Companies Compete for Human Capital With Non-Qualified Plans

November 23, 2001
Between the time I write these words and the time you read them, hundreds of topexecutives will have left key positions at small and midsize companies. In manycases, these will be people who were happy with their jobs, their organizations,and their salaries -- but who were lured away by enterprises offering them morediversified benefits.

Today, many small to midsize companies focus on three key tools to recruit,reward, and retain talented employees: salary, stock options, and qualifiedpension plans. In general, these last two items remain highly-valued perks.Yet in the past year, when so many equities performed poorly, stock optionslost some of their luster.

When a stock sinks under water -- as it did for many companies last year --the retention value of stock options seriously diminishes. Indeed, if you havean experience like Jaap van der Meer, president of Alpnet, Inc., who watchedthe value of his own stock in this small corporation sink from over $14 millionto under $715,000 in less than eleven months, your concern may not be whetherto leave your organization, but when.

The upshot of declining stock values is that many keyemployees at small and midsize enterprises are now asking for more hard cashin addition to stock options. Faced with low stock prices and a concern thatmany of their key people will bolt, some companies are complying and payingout hefty bonuses and other cash rewards. But this retention strategy cannotremain viable indefinitely. As Merrill Lynch analyst Henry Blodget noted inThe Wall Street Journal, "Unfortunately, at some companies, it canlead to a vicious cycle where employees demand more cash. That causes earningsestimates to go down and puts further pressure on the stock price, which canlead to further demands on the company for cash."

What about qualified pension plans, then? Are these doing much to help smalland midsize companies get and keep highly valued people? Unfortunately, thegeneral answer is no, because federal regulations strictly limit the benefitsthat such plans can provide to highly-compensated employees.

There are two basic types of qualified plans, each with a limitation that particularlyaffects highly paid people (in 2001, those whose compensation exceeds $170,000annually):

  • Defined benefit plans, in which each month the employee receivesa percentage of her final compensation once she retires. These plans arealways employer-funded. Limitation: All participants mustreceive the same pre-set percentage of their final salaries, with a benefitscap based on the compensation limit ($170,000 in 2001). Thus a rank andfile employee who retires might receive 80 percent of his final salary inretirement benefits, while a highly paid vice president might receive lessthan 20 percent of her final salary.

  • Defined contribution plans, in which the employee provides mostor all of the funding (sometimes with a partial employer match and/or withdiscretionary profit-sharing contributions) by deferring a percentage ofhis salary; once he retires, he has considerable flexibility in taking cashdistributions. Limitation: In a defined contribution plan,all employees are subject to the same annual contribution limit, which isset at 15 percent of their salaries. Furthermore, these plans are subjectto the Sec. 401(k) annual cap (currently $10,500) on employee contributions,regardless of the level of compensation. Thus a CFO or CEO's contributionmay be limited to 5 percent of their salary (or even less).

In companies of all sizes, the trend has clearly been toward defined contributionplans. Many enterprises that have sponsored defined benefit programs have recentlyswitched to defined contribution plans, and of the companies that are settingup new plans, the overwhelming majority are choosing defined contribution programs.

There are sound financial reasons behind this trend,as Graph 1 demonstrates. This graph compares the results ofputting $25,000 of deferred income a year into a defined contribution plan withtaking that same $25,000 as income each year and investing it. Assuming forboth arrangements a 9 percent annual return and ten years of contributions orinvestments, the defined contribution plan ultimately yields over $1.4 million,while the outside investment yields just over $500,000 -- a 176 percent difference.

Another cause of this trend is the benefits cap builtinto defined benefit plans. Graph 2 clearly illustrates thislimitation. (This graph, based on several economic studies, employs financialprofessionals' rule of thumb that people need about 80 percent of their finalsalaries in annual income once they retire.) As this graph reveals, a retiredsenior manager whose final salary was $100,000 will receive only about 60 percentof that salary from his defined benefit plan and social security. A retiredvice president whose final salary was $300,000 would receive only about 34 percentof her salary from these sources. In either case, the difference would needto be made up from some other income stream.

Practicing benefits diversification
Long-term investors often stress the importance of diversified investments-- which, they argue, keep people from being at the mercy of a volatile market.Yet many small and midsize enterprises often neglect to follow this essentialprinciple in offering recruitment and retention incentives to key people. Bymaking stock options their primary perk, these companies discourage diversification,and in some cases unwittingly increase the financial risk of the people theyvalue the most.

One cost-effective way to establish greater diversity -- and to create a moreeffective balance of benefits for highly valued employees -- is to provide substantialadditional retirement income through a non-qualified plan, or NQP.

NQPs can be particularly attractive to top executives, because they can makeup most or all of the huge potential difference between their final salariesand their post-retirement income from social security and qualified pensionplans. For example, a 47-year-old executive earning $300,000 today may makewell over $700,000 on retirement at age 65, yet receive an annual pension ofunder $65,000 and social security benefits of less than $25,000 -- a net incomereduction of almost 87 percent. An NQP can be designed to make up most of allof this $610,000 shortfall.

Non-qualified plans come in the same two variationsas qualified plans: defined benefit plans (more often known as SupplementalExecutive Retirement Plans, or SERPs), and defined contributionplans (often called deferral plans). These operate very much liketheir qualified plan counterparts, but with some crucial differences: your companyhas the freedom to choose which employees will participate, as well as whatbenefits will be provided to each participant. Indeed, in general these planshave few limitations and much flexibility.

Another benefit of NQPs is that they avoid the ERISA reporting requirementsand discrimination testing of qualified plans, making them relatively easy toadminister. One other plus is that a non-qualified plan does not -- and cannot-- move with an employee. Furthermore, since non-qualified plans can be designedin almost any way you choose, you can create a program in which an employee'sbenefits are contingent on a specific number of years of service, or on thesuccess and growth of the company, or on almost any other reasonable criterionyou select. (This is partly what makes an NQP such a potentially powerful retentiontool: you can design a plan so that the longer key people stay with the organization,the more future benefits they forfeit by leaving.)

Thus, in the 21st Century, many small and midsize companies are following inthe footsteps of Fortune 1000 corporations and turning to non-qualified plansas cost-effective tools for recruiting, retaining, and restoring benefits tohighly valued human capital.

The small print on non-qualified plans
Like any other benefit, an NQP needs to be properlydesigned, implemented, monitored, and financed if it is to create the most valueto both employers and key employees. Furthermore, once your company decidesto offer NQPs to some or all of its most valued people, it is essential thatit consider these important issues:

First, the terms of any non-qualified plan should be stated clearly, in writing.It can be tempting to recruit people by making verbal promises, with an understandingthat the terms will get written down (or the blanks filled in) later. Resistthis temptation, however, because it's all too easy for the blanks to stay blank,and for the promises to stay unwritten, for years. All too often, this neglect-- whether deliberate or benign -- results in lawsuits over what was actuallypromised or agreed to.

A promise of a benefit normally creates a legally binding agreement, so treatit as one. Engage a capable attorney who specializes in (or is very familiarwith) NQPs, and have him prepare a formal, detailed, fully-quantified descriptionof any non-qualified plan that you offer to anyone (including yourself). Thisdocument should specify:

  • when plan benefits will begin to be paid (e.g., on retirement at age 65or older)

  • how much those benefits will be (e.g., in dollars, in percentage of finalsalary, etc.)

  • how often those benefits will be paid

Note: If your company has already agreed to provide benefits through an NQPto one or more key employees, but has not yet prepared such a formal description,have your attorney draw up a plan document as soon as possible.

Second, if your company is privately-owned, and largely or entirely run byone person, you'll need to create a business continuation plan for when itspatriarch or matriarch leaves the company. In the absence of such a plan, whenthis person dies or retires, the company may simply be dissolved -- at whichpoint all future non-qualified benefits for all key employees would disappear.

Another important consideration: by law, NQP benefitsmust be paid out of either operating income or borrowed funds. This meansthat once a promise to pay a benefit through an NQP has been made, it becomesa liability to the company -- just like rent, salaries, or any other operatingexpenditure -- and the future beneficiary becomes one of its creditors.

This liability -- like any liability -- needs to becarefully planned and accounted for. However, by law you cannot formallyestablish a fund to pay NQP benefits, because recipients must be subject tothe same risk of forfeiture as all other creditors.

One common way to handle this is to financially quantify what your total after-taxNQP liabilities will be, year by year, for all plan participants. Then set upa sinking fund -- one not tied to NQP benefits in any way -- from which thecompany will draw money for general operating expenses. However, the fund shouldbe designed so that it yields roughly the amount needed to pay all NQP liabilitieseach year. All NQP benefits will then be paid out of the general operating account.

Where NQPs meet corporate-owned life insurance

Large and midsize companies use a wide range of options for building assetsin these sinking funds -- corporate-owned life insurance (COLI), managed portfolios(mutual funds), corporate annuities, real estate, tax-exempt bonds, zero couponbonds, unregistered company stock, preferred stock, and so on. However, themost popular -- and, to my mind, most cost-effective -- option today is COLI.In a recent survey of large companies offering non-qualified plans, 85 percentused COLI as the informal financing vehicle supporting these plans. Managedportfolios -- another good choice, in my opinion -- ranked second.

To use COLI most cost-effectively, a small or midsize company can buy a properlydesigned high-cash-value life insurance policy on the key employees enrolledin its non-qualified plan. However, for maximum benefit and cost-effectiveness,these policies (and their costs) should be pooled. Many large companies takethis pooling a step further, and write life insurance not only on their keypeople, but on a larger group of employees as well. This maximizes these companies'potential benefits from their COLI investments, and provides a number of taxadvantages as well.

The company owns each policy, pays the premiums, and designates itself as thebeneficiary. Each policy should of course be carefully designed and managedto yield the optimum benefits and payout to the corporation.

Whatever informal financing vehicle you choose for your own company, however,you will be joining the ranks of small and midsize enterprises that are lookingbeyond stock options and qualified pension plans to recruit, keep, and rewardthe human capital critical to their success.