COURSE AND DIRECTION - Guest Article - Securing Executive Benefits from Takeover or Bankruptcy<

Securing Executive Benefits from Takeover or Bankruptcy
Written By:
William L. MacDonald
CEO/Chairman of Retirement Capital Group

Even in a tight economy, organizations — large and small — face the challenge of how to attract, retain and reward key employees. More than any other asset, employees, especially executive staff, can make a big difference in a company's profitability and overall future.

For decades companies relied on the 401(k) and other traditional defined contribution and defined benefit plans to secure and satisfy top talent. But now, because of government restrictions on qualified plan offerings, along with accounting, funding and creditor security issues, these plans are not enough. Nonqualified deferred compensation plans are stepping up to fill the void (see chart below). In fact, 86 percent of Fortune 1000 companies have put these plans in effect.

Qualified Plans

Must include all eligible Participants in plan design
Must meet ERISA reporting requirements
Employer gets immediate tax deduction for contributions
Contributions protected from creditors of the employee

Qualified Plans

Can be selective
No onerous reporting requirements
No tax deduction until benefits are paid
Assets subject to claims of corporate creditors

Nonqualified deferred compensation plans are contracts in which an employer defers a certain amount of compensation received by the employee. The plan is called "nonqualified" since it does not qualify for income tax deductions. Monies accumulate within the plan over time without being considered income subject to taxation until the benefit is paid.

Nonqualified deferred compensation plans offer flexibility for the company to determine the level of employee covered and to tailor the options to the needs of a select group. They are informally funded, meaning that the employer makes a contractual promise to pay the executive employee at some date in the future. Many companies set aside assets, however they are still subject to creditor claims.

The downside of many nonqualified deferred compensation plans, however, is that after several years of wealth accumulation, executive participants may face the possibility of losing their retirement savings. In the event of bankruptcy, hostile takeover, or sudden change of management control, they may loose their benefits because they are "unsecured general creditors" of their employers.

Most companies with deferred compensation plans in place provide benefit security through a Rabbi Trust. Within a Rabbi Trust, a company contributes assets to an independent trustee with the aim of providing protection to executives if the company fails to make payments. But Rabbi Trust assets are subject to the claims of creditors, providing no benefit protection if the company becomes bankrupt. Most alternatives to the Rabbi Trust that try to protect the executive in the event of bankruptcy are seen as pushing the corporate governance envelope. One of the only true and safe alternatives today is to use the Secular Trust, but is there a better economical alternative?

Insured Security Option Plan – The Best of Both Worlds

A new option has emerged. It provides the executive with a fully secured asset that they control. Unknown to many companies, it is called the Insured Security Option Plan, or ISOP.

To understand how the ISOP works, it will be important to understand how traditional qualified deferred compensation plans (i.e. 401(k)) and nonqualified plans (i.e., NQDC) work from a tax and cost prospective.

When an executive participates in a typical nonqualified deferred compensation plan, the employer holds the executives deferred dollars in the corporation. For balance sheet purposes the company sets up a deferred tax benefit, however, no current tax deduction is realized. Since these assets are held by the company, the executive is subject to the claims of creditors.

So, if an executive defers $100,000, the company (assuming 40% tax bracket) loses $40,000 to corporate taxes plus its cost of money. With most plans, the company sets the entire $100,000 aside in a Rabbi Trust with a current cost of $40,000. The company will realize its deduction when benefits are paid. So in this case, the company is lending the executive the tax deferred savings.

Turning to the qualified plan, its major advantage is the current tax deduction to the company and the postponement of taxes to the individual, as well as bankruptcy protection to the participant. In this case, the government is lending the tax to the executive on his/her deferral. The only major problem with the qualified plan is that government limits on 401(k) deferrals ($12,000 in 2003) and levels of compensation that can be used for such plans ($200,000 in 2003) make them unsuitable for deployment to senior executives. Unlike the nonqualified plan, ERISA provides full protection against creditors.

If we could combine the benefits of current corporate deduction, creditor proofed with ERISA, while allowing the executive to accumulate retirement dollars, we meld the best of all worlds. Well that's what the ISOP does. The ISOP has added third party lender to the plan in place of the company in traditional deferred compensation or the government in qualified plans.

ISOP Operating Mechanics

An ISOP secures the payment of supplemental retirement income or deferred compensation benefits and provides a death benefit to the executive's beneficiary. Typically, the executive will be covered by an unfunded deferred compensation plan and/or by a group term/supplemental death benefit. The ISOP program replaces one or both arrangements to deliver the benefits regardless of changes in the solvency or management of the employer.

Thus, the ISOP program is similar to the Secular Trust under which an employee trades off tax deferral for benefit security. However, unlike the Secular trust, the ISOP program does not result in current tax on the investment earnings, and the third party lender substitutes the taxes with a loan giving the participant full accumulation on the pre-tax deferral amounts. The loan, since it is part of the "employee's plan," complies with the requirements of the Sarbanes-Oxley Act for publicly traded companies.

The plan design can be flexible to meet corporate and individual objectives. A basic design would have the employer adopt an ISOP program for eligible employees as defined by a plan document. The employer can pick and choose the eligible employees similar to a traditional nonqualified plan.

Next, the plan provides for contributions made by the employer and/or by the employee from current salary and/or bonus. Generally, the employer will be the "plan administrator" and "named fiduciary" (as defined in ERISA) for an ISOP program.

Because the ISOP trust's income is taxed to the participant, the trust usually invests in tax deferred or tax free assets such as tax exempt bonds, annuities or life insurance. The tax free or deferred accumulation helps to provide a similar after tax benefit to traditional deferred compensation (see chart).

Qualified Plans

Pre-Tax After Tax Year ISOP Trust Net trust value

$ 106,000
$ 587,531
$1,397,164
$2,467,252 $ 63,600
$ 358,519
$ 838,298
$ 1,480,351 1
5
10
15 $ 68,070
$ 347,360
$ 774,080
$ 1,449,266

Net of loan on taxes
Assumes 6% and 40% tax bracket

The ISOP is a solid retirement funding alternative, which eliminates risk of loss through bankruptcy or sudden management change. It truly combines the best of the nonqualified and traditional deferred compensation plans in a win-win for the company and the executive.

Securities offered through Securities America, Inc. a registered broker/dealer Member NASD/SIPC.

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