The process involved in developing a Non-Qualified Plan (NQP) whether it’s for a small or large organization is to (1) design the program, (2) implement and communicate, (3) choose an administrator, (4) informally fund or hedge the plan, and (5) provide ongoing services to sponsors and participants. Most large employers have multiple parties involved in all phases of the process such as Human Resources, a CFO, a controller or finance specialist, and sometimes a compensation committee. In contrast, the NQP process for small companies is usually driven by the CEO. In some cases small employers may also have a CFO or HR rep involved. In a nonprofit organization, the executive director and maybe a couple of people on the Board take the lead on the project. Quite often, none of these folks have any expertise in the subject matter, financially or conceptually. After the first meeting the CEO or Executive director is left to see it through.Keep in mind that although a NQP is not subject to ERISA, the simple act of sponsoring a plan creates fiduciary responsibilities for the plan sponsor and any person in the organization who makes decisions regarding the plan’s structure and investments, which may fall under state common law statutes that define duties and standards of care for individuals dealing with retirement plans—a compelling reason to engage the services of an NQP expert—such as an adviser, consultant or attorney.
So within this context, the real life challenges facing small employers are as follows:
Often there is a definitive spread between what the CEO thinks is beneficial and what the participants think is beneficial. Clearly, the CEO has the best interests of the company in mind (profits) and the participants have their best interests in mind (wanting to share in the profits). The challenge is to mesh the two lines of thought so that profits continue and the participants have “skin in the game.” It’s important to gain a high participant value perception so that they can actually see that they are sharing in the profits.
When it comes to plan design, clearly, in almost all cases, simple is better. Fancy, complicated designs that involve multiple in-service distributions, a variety of choices for deferral or distribution elections, and complex crediting sound great, but are often misunderstood and ultimately work against the plan and its participants. Tax-saving strategies sometimes aren’t all they’re built up to be. Small companies quite often become overly enamored with these concepts when simple incentive based cash compensation would not only be adequate, but would be more appreciated by the participating group.
In the tax-exempt world the pure non-qualified options are 457(b) or (f) plans. If a nonprofit uses a 457(b) plan, they need to be sure they are fine with the risk of forfeiture in the event of insolvency. If they look to a 457(f) plan, then they need to comply with all the rules of 457 and 409A. This can be a bit cumbersome especially when the participants realize that their benefits are taxable immediately upon vesting.For some small employers, plan document sticker shock can also come into play. A good agreement drawn up by an attorney can run upwards of $5,000 to $10,000.
The key to minimizing fiduciary risk for any organization is to thoroughly document decisions and information to establish that a prudent process was followed. This does not have to be an onerous process, simply keep records (minutes) of key meetings and maintain thorough files.
Implementation.This is the real rub. And don’t take this the wrong way. Because they are pulled in so many directions, a CEO’s attention span is pretty short. So anything discussed in the initial design meeting is usually forgotten. There are numerous examples of enrollment meetings where the CEO says, “no, that’s not right,” and “I’m not going to do that,” about provisions in the plan that were previously discussed several times in previous and numerous design meetings. This makes for a pretty uncomfortable, confusing and sometimes combative enrollment meeting that results in not so great results in terms of perception, participation or commitment. The plan sponsor and participant are at odds before the plan even takes effect.
Communication.Plan communication is very critical. The plan sponsor has to be a big player in this process, which requires a full understanding of the plan itself. The most successful plans are those where the plan sponsor is not only on board, but participating in the initial and ongoing education and communication.
Participants need to understand completely that they can’t change deferral elections during the year, take money out anytime, and that their money in the non-qualified plan is exposed, i.e., subject to corporate creditors or risk of forfeiture. They must understand that their money is not necessarily in an account and if it is, it’s not in an account that they own or can access. Many plan sponsors and participants have trouble with the concept of the plan liability simply being the company’s promise to pay; and, that plan assets (i.e., insurance policies or other informal funding investments) are the property of the company. This can be said 100 times and still participants want to change elections and take money out at will. Their money being at risk is usually the biggest hurdle that has to be jumped in order to get a plan in place.
Administration.Many small companies don’t understand the need for an administrator. Administrators can be a bit pricey. Although they have an administrator for their 401(k) plan, plan sponsors think either the plan (participants) can pick up the cost, like the 401(k), or that administration can be done in-house. Section 409A makes it almost imperative that an administrator be involved because of the stiff penalties associated with noncompliance. An administrator is charged with complying with Section 409A and takes that burden from the plan sponsor. An administrator also assists in the ongoing service and communication with participants and the plan sponsor.
Although an administrator will be handling many of the day-to-day operational issues, it’s important for the sponsor, as the ultimate fiduciary to the plan, to document their decision process for selecting the administrator and the other vendors involved. The sponsor/fiduciary also needs to periodically review and benchmark the provider to ensure that fees are reasonable and that the services are being performed as contracted.
Informal funding.Many small plan sponsors have a difficult time with funding or hedging the liability. Most want a hedge, but don’t want the tax burden (timing of lost tax credit in the for-profit world) or don’t understand where they should put the money (not-for profits). Many small businesses are either LLCs or S corps. In these cases, traditional deferred compensation plans may have a negative tax impact to the business owner and other arrangements should be considered.
Corporate-owned insurance (COLI) is often used to fund the plan. Utilizing retail products is usually a recipe for disaster. There is little liquidity in a retail product. Expense ratios are usually very high compared to institutional policies until much later in the policy life. There is also limited flexibility with retail products. In a bad year where funding is suspended, the policy can crater. Finally, there can be insurability issues when there is a small group of participants.
Any investments held in the funding vehicles need to be monitored for risk, performance and style adherence. Although not a requirement, it is helpful to have an Investment Policy Statement in place.
Ongoing service.Quarterly reviews are always important to track the plan’s progress. And when it comes to sponsor and the participant communication—more is better. More often than not, plan details are forgotten almost immediately after enrollment. The more it’s talked about, the better it’s grasped. Not to pick on CEOs, but they are usually the worst, especially when they are participants. CEOs see the plan through their eyes only and usually only remember what makes a difference to them. Plan details are forgotten and then communicated incorrectly to others. We had a bank case where the CEO asked the same question every quarter for six years until he retired, even though he got the same answer every time. Some participants get the concepts; others don’t, and most likely won’t, so continued communication is paramount.
When it comes to small employers, the challenges amount to education, continued communication, and restating the facts over and over even when it seems clear everyone has it down. Getting more people involved is better. Taxes shouldn’t be the only driver. Take care to highlight ALL the costs and risks involved, both long- and short-term. To stave off potential conflicts of interest and mitigate the risks of possible participant litigation, document all processes and decisions.Non-qualified plans are becoming more prevalent and will continue to play a larger role in supplementing retirement and enhancing retention strategies. Highly compensated people simply can’t get to where they want to be at retirement age simply by contributing to a qualified plan. Key employees are hard to come by, so retention is critical. NQPs are a necessary part of any compensation package so make sure that the plans are fully understood on the corporate and participant levels.
This material was created to provide accurate and reliable information on the subjects covered, but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.Gallagher Benefit Services, Inc., a subsidiary of Arthur J. Gallagher & Co., (Gallagher) is a non-investment firm that provides employee benefit and retirement plan consulting services to employers. Securities may be offered through Kestra Investment Services, LLC, (Kestra IS), member FINRA/SIPC. Investment advisory services may be offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Certain appropriately licensed individuals of Gallagher are registered to offer securities through Kestra IS or investment advisory services through Kestra AS. Neither Kestra IS nor Kestra AS are affiliated with Gallagher. Neither Kestra IS, Kestra AS, Gallagher, their affiliates nor representatives provide accounting, legal or tax advice. GBS/Kestra-CD(290344)(exp072019)