Small business discovers nonqualified pensions - supplemental retirement plans - Small Business Financial Advisor

Nation's Business, Sept, 1995 by Mary Rowland

Because regulatory changes keep whittling away at the amount of money that can be contributed to retirement plans and keep burdening companies with complex requirements, more employers are turning to supplemental plans, also called "nonqualified plans," where they can largely make their own rules.

Why Companies Set Up Nonqualified Retirement Plans

  Replace     Retain        Enable       Provide      Attract
benefits lost  key        participants   benefits    middle-
 as a result employees     to defer based on         to late-
  of lower                  tax on      bonuses       career
government               compensation   or awards   employees
   limits
   69%         35%          19%           16%         14%

Results of survey responses from 374 companies that were asked to name their top two objectives in setting up a nonqualified plan.

SOURCE: FOSTER HIGGINS

Such plans were begun 25 years ago at large companies, and now "the concept of providing supplemental pension benefits is sneaking down into smaller plans," says G. Patrick Byrnes, president of Actuarial Consultants Inc., in Torrance, Calif.

Traditional pension plans are called qualified plans because the employer qualifies for a tax deduction for contributions made. In exchange for the deduction, the government makes the rules, including how much can be contributed to the plan for each employee, how much can be paid out in annual benefits, and how the plan must be tested to make certain it does not discriminate against lower-paid workers.

Over the past decade, qualified plans have been a congressional target because tax-deductible contributions are viewed as a major source of lost tax revenue. At least a dozen pieces of legislation provide new limits and rules for these plans.

Employers have responded by setting up their own retirement plans that are outside the purview of the government. These plans, which are called nonqualified plans because they get no immediate tax deduction, can operate in any manner the employer chooses. They can include only a handful of people. They can give each participant a different benefit amount. They can be used as recruiting tools.

"One employee could get 20 percent of salary and another 3 percent," says Ethan Kra, chief actuary for retirement services at William M. Mercer Inc., benefits consultants in New York. "The benefit could be based on a performance rating, or length of service, or the profitability of your territory."

For participants, the biggest drawback to nonqualified plans is the lack of benefit security. The benefit cannot be funded by setting up accounts in the names of plan participants. If participants are given ownership of the funds that will pay their future benefit, the Internal Revenue Service maintains that such funds are currently taxable to the employee.

As a result, a nonqualified plan merely represents the company's promise to pay a benefit. That promise could be canceled in the event of bankruptcy, a change in management, or simply a change in management's opinion of the employee.

A recent survey by the Foster Higgins consulting firm found that 61 percent fund their nonqualified plans on a pay-as-you-go basis. This approach assumes that future growth of the business will cover the benefit obligations. Most of the other plans are funded either through a "rabbi trust"--so named because the first one was set up for a rabbi in Baltimore--or through company-owned life insurance.

The insecurity of a nonqualified plan's benefits is a particular concern for small companies. "With a small organization where bankruptcy might be a daily concern, a contractual promise without assets set aside could be somewhat scary," says Bob Romanchek, an executive-compensation consultant at Hewitt Associates, benefits consultants based in Lincolnshire, Ill.

Yet a 1993 tax law change forced many more small companies to consider nonqualified plans. The new law reduced to $150,000 in 1994 from $235,840 in 1993 the amount of annual compensation that can be considered for calculating pension benefits. The $150,000 figure is the cap for an employee at age 65. It must be reduced for younger employees to project a salary of $150,000 at age 65.

This change also had a devastating impact on 401(k) because of the nondiscrimination tests they must pass. For purposes of this test, highly compensated workers are considered to be those who make more than $66,000 a year.

To perform the test, the employer must group all the lower-paid workers and calculate their average 401(k) contribution; higher-paid workers are grouped separately for calculation of their average contribution. If the average for lower-paid workers is 4 percent of salary, for example, then the higher-paid group can contribute no more than 6 percent. For a worker earning $66,000, that is $3,960.

This change affected smaller companies more than larger companies because they have fewer employees to include in the test. Many small companies responded by setting up nonqualified "excess plans" to replace retirement-plan benefits lost because of the 1993 tax-law changes.