Deferred compensation plans, long flying under the radar screen of the Internal Revenue Service, have recently been thrust into the spotlight thanks to the financial difficulties at major airlines, Enron, WorldCom and the like. While these companies pleaded poverty, they were discreetly funding a trust for their Supplemental Executive Retirement Plans, which had until then gone unfunded.

Bill Peartree

Recent headlines have drawn concern about controversial supplemental plans for senior executives at corporations experiencing financial troubles. The Bush Administration's tax proposal, federal legislation and Congressional reports all indicate that regulations for deferred compensation plans must be tightened to thwart participants from having too much control. Legislation appears likely to pass that will mandate changes in plan design. While Congress never intended a deferred compensation plan to be disguised as a 401(k), over the years they have taken on a similar complexion to that of a 401(k), without being subject to the same rules.

The popularity of deferred compensation plans increased dramatically in the 1990s in the wake of 401(k) contribution limits for highly paid executives. If you recruit a key executive in their late 40s or early 50s, you hope you are able to get a good 10 years or more, and there is only so much that executive is able to accumulate in a 401(k). Because of the limitations in a qualified plan like a 401(k) plan, many companies turn to the nonqualified deferred compensation plan.

For those companies that have actually funded or partially funded their deferred compensation plan, the most common funding is corporate-owned life insurance (COLI) policies on executive lives bought by an employer and naming itself as the beneficiary. If the executive passes away prior to retirement, a portion of the death benefit can be used to fund a lump-sum payment to his or her estate. If the executive lives to retirement, the company will have the option of withdrawing (or borrowing) from the cash value of the policy or putting up the money from cash flow and recouping its cost from the policy death benefit when the executive dies.

For the executive, a deferred compensation plan is an opportunity to defer compensation in excess of qualified retirement plan limits on a pre-tax basis. There are no limits, unless imposed by the company, on the amount an executive can contribute, and the earnings accumulate tax deferred.

For the company, the deferred compensation plan solves a problem by providing valuable key employees the opportunity to save for retirement on a pre-tax basis in excess of qualified retirement plan limitations. The company can make both discretionary and discriminatory incentive contributions to recruit, retain and reward valuable key employees. The plan is simple to administer and requires no discrimination testing or 5500 filing, if set up properly.

The simplicity of the plan is perhaps the crux of why the House and the Senate aretaking a closer look at enacting legislation addressing the potential abuses of deferred compensation plans. Under the House bill, new regulations would force much stricter criteria in order for executives to avoid balances being taxable. While the House and Senate took different routes in 2002, it appears the two sides are converging.

Since 1978 there has been a section of the law limiting the ability of the Treasury and the IRS to regulate these plans. If anything, it is expected that this section will be repealed. Congress will be faced with writing new rules for itself, leaving it up to the Treasury to determine the rules or doing some combination.

In addition, Congress may make it more difficult for executives to take money out of deferred compensation plans while still working for the employer, on top of reversing the investment control the key executive has with the plan. Some feel that participants have too much investment control in deferred compensation plans, which could violate the constructive receipt guidelines.

If the rules are tightened, plan sponsors might have to choose how and where money is invested. After all, the money is considered a corporate asset and is subject to creditors.

Short of Congress doing anything too drastic, there should not be overwhelming hurdles for most plans. Instead of seeing more or less of these plans, we would see the tapering of certain designs. The crackdown will come on the plans that have pushed the envelope and remain on the aggressive end of the spectrum.

Peartree is the director of retirement services in Barney & Barney's Employee Benefits Department. For information, call (858) 550-4978 or e-mail billp@barneyandbarney.com.