In Enron's Wake, Time for a Review of Nonqualified Plans
The collapse of Enron and other companies plagued with financial wrongdoing has shaken employees’ faith in once venerable institutions such as stock grants and 401(k) plans. Those scandals have also damaged the reputation of another important part of corporate benefits planning: the nonqualified--not subject to federal contribution limits and insurance protections--retirement plans that companies have long provided to a limited cadre of top management to supplement standard company pensions.
In the Enron case, shortly before the Houston-based energy giant went bankrupt in December 2001, the corporate nonqualified benefits plan was used to illegally funnel $53 million in early distributions to a handful of executives, according to a February 2003 report by the staff of the congressional Joint Committee on Taxation. That abuse, which came at a time when ordinary Enron employees were losing tens to hundreds of thousands of dollars in retirement savings they had been encouraged to invest in Enron stock, stirred outrage on Capitol Hill, where some legislators have proposed tightening the regulations on nonqualified plans. It also apparently has caught the attention of the Internal Revenue Service. Since last summer, federal auditors have been scrutinizing the nonqualified retirement plans of executives at a number of U.S. companies to see whether they comply with tax laws, according to numerous consultants and law firms that advise companies on tax issues.
"The problem with nonqualified retirement plans is that they’re often pretty complicated," says Brent Longnecker, president of Longnecker & Associates, a Houston-area consulting firm that specializes in corporate-governance issues. "When something is tough to understand, it’s potentially easy for someone to abuse. Now the IRS audit is looking at the nonqualified plans, which is going to make due diligence absolutely key."
The crimes of a few corporate criminals notwithstanding, nonqualified retirement plans are getting an unfair bad rap, Longnecker and other consultants say. Most companies are using them not to launder illegal payments, as Enron allegedly did, but for a more benign purpose. Nonqualified plans, unlike traditional defined-benefits pensions which are not federally insured, provide a way to supplement standard pensions and 401(k) contributions. Corporate executives aren’t penalized unfairly by federal rules that limit their participation in such retirement plans. In addition, the plans are a useful tool for recruiting and retaining top executive talent.
All the same, the experts also say that it’s prudent for companies to take a fresh look at their nonqualified plans, with an eye to simplifying them and eliminating any anomalies--such as an unusually complex or lucrative custom plan created in the past for a specific executive--that might turn into tomorrow’s time bomb. And it’s also a good time to make sure that both employees and shareholders are fully informed about executives’ nonqualified retirement benefits, so that they don’t come as an unpleasant surprise in the midst of some future corporate crisis.
Despite the recent controversy surrounding nonqualified plans, they are a widespread practice in corporate America. In a 2003 study of 200 Fortune 1000 companies by Clark Consulting, a firm in North Barrington, Illinois, that advises companies on compensation issues, 93 percent reported that they offer some sort of nonqualified benefits plan. That’s up 13 percent from a similar Clark study in 1997-1998.
For years, virtually no one questioned the common practice of offering top executives additional benefits beyond the standard corporate pension and employee savings plans, says Les Brockhurst, president of the Executive Benefits Practice in Clark’s Los Angeles office. The regulations that govern qualified retirement plans--that is, traditional defined-benefits pensions covered by federal insurance--limit the amount of salary that can be included in the calculation of benefits to $200,000. In addition, federal rules set the maximum annual contribution to a corporate 401(k) plan at $12,000. As a result, at least in theory, ordinary employees had an easier time maintaining their income level in retirement than top executives did. But federal regulations also provide a limited loophole, the "top hat" exemption, which allows companies to supplement the retirement benefits of a few executives. "Basically, it’s a way of giving the chief executive the same opportunity to save that his workers get," Brockhurst says.
Companies also benefit from the plans, which provide both tax benefits and a perquisite that they can offer to executive recruits. Brockhurst says that nonqualified plans are particularly advantageous as a retention incentive as well. "They can be golden handcuffs," he says. "While you’re entitled to your own money that’s in the plan, you’re not necessarily entitled to the corporate match. And you can’t roll your nonqualified savings into another plan, so if you leave, you have to pay the tax then."
"The guiding principle is ‘keep it simple.’ The fewer complications that you build into the plan initially, the fewer problems you’re likely to have down the road."
And while Enron helped create a sensationalized image of nonqualified plans as under-the-table payoffs for a select few fat cats, the reality at most companies is considerably different. For one thing, federal regulations are a bit vague about who should be eligible for the "top hat" exemption, except to say that an eligible employee must be "highly compensated." In the Clark study, 44 percent of the companies granted nonqualified benefits to staffers with annual compensation of $100,000 or more, which indicates that some senior managers as well as executives are getting access to such benefits. Additionally, most companies are merely giving highly paid employees a chance to save their own money and defer taxes. About 85 percent of the companies in the Clark study stated that they allow executives to defer part of their compensation in a nonqualified plan, and 93 percent allow participants to defer bonuses and other short-term incentives. In contrast to 401(k) plans, for which 96 percent of employers made matching contributions to employees’ savings, only 41 percent of the companies contributed to executives’ accounts in nonqualified plans.
The trade-off is that the benefits don’t enjoy the same regulatory protection that traditional pension benefits have. If a company goes bankrupt, for example, employees’ qualified pension benefits are insured under federal law. An executive with nonqualified benefits, however, simply becomes another general creditor in the bankruptcy, which probably means that he or she will lose that money.
"At Enron, what they tried to do was work out a device to eliminate the risk," Brockhurst says. "That basically was eliminating a key element of what a nonqualified plan is supposed to be." Additionally, Enron paid an early distribution to its favored few without deducting a penalty--known in accounting parlance as a "haircut"--from the money, as most companies do. Such maneuvers, however, are likely to become a thing of the past. The Joint Committee’s report recommended that Congress rewrite the laws and subject nonqualified benefits to federal taxes if a company allows early distributions.
A few companies have played fast and loose with business ethics in other ways, consultants say. Some have attempted to use offshore trusts to put executives’ retirement benefits out of the reach of U.S. tax collectors, Brockhurst says. Others have sweetened executives’ nonqualified retirement benefits by giving them credit for more years of service than they actually have worked, a recent AFL-CIO study reports. Brockhurst insists that such abuses are relatively rare. "At 99 percent of companies, the executives retire, take their payouts, the IRS gets its share and the company gets a tax deduction," he says.
With nonqualified benefits increasingly subject to regulatory scrutiny, consultants say that companies should take a careful look at their plans to make sure there aren’t any potential problems. One particular red flag: nonqualified benefits plans designed for particular executives, or negotiated by them. The worst-case scenario, Longnecker says, is an executive at a struggling outfit who tries to renegotiate his benefits package. "It’s one thing if he’s doing a good job and he says, ‘I want more.’ But if the company is stagnating, you may be in a situation where a guy is panicking and thinking that he needs to line his pockets because he’s going to be on the outside soon. That’s something you need to watch out for."
Pete Neuwirth, a senior vice president, Human Capital Practice at Clark Consulting in Berkeley, says that companies can avoid such problems by offering all executives the same nonqualified benefits package. "The guiding principle is ‘keep it simple,’ " he says. "The fewer complications that you build into the plan initially, the fewer problems you’re likely to have down the road."
It’s also essential to think carefully about how nonqualified benefits plans may appear to employees and shareholders. Given recent headlines about underfunding of traditional defined-benefits pension plans at many U.S. companies, it’s risky to even appear to be giving executives excessive pension benefits, whether or not the two issues are directly related. (The presently underfunded plans remain federally insured, and regulators can compel companies to increase their funds’ reserves. Nonqualified plans, in contrast, enjoy no such protections.) Longnecker recommends a corporate communication campaign to explain to everyone, both inside the company and out, what sort of benefits are being offered to executives and why the deal is fair.
Workforce Management, March 2004, pp70-72. 15 -- Subscribe Now!