Nonqualified Plans - To Fund or Not to Fund A Case Study of the Ross Stores NQDC 19th Annual TMA Conference November 17, 1998 Orlando, Florida

Transcription

1 Nonqualified Plans - To Fund or Not to Fund A Case Study of the Ross Stores NQDC 19th Annual TMA Conference November 17, 1998 Orlando, Florida Ms. Linda Ruiz-Zaiko Phone: Fax: Website: Mr. Berne Scalisi Director of Risk & Benefits Ross Stores, Inc. Phone: Fax: Mr. James Marsh Pension Consultant Phone: rfp@bridgebay.com

2 Nonqualified Deferred Compensation Plan (NQDC) Employer retirement, savings, or other deferred compensation arrangement Not satisfy the Internal Revenue Service (IRS) requirements for qualified plans Employer makes an unsecured promise to pay an employee compensation in a future tax year. Provides equal or greater benefits to a unique group of highly compensated employees or executives Can be tailored to meet strategic corporate objectives and supplement key executive's retirement needs

3 Nonqualified Deferred Compensation Plan (NQDC) NQDC plan is excluded from complicated and expensive nondiscrimination testing NQDC maintains its tax deferral status by avoiding three principal tax situations as defined by the IRS Doctrine of constructive receipt Economic benefit theory Section 83 of the IRS Code.

4 Key Employees Face Special Retirement Challenges Restrictive pension regulations limit retirement benefits to executives Qualified plans cap eligible compensation at $160,000 limit regardless of actual pay Plan sponsors reduce HCE pre-tax contributions so 401(k) plans pass discrimination tests Often HCE do not participate in 401(k) plans Increase penalties assessed on qualified plan distributions HCE receive lower proportionate Social Security retirement benefits

5 Qualified Plans Subject to Limitations and Penalties IRC Section 415 limitation on annual additions to participant's account Qualified plans prohibited from basing benefits/contributions on compensation >$160,000/year Salary reduction contributions to 401(k) plans are limited to $10,000 HCE limited in the amount of contributions by the 401(k)/401(m) nondiscrimination tests. Qualified plan costs have skyrocketed due to number and complexity of tests

6 Nonqualified Deferred Compensation (NQDC) An excess contribution retirement plan for a select group of the highly compensated employees (HCE) Pre tax employee contributions can be combined with Employer match Profit sharing monies Amounts are arbitrary by individual The NQDC can be stand-alone integrated with the 401 (k) IRS Private Letter Ruling on integrated structure Deferral of payouts can be to age 65 or as short a period as 5 years

7 NQDC Plan Assets Assets of the NQDC plan in grantor trusts Owned by the employer, subject to creditor calls in the event of bankruptcy, substantial risk of forfeiture requirement fulfilled Or owned by the employee, right of nonforfeiture Investment option lineup can include Self-directed brokerage accounts Mutual funds, collective bank trusts Asset allocation funds The Mirror investments of 401 (k) plan There is no federal reporting except DOL "notice"

8 Most NQDC Plans Are Turnkey or Full Service Provide operational assistance, education, counselling Provide documents, administration, recordkeeping and investments Plan operation for the participant similar to 401(k) features Quarterly statements, 800#, internet access Multiple investment options, asset allocation, self-directed brokerage Employer matching contributions

9 Funded NQDC Secular Trust - Post-Tax Money Post-tax, all contributions into plan have already been taxed Employee has trigger mechanism to get his money No substantial risk of forfeiture No employer ownership of asset Deferred compensation earnings in account taxed Employee pays taxes on earnings annually Most common agreement Letter from employee States that employee defers receipt of bonus this year to a future period

10 Funded NQDC Secular Trust Participant has nonforfeitable right to contributions made to trust Contributions generally included in participant's income Taxed in year contributions made to trust

11 Unfunded NQDC Rabbi Trust - Pre-Tax Money Pre-tax, all contributions into plan not taxed until distributed Employee pays taxes on amounts distributed at later date Employee does not have access to the money All plan assets are owned by the employer and revert back to corporation after benefits are paid Substantial risk of forfeiture In bankruptcy, employee becomes general creditor of the company In takeover, merger or change of control plan assets are protected for the employee

12 Unfunded NQDC Rabbi Trust - Pre-Tax Money Grantor trust addresses constructive receipt doctrine Corporation takes tax deduction on distributed amounts, not amounts contributed Trust assets taxable to corporation Company pays taxes on earnings annually at current corporate income tax Assets revert back to corporation after benefits are paid

13 Model NQDC Most Advantageous Plan Top Hat, pre-tax, Rabbi trust Unfunded supplemental pension plan For less than 10% of your total employee group Eligibility is arbitrary by class or position, title or compensation level or combination of all three Employer expenses deductions for contributions Both employer and employee deferrals Employee taxed when benefits are withdrawn Employer pays corporate income tax on plan earnings Employer takes expense deduction at benefit payout time

14 NQDC Employer Owned Plan Assets Assets at risk in the event of bankruptcy. Also creates substantial risk of forfeiture requirement. Rabbi Trust Full service program includes documents, administration, investments and education. Eligibility includes a select group of the highly compensated (HCE) creating a Top Hat plan. This group is probably 5% of less of the total employee group Investment funds include self directed, mutual funds, asset allocation funds and institutional managers. Minimal Federal reporting Employer pays current corporate income tax on plan "earnings". Rabbi Trust Arms length arrangement guards against employer use, corporate takeover and constructive receipt. Pension Consultant Pre-tax employee deferrals and employer contributions directed to trust Payout held off for 5 years or longer Principal and interest (earnings) paid to participant and taken as business expense deduction by employer at time of payout.

15 Investment Choices Available for Secular or Rabbi Trusts Cash funding - low cost, efficient, liquid, optimal returns Mutual and commingled funds, collective trusts Self-directed brokerage - control issues Variable annuities Costly, redundant tax deferral features, less efficient, less liquidity Corporate Owned Life Insurance (COLI) Costly, illiquid, not all qualify, underwriter risk Can incorporate pre-tax estate planning life insurance if participants young, healthy, insurable and cost not paramount to overall plan

16 Ross Stores, Inc. "Dress for Less" Retail, discount clothing store headquartered Newark, CA Process 35,000 W-4s annually 400 stores located in 40 states 6,000 employees on benefits, 4,000 participants High percentage of young, hourly, part-time employees 250 HCE eligible for the NQDC Over $40MM in 401(k) assets NQDC deferrals up to 100% of compensation Over $25MM in NQDC plan

17 The Problem HCE 401(k) contributions were capped at <5% of eligible compensation annually 401(k) plan testing was frequent with annual contribution cutbacks for HCE Total 500 HCE - half eligible for NQDC NQDC eligibility <1% of total employee group

18 The Interim Solution Create NQDC that allows eligible HCE to contribute up to 100% of earned income from employer HCE can still participate in the 401(k) plan although less meaningful Testing was still required HCE HCE not eligible for NQDC still had contribution cutbacks

19 The Ultimate Solution Design an integrated NQDC/401(k) plan NQDC plan mirrors the 401(k) plan Similar investment options - mutual funds Employer match is identical Utilize eligibility rules Self-directed brokerage attracts 25% of plan assets Education and communication for both plans integrated Private Letter Ruling took several years to be approved Both plans administered by the same bundled provider

20 How the Private Letter Ruling Works Establish an unfunded NQDC plan (top-hat) Calendar year is plan year for both plans Top-hat plan designed with similar benefits and employer match to HCE as 401(k) plan Only members of select group of HCE are eligible to participate in top-hat plan Eligibility determined by salary, position, title Annually HCE complete salary reduction agreement Total percentage of compensation to top-hat Make an irrevocable election to contribute to the NQDC

21 Pre-Tax Integrated Non Qualified Deferred Compensation HCE Contributions NHCE Contributions NQDC Plan 415 & 402g Excess ADP/ACP Test Limits Annual Test 12/31 401(k) Plan Recharacterization for HCE Contributions by 1/31 ADP/ACP Test Limits

22 Testing of Integrated 401(k)/NQDC Plans The employer performs ADP and ACP tests by December 31 By January 31 contribution distributed to 401(k) plan Determine maximum elective deferrals for HCEs to 401(k) plan by testing One time contribution and matches to 401(k) Earnings on elective deferrals and matching contributions remain in the NQDC

23 Private Letter Ruling Innovative Plan Design Valuable administrative benefits for the integrated 401(k) and NQDC Plans 401(k) Plan benefits from: Only one test per year No capping and recapping the HCE No refunds No test failures No guess work on savings amount for HCEs

24 Summary