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Efforts to Toughen Deferred Comp Plan Laws Creating Compliance Concerns for Employees
08/03/04
By: Karen Lee, Employee Benefit News
Three years after retirement plan shenanigans helped ruin Enron, the effects are still being felt, and not just in a federal courtroom.
The Enron debacle prompted a stealth effort in Congress to revamp the rules of non-qualified deferred compensation (NQDC) plans. The effort is seen not only as an attempt to correct the system that allowed Enron executives to make millions of dollars while rank-and-file employees lost their accumulated retirement savings, but also as a means to raise money to offset other business tax breaks.
Both the House and Senate have passed bills that would impose new restrictions on NQDC plans and, at press time, were expected to try to hash out their differences in a conference committee. Observers predict some version of the legislation, including the deferred compensation provisions, will be signed into law.
That could mean some hardship for employers, and experts believe they should start preparing now for that eventuality.
"The bills aren't that far apart," says Lynn Dudley, vice president and senior counsel for the American Benefits Council (ABC). "Employers are probably in the process of writing their deferral elections, and they might want to account for the [proposed] changes. Some [employers] are putting asterisks in [the elections] saying they might have to redo this. Others are holding up to see what happens. But if you are considering wholesale changes, you can't wait."
The problem is, there may not be much employers and the executives who participate in these plans can do right now. Not only would plans' rules on taxation, elections and payments have to be amended, but as the bills are written, there would be almost no time to do so before the next plan year.
That, among other things, has aroused opposition among retirement and compensation experts.
Beyond necessary
Non-qualified deferred compensation plans historically have been thought to pertain solely to a few high-level, highly compensated executives. A privately owned company might use a long-term incentive plan, while a publicly traded firm might offer mostly stock.
However, according to the ERISA Industry Committee (ERIC), the programs are being used increasingly for middle management employees as well as top executives, despite its bad public rap. Paul Dorf, managing director of Compensation Resources, acknowledges that some people see deferred compensation plans as "a way for senior executives to hide money.
"For the most part, though, they are legitimate means for companies to provide an additional return in benefits that are not necessarily allowed under ERISA," Dorf continues, citing supplemental executive retirement plans (SERPs) as an example. "Companies also use deferred compensation to provide an extra handcuff for executives."
The proposed rules, though, will change the way NQDC plans are structured, and not for the better, many observers contend.
"Undue burden"
Letters from both ERIC and the American Bar Association's taxation section to committee chairmen have expressed concern over what officials in both groups see as undue burdens on employers and employees. These include an extremely broad definition of what an NQDC plan is; investment restrictions that tie the compensation plan to the qualified retirement plan with the smallest number of investment options; rules that force participants to make their deferral elections much sooner than they would otherwise; and an effective date that makes it almost impossible to put those changes in place.
Such restrictions, wrote ERIC President Mark J. Ugoretz in his May 3 letter, "have gone much too far - and well beyond what is necessary to curb potential abuse."
Major revamping
Retirement and compensation experts agree that the legislation, if passed, will result in a wholesale adjustment of deferred compensation plans that may end up penalizing employers and participants.
For instance, deferral elections, which currently can be made any time before payment starts, under the bills would have to be made during the year before services are performed. So, an employee participating in a long-term incentive plan that lasts four years would have to make his election a year before that program even begins.
Moreover, distributions would only be permitted in the event of disability, retirement, death, a change in ownership as defined by the IRS or an unforeseeable emergency, also as stipulated by the IRS. Under the current rules, explains ERIC Legislative Counsel Vanessa Scott, an executive who gets his hands on the money before the agreed date is subject to a 10% "haircut" - a penalty on early withdrawals. However, she says, the new rules are more specific and the penalties stiffer, and any violation means all participants in the plan would be taxed, even if only one person commits the transgression.
Impact on stock options
It also will be hard to tell exactly who these rules will affect because the bills' definition of a deferred compensation plan is so broad, says Stuart Lewis, an attorney who is chairman of the tax section and the employee benefits group at the firm of Buchanan Ingersoll. The bills' definition of such a plan may include not just formal deferred compensation programs, but also plans that are built into individual executive contracts, stock appreciation rights plans and even stock option plans.
"Employers have to decide what they want to do with these plans," Lewis explains. "They can freeze the plans, or they can amend their old plans or they can cap them off and start new ones. But most of these are not unilateral; employers may not be able to amend their plans without their executives' consents."
Effective preparations
Employers will need to figure this out as soon as they can, because the bills' compliance dates could strand them with plans that already are in violation of the new rules. Passage is not expected until fall, which leaves employers no time to revise their plans before the next plan year, when the Senate's version would take effect.
The House's bill includes an even more onerous effective date, although some believe legislators might be amenable to changing it. In his letter to Senate and House committee leaders, Richard Shaw, the chairman of the ABA's taxation section, points out that the provisions, which apply to amounts deferred after June 3, 2004, is "unfair as a matter of tax policy."
"Systems and administrative changes that would be required to accommodate a June 3 effective date will require a long lead time to implement and substantiate expenditures, yet with the uncertainty of passage of the new rules, many companies likely will be reluctant to commit the resources needed to implement the changes," Shaw writes, suggesting that Jan. 1, 2006 would be a more reasonable effective date.
Certainly, employers are not happy, according to David Wray, president of the Profit Sharing/401(k) Council of America (PSCA). However, he notes, many are "accepting that there will be changes. They just want a bill that can be enacted in a way that can be administratively managed."
To that end, employers should do a few things in preparation, writes Richard L. Menson, a partner in the law firm McGuire Woods, in PSCA's compliance newsletter. They should:
* Identify which plans would be subject to the new rules. Because so few types are excluded from the legislation, start by figuring out whether you have excluded plans.
* Review the terms of each plan. In particular, look at terms such as the timing of initial deferral elections, the timing of the distributions, investment alternatives and the definition of disability.
* Consider all the compliance alternatives to a non-complying plan. These may include prohibiting additional deferrals of amounts earned after the effective date and eliminating provisions that allow employee elections, substituting an employer decision.
* Develop an implementation strategy. Amendments should be prepared, adopted and communicated to employees before the effective date.
* Continue to monitor developments.
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