Nonqualified Deferred Compensation Plans

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1 RETIREMENT & BENEFIT PLAN SERVICES Workplace Insights Nonqualified Deferred Compensation Plans Working today for tomorrow s benefits In the competitive landscape for top talent, nonqualified deferred compensation (NQDC) plans can be one of the most valuable assets in a company s benefits package. The unique features of these plans help participants manage their tax liability, close the retirement savings gaps caused by contribution limits on 401(k)s and other qualified retirement plans, and save for financial goals other than retirement. These advantages in turn can help companies attract, retain and reward a select group of key managers or other highly compensated employees. But maximizing the benefits of an NQDC plan requires plan sponsors and participants to understand the role of deferred compensation: not as a stand-alone program, but as part of an integrated, comprehensive compensation and benefits package. Plan sponsors should design NQDC plans that complement other benefits programs including 401(k)s, defined benefit plans, company stock awards and health benefits to help the company and its key personnel meet specific objectives. Likewise, participants should make decisions about their deferred compensation based on goals for overall financial wellness, which includes considerations of their current income needs, tax exposure, retirement savings strategies and financial goals. NQDC plans are only appropriate for companies that are financially secure. These plans are incredibly flexible, allowing sponsors to customize plans to help meet their companies and participants financial objectives. This paper outlines several plan design and program management strategies that can help your organization get the most out of this powerful financial tool. baml.com/workplaceinsights Bank of America Merrill Lynch is a marketing name for the Retirement Services business of Bank of America Corporation ( BofA Corp. ). Banking activities may be performed by wholly owned banking affiliates of BofA Corp., including Bank of America, N.A., member FDIC. Brokerage services may be performed by wholly owned brokerage affiliates of BofA Corp., including Merrill Lynch, Pierce, Fenner & Smith Incorporated ( MLPF&S ), a registered broker-dealer and member SIPC. See last page for important information. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Table of contents Integrating NQDC into a benefits strategy... 2 Choosing an NQDC recordkeeping system... 5 Helping improve financial wellness... 6 Current benefits, future rewards... 7 NQDC plans provide important support for financial wellness for certain employees, particularly highly compensated executives. The plans, offered as part of an integrated suite of benefits, provide unique flexibility to save for both short-term goals and long-term goals while managing taxes and other considerations. The value NQDC plans bring makes them valuable for employers looking to attract and retain key employees. Margie Feola, Director; Product Management Executive To read our latest insights go to baml.com/workplaceinsights.

2 NONQUALIFIED DEFERRED COMPENSATION PLANS 2 Integrating NQDC into a benefits strategy Employers typically implement NQDC plans to achieve a specific business goal. For example, many companies looking to recruit top talent incorporate deferred compensation plans to make their benefits packages more attractive. Others use deferred compensation to retain key managers or to provide incentives for meeting performance goals. Deferred compensation works well in a wide range of circumstances in part because NQDC plans, unlike qualified Employers have a variety of goals in mind when considering a nonqualified plan. To have a compensation program that is competitive with peer companies To retain executives To allow executives to accumulate assets for their financial planning needs To attract executives To compensate executives in a more tax-efficient manner To increase stock ownership of the firm by eligible executives Critical Very important Why offer NQDC plans? 35% 28% 27% 23% 18% 46% 52% 25% 25% 47% 49% 56% Somewhat important 26% 24% 46% 16% 21% 13% Not important The Newport Group, Executive Benefits: A Survey of Current Trends, 2014/2015 Edition. retirement programs, are not subject to most ERISA requirements. That means employers have considerable leeway and discretion in deciding: Which select groups of management or highly compensated employees (HCEs) are allowed to participate What types of compensation participants can defer, including salary, bonuses, commissions and restricted stock units When and how participants can take distributions, such as only upon retirement or while still employed, or as a lump sum or in installments To design a plan that meets your company s needs and remains an attractive benefit for participants, start by determining where NQDC fits in with your overall compensation and benefits strategy. For example, here is how you might design a plan to help meet the following four common goals: 1. Helping close the retirement gap Annual contribution limits on 401(k)s and other qualified plans mean that highly paid workers can t defer enough in those accounts to reach the recommended 80% 90% income-replacement level for retirement. Deferred compensation allows participants to contribute much larger sums each year in order to close that gap. You also can help participants meet their retirement savings goals by making employer contributions to participants accounts a feature about 50% of plan sponsors currently offer. 1 One idea is to mirror the matching structure of your 401(k) plan, such as contributing $0.50 for each dollar of deferred compensation up to 6% of the participant s salary. Or, for more flexibility, write plan rules to say that the company may choose to provide a contribution at any time.

3 NONQUALIFIED DEFERRED COMPENSATION PLANS 3 2. Recruiting top talent Including an NQDC plan in your benefits and compensation package can help you attract strong candidates for key management positions. The ability to defer compensation for goals other than retirement is one of the most attractive features of this benefit, so designing a plan that allows in-service distributions can make your offer more competitive. The specified date of in-service distributions, combined with a choice for either lump-sum or annual installment payments, provides greater flexibility for participants to save for goals such as a child s college education. 3. Retaining key management Employers can use their NQDC plans as retention tools by adding a vesting schedule for some employer contributions and paying the employer contributions when employees leave the company. For example, you can make a deferred contribution as part of a signing bonus for a new key manager but require him or her to stay with the company for five years to allow the funds to vest. Alternatively, consider a rolling bonus strategy for long-term retention such as making annual contributions that won t vest for at least three years. That way, any year the participant thinks of leaving the company, he or she will have to consider walking away from a deferred bonus. 4. Equalizing benefits among select members of management You can target a plan specifically to highly compensated employees or key members of management who are otherwise shut out from other benefits or compensation programs. This strategic use of deferred compensation can make your overall benefits strategy equitable without having to offer the same programs to all managers. For example, a privately held company may wish to offer deferred compensation to eligible participants who don t receive a stake in the company. Or if your company has a frozen defined benefit plan, an NQDC plan can be offered to key employees who joined the company too recently to be eligible for such a plan. Besides reviewing goals for the plan, your plan-design process could incorporate financing strategies that make the most sense for the company s financial situation and cash flow needs. For example, one of the first issues to resolve after the plan design is solidified is whether or not to fund the plan informally. The number of eligible participants is limited to a small percentage of company employees. NQDC eligibility for employees 5% to See, e.g., Duggan v. Hobbs, 99 F.3d 307 (9th Cir. 1996) (5% coverage); Belka v. Rowe Furniture Corp., 571 F. Supp (D. Md. 1983) (4.6% coverage); DOL Adv. Op (Aug. 1, 1975) (4% coverage). To help ensure your plan remains a nonqualified top hat plan, participation must be limited to a select group of management or highly compensated employees. Employers can identify eligible employees based on a number of characteristics, including the employee s rank, position and ability to influence their compensation level. In addition, you should review the company s overall employee makeup to compare the rate of compensation and eligibility percentages. Generally, eligibility for NQDC plans is limited to 4% 5% of the company s employees a level that s been upheld by courts and federal authorities. 2

4 NONQUALIFIED DEFERRED COMPENSATION PLANS 4 The prevalence of NQDC NQDC plans are more common at larger companies. They are typically suitable for regular C corporations. They generally are not appropriate for partnerships, sole proprietorships and S corporations. 78% offer an NQDC plan 55% are considering offering a plan in the next two years The Newport Group, Executive Benefits: A Survey of Current Trends, 2014/2015 Edition. In order to satisfy the dual goals of deferring taxes and avoiding most ERISA requirements, NQDC plans must be both unfunded meaning the funds are not actually owned by participants until the distribution occurs based on plan features or their elections and maintained solely for a select group of management or highly compensated employees. The plan also should be unsecured, meaning any assets related to the NQDC plan deferrals remain corporate assets and are subject to the claims of your general creditors. Employers need to determine if they want to keep these assets available for corporate purposes or set them aside to be better prepared for benefit payments in the future. Participants have no rights to any assets other than as a general unsecured creditor. If an employer decides to set aside these deferrals, informal funding strategies, such as establishing a rabbi trust, can provide some protection for those funds. While funds in a rabbi trust are still subject to creditors in bankruptcy, the structure prevents the company from using those funds for anything other than NQDC distributions and protects the assets from a change of control at the company. A rabbi trust can be structured to hold mutual funds and/or corporate-owned life insurance, which are the most common financing strategies of NQDC plans. Work closely with your treasury department and finance and tax professionals to determine the informal financing structure that would most benefit your company. Your company s treasury department also can help you determine whether offering lump-sum payments, installments or a combination of both options is the best strategy for the plan s payout method. In addition, participants may be more attracted by monthly or annual distributions, which offer them more flexibility to manage the taxes owed on their deferred compensation. Finally, remember that the more options you offer in your plan, the more complicated the recordkeeping becomes. That s why it s essential to work with an experienced NQDC plan provider that has a recordkeeping system designed for the unique needs of a deferred compensation program (see Choosing an NQDC recordkeeping system, page 5). NQDC deferrals and any earnings have an opportunity to grow tax-deferred until withdrawal. The deferral advantage $633,632 Potential growth of NQDC deferrals over 20 years $497,581 Potential growth of after-tax contributions over 20 years Bank of America Merrill Lynch, October Figures assume a 6% annual rate of return and a 35% tax rate. This hypothetical illustration assumes contributions at the beginning of the year, a 6% annual effective rate of return, and taxes at 35%. For the nonqualified deferred compensation example, contributions are made before taxes ($25,000 per year) and taxes on both contributions and earnings are deducted at the end of the accumulation period. To reflect a fair comparison, the after-tax account assumes contributions are made after taxes are paid (i.e., $25,000 minus $8,750 for taxes = $16,250 contributed each year) and taxes are deducted on an ongoing basis from investment earnings. Changes in tax rates and tax treatment of investment earnings (e.g., lower minimum tax rates on capital gains and dividends) may impact the comparative results. In a taxable account realized capital losses may potentially be used to offset realized capital gains, offset earned income, reduce your taxable income or offset realized gains in future years. Please consider your personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision as these may further impact the results of the comparison. Hypothetical results are for illustrative purposes only and are not meant to represent past or future performance of any specific investment vehicle. Investment return and principal value will fluctuate and when redeemed the investments may be worth more or less than their original cost.

5 NONQUALIFIED DEFERRED COMPENSATION PLANS 5 Choosing an NQDC recordkeeping system Managing all the variables involved with an NQDC plan requires careful recordkeeping. To assess whether a provider s system can meet your needs, look for the following features: 1. Robust electronic enrollment The enrollment system should make it easy for participants to set up the most important elements of their individualized plans, such as: How much compensation to defer from sources including salary, bonuses and other options When and how to take distributions (lump sum or installments) Investment benchmark selections 2. Sophisticated distribution tracking Plan sponsors need to track the details of multiple distributions for each participant, such as a participant who schedules a $40,000 distribution in five years paid in four installments, then schedules another $25,000 lump-sum distribution two years after that, and so on. 3. Integration with other retirement account information Displaying NQDC records alongside other retirement programs helps participants take a comprehensive approach to managing their benefits against their overall financial objectives. Likewise, an integrated system can help sponsors track the details of each employee s participation in multiple benefit plans. 4. Flexible reporting capabilities Customized reports can help plan sponsors accomplish tasks related to managing an NQDC program. For example, a company s treasury department might run a report of all participant distributions scheduled for the next 10 years to incorporate those costs into financial projections. Plan sponsors also could generate a daily update report during the annual deferral election period to see which eligible employees have taken action and which may need a reminder.

6 NONQUALIFIED DEFERRED COMPENSATION PLANS 6 Helping improve financial wellness After spending time carefully designing an NQDC plan to help meet specific goals, your company should be sure that eligible employees take full advantage of the program. That means working closely with participants to explain the details of the plan and the potential benefits of deferring compensation. Start by reiterating that the plan is limited to a select group of participants. When eligible employees understand that it s a unique benefit, they ll be less likely to overlook the opportunity. Then, help participants understand that NQDC is not just a retirement plan it s an extremely flexible, powerful tool to help support their overall financial wellness. Using deferred compensation to help support financial wellness means making decisions about deferrals and distributions based on a comprehensive review of employees financial considerations, including: A complete salary and benefits picture Current and future cash flow needs Short- and long-term financial goals Tax management strategies That said, NQDC plans aren t for everyone. Before participants enroll, it s important that they understand exactly how such plans work and how one might fit into their overall financial plans. NQDC plans have the potential for tax-deferred growth, but they also come with substantial risks, including the risk of complete loss of the assets in your NQDC plan. We strongly recommend executives review their NQDC opportunity with their legal or tax advisors. You can share these five ideas with your participants to explain the opportunity and help them benefit from the NQDC plan: 1. Identify goals for deferred compensation at enrollment New participants must first determine what they hope to achieve with deferred compensation. For plans that allow in-service distributions, remind participants to consider multiple goals besides retirement, including saving for children s college educations, buying a house or a boat or putting aside funds to cover an aging parent s potential health care needs. NQDC participants have the option of saving for several financial goals at the same time. $100,000 annual deferral 15% Vacation home Consider all financial goals 25% College This is a hypothetical illustration, not a recommendation or based on actual figures. Identifying these goals up front lets participants plan for distributions based on how they are likely to use the funds. Then they can divide their annual deferrals among different distribution buckets for each goal. 2. Base deferral elections on 12-month personal finance projections Participants must decide on the amount and types of compensation to defer in the year before they earn that compensation and the elections can t be changed. So encourage participants to choose their annual deferral elections after a careful examination of their income sources, cash flow needs and expected tax liability for the next year. For example, a participant who expects a large distribution of company stock in the coming year might choose to defer more salary than usual to level out taxable income. On the other hand, a participant who anticipates a big cash layout in the next year such as paying for a child s wedding might elect to defer less compensation. 3. Consider the impact on other retirement plans 60% Retirement NQDC participants can continue to maximize contributions to their 401(k) accounts. But remind them to review their 401(k) contribution rates after making their annual NQDC elections because elections for deferred compensation

7 NONQUALIFIED DEFERRED COMPENSATION PLANS 7 are removed from participants salaries before their 401(k) elections are calculated. Particularly large salary deferrals might allow them to boost the percentage of pre-tax funds they contribute to their 401(k) plans before reaching plan limits. On the other hand, large salary deferrals might decrease future benefits for employees who also participate in defined benefit programs because pensions are based on salary levels. These employees might focus on deferring bonuses, stock awards or other non-salary compensation to protect their pension benefits. 4. Keep an eye on health benefits Encourage participants to think about current health benefits and future health care expenses when planning compensation deferrals. For example, NQDC plan participants can continue making the maximum annual contribution to their Health Savings Accounts (HSA), if they also elect a High-Deductible Health Plan. Setting money aside in an HSA to cover qualified medical expenses can make employees more comfortable deferring larger percentages of their salaries. What s more, planning to use distributions from an HSA for qualified medical care in retirement can help participants gauge how much additional income they ll need from deferred compensation to cover other living expenses. 5. Consider all sources of retirement income when planning payouts Participants weighing lump-sum vs. installment distributions should analyze their anticipated tax liabilities, as well as other sources of potential income. For example, a participant who plans to retire at age 60 but delays taking Social Security or other retirement benefits until age 67 might select a seven-year annual payout to bridge the gap between retirement and supplemental income sources. Another participant might prefer to pay all deferred taxes up front by taking a lump sum, and then reinvest those funds in non-retirement accounts that can be managed directly for future income needs. Participants who retire at 60 but delay taking Social Security benefits may need an annual payout from the NQDC to bridge the gap. 60 Retirement Factor NQDC into all retirement income sources Annual payout This is a hypothetical illustration, not a recommendation or based on actual figures. 67 Social Security Current benefits, future rewards The flexibility of NQDC plans means that employers and participants have tremendous freedom to decide the best approach for their unique needs. There s no one-size-fits-all plan that every company should adopt. The appropriate plan for your business requires up-front analysis of the NQDC plan in the context of an overall compensation and benefits strategy. Likewise, participants must think carefully about deferral elections and distributions based on their overall financial pictures and future goals. Working with a qualified, experienced provider that understands how to design and service NQDC plans can help you identify an appropriate strategy. And when done properly, this up-front work can pay off for years to come. When you see participants fully utilizing the deferred compensation plan as part of their overall financial wellness strategies, you ll know you ve designed the right plan to help them and your company work towards a more secure future.

8 NONQUALIFIED DEFERRED COMPENSATION PLANS 8 A comprehensive perspective Nonqualified deferred compensation plans function most effectively as part of an integrated suite of benefits offerings possibly including defined contribution and/or defined benefit retirement plans, accounts such as HSAs and FSAs, stock purchase plans and other benefits. To make the most of NQDC plans and your benefits package as a whole, you need a provider that understands all of your firm s offerings and has the resources to help ensure that they work in concert, including robust recordkeeping capabilities and employee communications. Bank of America Merrill Lynch is one of the only providers in the market offering a comprehensive array of benefits services. Our representatives can help you examine the benefits packages you make available to employees and can talk with you about strategies that may make the packages more effective both as recruitment and retention strategies and as pillars of employees financial wellness. For more information about NQDC plans, contact your Bank of America Merrill Lynch representative. You also can call us at , visit us online at baml.com/workplaceinsights or us at benefitplans@baml.com. To read our latest insights go to baml.com/workplaceinsights. 1 The Newport Group, Executive Benefits: A Survey of Current Trends, 2014/2015 edition. 2 See, e.g., Duggan v. Hobbs, 99 F.3d 307 (9th Cir. 1996) (5% coverage); Belka v. Rowe Furniture Corp., 571 F. Supp (D. Md. 1983) (4.6% coverage); DOL Adv. Op (Aug. 1, 1975) (4% coverage). Unless otherwise noted, all trademarks and registered trademarks are the property of Bank of America Corporation. The strategies presented are intended to illustrate the products and services available through Bank of America Merrill Lynch; it should not be considered an offer, solicitation or endorsement. These illustrations may not be used with the general public under any circumstances. This material does not take into account your plan s objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any information in this material, you should consider whether it is suitable. If necessary, seek professional advice. IRS Circular 230 Disclosure: United States Treasury Regulations provide that a taxpayer may rely only on formal written advice meeting specific requirements to avoid federal tax penalties. Any tax advice in the text of this message, or in any attachment, does not meet those requirements and, accordingly, is not intended or written to be used, and cannot be used, by any recipient to avoid any penalties that may be imposed upon such recipient by the Internal Revenue Service Bank of America Corporation. All rights reserved. ARQH5XMM WP /2014