Employee Retention: The Role of Non-Qualified Deferred Compensation Plans
Many employers are struggling with employee hiring and retention. When it comes to employee retention, competition is fierce, and a good portion of the workforce are employees that are willing to move jobs, often for far less in wage increases or benefit advantages than in past years. An effective tool in an employer’s “retention toolbox” is the issuance of non-qualified deferred compensation to key employees.
Deferred compensation can be “qualified” or “non-qualified”. “Qualified” deferred compensation is compensation earned through plans that are required by law to be separately administered for the benefit of employees, such as your standard 401(k) plan. “Non-qualified” deferred compensation is different, primarily because it is not required by law to be separately administered, and as a result the funds do not have to be set aside. It is simply a promise from the employer to the employee to pay funds, based on certain criteria, in the future.
Non-qualified deferred compensation (NQDC) provides a number of benefits to employers. NQDC can be granted to any employee, although it is typically used as a retainage tool for management level employees and employees that are projected to become management level employees in the near future. In its simplest structure, a NQDC plan provides for payment of an amount of money, sometime in the future (typically 3-7 years but it varies), based on a formula the employer identifies at the time the plan is created. The key is that the NQDC is not paid, and is forfeited, if the employee does not reach the full term (subject to certain exceptions, noted below). NQDC can be determined based on stock or ownership appreciation (i.e., value is based on the appreciation in the value of the ownership between grant and payment), certain revenue or profitability goals, or discretionary amounts determined by the employer based upon yearly performance metrics. The NQDC award can be coupled with the employee’s agreement to non-competition and non-solicitation restrictions, and the issuance of the NQDC is a strong basis to support those restrictions. At the time the NQDC is paid, it is considered an ordinary business deduction for the employer (and payroll compensation to the employee). NQDC plans also have “retirement” qualities: an NQDC plan that is for 5 years can be replaced with another NQDC plan (on the same or different terms), and so on and so forth. NQDC plans can be structured to “renew” enough times to get the employee to retirement, as your employee!
NQDC plans are subject to certain limitations under federal law, specifically Section 409A of the Internal Revenue Code. Generally speaking, an NQDC plan must: (1) be in a contract signed by the employer and employee; (2) concretely define the way payments are calculated and the timing of payment; and (3) restrict payment to specific payment events, being termination of employment, death, disability, change in control of the employer, or a specified time provided for in the plan. As mentioned, awards are generally between 3 and 7 years, and that is the typical “trigger” for payment, unless one of the other events occurs in the meantime. Note that employers are not required to pay out on those events, they are simply what the IRS allows for payment.
An NQDC plan can be combined with a standard annual bonus structure. This can provide the employer with the maximum benefit: short term employee performance incentives with long term employee retention.
While the contract between the employer and employee cannot require that an NQDC plan be funded, it is good practice for an employer to provide a mechanism for payment in the future. The funding mechanism also adds some potentially attractive features for employers and employees. As an example, the employer may purchase life insurance on the employee. That life insurance can be death value only, which ensures the employer has the funds to payout the NQDC if the employee dies prior to the end of the NQDC plan term. Life insurance can also have a cash surrender value component, which allows the build-up of money within the policy so that the company not only protects against a death event, but is also investing the funds should a need arise to pay out on an NQDC at the end of its term. The purchase of life insurance on the employee can also fit other intended priorities of the employer. In particular, it can provide a fund from which the employer can entice a prospective employee to come on board to replace a key employee that unexpectedly dies.
NQDC plans are a very attractive way to retain key employees on relatively favorable employer terms, motivate key employees without providing an ownership interest, and potentially introduce non-compete and non-solicitation provisions that might have been missed at hiring but certainly become even more important as an employee moves up in your organization. It is very important to make sure the plan is compliant with applicable law. FGKS Law is well-versed in the requirements for these plans and drafting of these plans. Feel free to reach out to your FGKS Law attorney with any questions. If you are interested in assistance with funding or administration of any plan, we can also assist you with finding good advisors to meet those needs.
