The 401(k) wraparound: an attractive benefit for top executives.

The statutory yearly limit on tax-deferred contributions to a 401(k) plan is $8,475--not much for a highly compensated executive. That maximum contribution is even less at companies where lower-paid employees contribute too little to the pension plan, triggering federal nondiscrimination rules. This can have a devastating impact on the efforts of a company to recruit and retain the best top executives.

However, there is a compensation package that overcomes the shortcomings of a 401(k): the 401(k) wraparound, a salary-deferral plan tailored to a company's special needs.

[As an alternative, a company can establish a supplemental executive retirement plan (SERP). Such a plan, however, can only provide extra pension benefits. A 401(k) wraparound gives the employee the option of using the funds as an additional pension, as a savings plan or as both. For more information on how SERPs work, see JofA, Nov. 90, pages 94-99.]

Here's how a large West Coast manufacturer designed its 401(k) wraparound: The company's board of directors identified 35 key executives as plan participants. The company placed no limit on how much the participants could defer, and it agreed to match the deferrals at $.50 on the dollar, up to 10% of annual income. To discourage top management turnover, a seven-year vesting period was imposed. The company guaranteed a return on the deferred income based on Moody's bond index; depending on company results, the bonus could be as much as 5% above the index.

DISCRIMINATION ALLOWED

In short, the company broke through every limitation on 401(k) plans imposed by the Employee Retirement Income Security Act (ERISA). This was possible because a 401(k) wraparound is a nonqualified benefit plan, not subject to the provisions of ERISA--and, as a result, not protected by it either.

Although the employees face some risk, since the deferred income is not secured as it would be in a qualified plan, there are offsetting benefits:

* Discrimination allowed. The employer can pick and choose who is eligible for the plan. The president of one subsidiary may be included, while another top executive, for whatever reason, can be excluded. In addition, directors can participate in the plan.

* No limit on salary deferral. Deferrals for wraparound plans are usually between 10% and 15%, but an executive may defer much more.

* Flexibly scheduled payouts. The Internal Revenue Service requires only that the payout be specified in advance and occur after a "substantial passage of time." Thus, one executive can begin receiving deferred income as family college expenses begin to mount while another may opt to wait until reaching normal retirement.

Because these plans are so flexible, they often are difficult to draft and administer. Nearly every aspect of the plan--percentage eligible for deferral, amount matched by the corporation, vesting period and payout policy--is subject to negotiation between each individual in the plan and the company.

CONSTRUCTIVE RECEIPT 

Such flexibility presents some problems, however, because an incorrectly structured plan can run afoul of IRS requirements. For example, the IRS requires participants who want to void taxes on deferred income to decide how much money to set aside before "constructive receipt" of the funds. For the most part, that means they must indicate before the end of each plan year how much they want to defer in the coming year.

The sponsoring employer also has to ensure the payout of funds occurs only according to the agreed-on schedule. In poorly run plans, individuals have been known to simply go to the human resources department and ask for, say, $10,000 of their deferred compensation. If a company allows that much flexibility, the plan is sure to run into serious trouble with the IRS.

For all these reasons, careful attention should be given to selecting a plan administrator, which will not only draft the plan but also be responsible for annual reporting activities, both to participants and for accounting purposes. The administrator should specialize in nonqualified deferred compensation plans, with CPAs, attorneys and actuaries on staff.

THE DRAWBACKS

A company considering a 401(k) wraparound also should be aware of its drawbacks. Whether the company actually sets aside the cash to pay the deferred compensation, the plans are considered to be "unfunded." This means deferred dollars remain in the control of the employer; in a qualified 401(k), the funds are in an ERISA trust.

While this financial freedom has a salutary effect on the company's cash flow statements, it also means that in the event of bankruptcy, the company's general creditors have as much right to the money as the plan's participants. Furthermore, if there is a change of corporate control, or even a change of heart on the part of management, the executives might have difficulty collecting their deferred compensation.

A company can offer participants some security against such changes. To ensure participants' confidence, a corporation should back up its promises by putting the cash aside. Using pay-as-you-go methods or relying on unsecured financial investments to fund the benefit, while more convenient for the company, could create morale problems among participants because it would arouse their suspicions about the safety of the money.

On the other hand, sound investments such as municipal bonds or fully funded corporate-owned life insurance are excellent funding mechanism because they build up tax-free cash on the balance sheet.

Another way companies can ensure employees the money will be available is to set it aside in a trust designed specifically for that purpose, the most common of which is the rabbi trust. Once placed in this grantor trust, the corporation can legally use the money only to pay for the prescribed benefit--except in the event of bankruptcy, when creditors also can reach into the trust.

Protecting the interests of participants in the event of bankruptcy can be achieved though various methods (see the sidebar above).

CORPORATE CHALLENGE

Participants enjoy the same preferential tax treatment in a wraparound as they do in a qualified 401(k); not so the employer corporation. Funds set aside by the company for deferred compensation cannot be expensed, for tax purposes, until the payout is made. Moreover, if the funds are invested in taxable vehicles, the accumulated interest is taxed.

But there are strategies to eliminate the ongoing impact of the interest expense on the company's profit and loss statement. Through the use of a rabbi trust and some carefully structured investments, the company can reduce or eliminate the interest impact. If a plan participant is relying on investment returns from assets held in the rabbi trust, the sponsoring employer need only book a liability for the deferred compensation itself. The interest would not be recorded as a corporate asset, nor would the interest payable to the executive be booked as a liability of the corporation.

For corporations that need to offer top executives a pension or savings plan more attractive than a 401(k), the 401(k) wraparound is an excellent vehicle.