Nonqualified Successes

A boom in ''top hat'' deferred compensation programs spurs companies to compare funding methods.

Like most companies, Boston Edison Co. likes to avoid unpleasant surprises. So last year, the utility chose to fund its nonqualifed deferred compensation plan with investments that mimic the securities in its established tax-sheltered 401(k) plan. The nonqualifed plan, a “top hat” designed to provide retirement benefits for senior managers, already had been fully funded for several years — using corporate-owned life insurance, or COLI. But by setting up a new approach that tracks the 401(k)’s performance, “we now have the best program imaginable,” declares Donald Anastasia, Boston Edison’s assistant treasurer.

The Massachusetts utility is in good company. At hundreds of corporations around the United States, finance executives are reviewing their funding choices for those deferred compensation plans that don’t meet Internal Revenue Service tax-exemption standards– hoping to get balance-sheet protection for the programs that serve the retirement needs of employees paid more than the maximum salary the IRS allows. Between 65 and 70 percent of concerns with more than 5,000 employees have top hats, according to New York­based Buck Consultants, specialists in deferred benefits planning. That’s up from 55 to 60 percent five years ago.

For the most part, the pursuit of funding for such liabilities is a recent development. Until 1992, few companies bothered to arrange funding for their top hats at all. Instead, they managed retirement benefits for the upper ranks of management–which were generally paid out in a lump sum at the point of retirement– on a pay-as-you-go basis. “As long as these liabilities were not so large as to be unmanageable, and the company was earning a more-than-average return on capital, then it made sense to finance the lump sums out of profits,” says Gordon Gould, chief actuary at Towers Perrin, an HR management consulting firm. (About half the companies with nonqualified plans still forgo formal funding for them.)

As 1993 approached, however, pressure on big companies to arrange funding increased sharply. That year, Congress declared that employees earning more than $150,000 couldn’t qualify for tax-sheltered 401(k) contributions. (The ceiling, which previously had been $235,840, has since been allowed to creep up to $160,000. Another boost in the ceiling, to $200,000, is now being considered.) With the ceiling set to be lowered, companies rushed to create or extend nonqualified plans–of either the defined- benefit or the defined-contribution variety — and the number of participants in such plans grew exponentially. In 1992, new nonqualified- plan filings with the Labor Department surged from 1,842 to 6,619, and filings have topped 4,500 each year since.

While reliable statistics on top hats are rare — the government doesn’t compile such data–Buck Consultants estimates that about $3 billion is likely deferred each year, based on reasonable assumptions about how many employees companies make eligible. And with plans in place, companies have expanded them by including lower-paid executives as well. Indeed, in 1998, the Los Angeles­based compensation and benefits strategy firm Compensation Resource Group found that 53 percent of Fortune 1,000 companies offered nonqualified benefits to employees earning less than $100,000 a year.

As nonqualified-plan participants have increased, so also has the importance of the plans as a source of retirement income. “As much as 90 percent of a CEO’s retirement income can come from a nonqualified plan,” says Chris Rich, president of Lyons Compensation & Benefits LLC, a Waltham, Massachusetts-based benefits consulting group.

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