely viewed from a long-term perspective. Cash flow, administrative costs, impact to earnings and return on investment are typically not monitored so as to provide a thorough understanding of plan costs and returns.
5. The various components of nonqualified plans are blurred. Nonqualified plans are often structured after a funding/financing vehicle is chosen or plan administration is dictated by other decisions, typically causing one area to drive operations, often at the expense of other areas.
6. Communications and administration need improvement. Nonqualified plans tend to be complicated; without careful and effective communications, they are often misunderstood by administrators and participants alike.

Looking Ahead

What's next for NQDCs? Based on this survey data as well as other employer input, NQDCs are certain to remain an integral part of executive compensation programs. However, changes in the economic and regulatory environments and corporate culture will reshape the landscape of nonqualified plans, almost certainly in the direction of more restrictions and less flexibility.

• It may become more difficult to fund/finance benefits.
• Companies will begin treating their nonqualified plans more like qualified or compensation plans in terms of design, integration, investment policy, investment options and fit with other programs.
• Nonqualified plans will be considered one valuable piece of an employer's total compensation strategy.
• Employers will integrate nonqualified plans with executive financial planning tools, including more strategic, focused and integrated communications as well as online access to all account information.
• Nonqualified plan administrative services will continue to evolve, becoming more like those provided for qualified plans.
• As liabilities in NQDC plans grow, it will become increasingly important to monitor funded status and choose appropriate financing vehicles. Companies will spend more time analyzing the financial impacts of various funding alternatives to establish a strategy that best serves their medium or long-term goals. More companies will combine funding/financing vehicles (e.g., COLI plus mutual funds) to align their nonqualified plans more closely with business needs.
• Companies will monitor cash flow needs and earnings and their impact on projected liabilities on a more frequent and regular basis.
• Companies will continue using the passing margin in the qualified pension nondiscrimination tests to move currently nonqualified liabilities into the qualified plan.