Ways to expand pension savings

Nation's Business, Oct, 1997 by Abby Livingstone

When a 1993 tax law reduced the amount that highly compensated employees could save under standard pension plans, the Berkshire Gas Co. needed to find a way for key executives to supplement their ability to save for retirement.

The board of directors of the 155-employee public utility in Pittsfield, Mass., opted to create a "nonqualified" pension plan for the company's top five executives. Nonqualified plans are those that are not subject to most federal pension-law provisions and, as a result, don't qualify for as many tax breaks as regular pension plans.

Berkshire Gas' nonqualified plan enables the five executives to make up the difference between what the law permits them to put into the company's 401(k) plan and what they want to defer, subject to the company's maximum deferral limit. While nonqualified plans are not subject to the contribution limits that apply to regular pension plans, Berkshire Gas sets a limit of 15.5 percent of income.

"We were looking for benefits to make us whole," says Michael Marrone, Berkshire Gas' treasurer and chief financial officer, who is covered under the new nonqualified plan. "We felt that the company's 401(k) plan discriminated against highly compensated employees."

And there's the rub. In 1993, Congress reduced the compensation that can be considered for calculating contributions to a qualified retirement plan from $235,840 to $150,000. (Such plans are fully subject to federal pension law.) The cap is adjusted periodically for inflation, but only in increments of $10,000. For 1997, the cap is $160,000.

The cutback reflected lawmakers' desire to ensure that pension plans not be operated primarily for the benefit of highly paid employees. The laws already contained anti-discrimination tests that limited tax-deferred contributions of the highly compensated in relation to lower-paid employees. Failure to pass these tests triggers a refund of excess contributions, which is taxed.

That's why more small companies, like Berkshire Gas, are supplementing their qualified retirement plans with nonqualified plans. Doing so enables companies to provide key executives with supplementary deferred compensation.

A Supplement On The Rise

A survey of 200 small businesses conducted by the Profit Sharing/401(k) Council of America, a Chicago trade group, found that 11.6 percent of respondents with 401(k) plans offered some additional nonqualified arrangement in 1995 the latest year for which data available. Two years earlier, only 2 percent of survey respondents offered a nonqualified plan.

"Nonqualified plans pick up where qualified plans leave off," explains Joan Vines, the national director of employee benefits and tax services in the Washington, D.C., office of the accounting firm Grant Thornton. "Companies are looking at their retirement plans to see if executives are getting their full share. If they're not, companies are providing something extra to bring them up to qualified plans, without any limitations."

Nonqualified plans give employers freedom to choose which employees to include, and they allow the employers great discretion in determining contribution amounts and vesting schedules. In addition, the plans are exempt from nondiscrimination tests, and there are no limits on how much pretax income highly compensated employees can defer into a nonqualified plan. Income from a nonqualified plan is not taxable until it is paid out to the recipient after retirement.

Beyond that, nonqualified plans typically offer investment options similar to qualified plans, such as mutual funds. They also contain hardship provisions that outline when funds can be withdrawn.

The biggest drawback for employers is that the company does not get a tax deduction for any contributions it makes to a nonqualified plan until the employee receives the benefit. At the same time, the company has to claim as income any earnings on assets put into the plan.

"Initially, it's a double negative," says Rob Vetere, vice president of Diversified Investment Advisors, an investment advisory finn in Purchase, N.Y, that specializes in retirement plans.

Potential Downsides

For employees, there are two major types of risks associated with nonqualified plans. One is the possibility that the company could not pay benefits if it went bankrupt. By law, money in a nonqualified plan is subject to the claims of the company's general creditors. If the company goes under, the employee becomes just another creditor.

The other risk is whether the company will remain willing to pay benefits. Executives might need assurance that future generations of managers will honor the retirement plans.

To make good on their promises to pay, many companies finance their nonqualified plans with variable life-insurance policies or mutual funds, or they set up a "rabbi trust" (so named because the first was established for a Baltimore rabbi).

With a variable life-insurance policy, the business takes out policies on the lives of the top executives. The investment grows without being taxed. When it's time to pay benefits, the company may withdraw the money from the individual policies piece-meal or cash them in.