The real cost of nonqualified deferred compensation plans.

With the reduction in the 401 (a) (17) limit on compensation to $150,000 for 1994, many 401(k) plans are finding it difficult to pass their actual deferral percentage (ADP) tests, which are designed to spot discrimination in favor of highly compensated employees. One solution has been to enroll highly compensated employees in nonqualified plans, variously called top-hat plans or excess-only 401(k) plans. But there is a price to be paid for such a move, and Robert J. Dema, CPA, president of CPI Qualified Plan Consultants, Great Bend, Kansas, and Kyle C. Frazier, CPI's pension administration supervisor, discuss those costs below.

A top-hat plan is a nonqualified deferred compensation plan that lets highly compensated employees defer taxes on pay and any employer-matching funds. Investments usually parallel those in the employer's 401(k) plan. Many pension advisers recommend that employers remove highly paid employees from their 401(k) plans to prevent the plans from failing the ADP test or to avoid the need for testing at all. But most companies don't realize that although this approach solves the test problem, it is expensive.

The first four columns in exhibit 1, page 87, show what happens to the pension account of an employee who opts for a nonqualified plan rather than the company's 401(k) plan. So that the employee does not suffer financially, the account is credited with full earnings without any reduction for taxes. In this case, the employee defers $8,000 of compensation and a $2,000 employer matching contribution, which are invested to earn 8% a year. At the end of 20 years, the fund accumulates $457,620 and, considering the 8% return on the growing fund, will be paid out at the rate of $46,610 for 20 years for a total payout of $932,200.

AN EXPENSIVE MOVE

The fifth and sixth columns in exhibit 1 address the cash flow effect on the company, assuming the cost of money is 10% before taxes and 6% after taxes and the company is in a 40% top marginal federal and state tax bracket. The cumulative cost of the lost tax deduction over 40 years is $819,770, including tax on the investment account earnings.

The last three columns in exhibit 1 show how much additional salary the employer could afford to pay an employee not participating in either plan. The employee could take full salary (without deferring anything) and receive a $12,977 raise ($2,000 for the match plus $10,977--or roughly 150% of the amount of deferral not made) and the employer would be no worse off.

This model makes many assumptions about earnings growth and tax brackets and does not deal with the effect of additional Social Security taxes. However, no matter how the arrangement is looked at, the cost of nonqualified deferred compensation to the employer is staggering.

RULING OVERTURNED

Last December, the Ninth Circuit Court ruled, in Albertson's v. Commissioner, that interest appropriately credited to a nonqualified deferred compensation arrangement did not count as compensation and could be deducted currently as interest expense (see "Interest Component of Deferred Compensation Is Deductible," JofA, Feb.95, page 25). In December 1994, that court overturned the ruling. It's not clear how other federal courts will deal with this issue.

So, since Albertson's still may survive court challenges, exhibit 2, page 87, shows the same example with the Albertson's exception: The employer gets a tax deduction for any interest credited to the account of the participant in the nonqualified deferred compensation arrangement. The cost to the employer after 40 years drops to $67,142 from $819,770. While there is a more than 90% reduction in the cost to the employer, there is still a net cost. This may be the greatest argument for not reversing Albertson's: For a nonqualified plan to make any sense at all, the employer must be able to deduct the earnings that are credited to the account of the nonqualified plan participant.

Exhibit 3, above, uses the same scenario, but this time the nonqualified benefit is informally funded with tax-exempt bonds. Although this reduces the 20-year annual payout to $25,540 from $46,610, it also shifts the employer cost from $819,778 to a gain of $124,080. That is, since the employer has a gain of $124,080, it can afford to provide an additional matching contribution to the employee of about $1,753. This additional matching contribution changes the employer compound tax costs from a gain of $124,080 to about zero.

These analyses would have come out differently if the purpose had been to compare the cost to the employer of nonqualified deferred compensation with the cost of compensating the executive directly.

These analyses originally were done to support use of nonqualified plans by highly compensated employees as an alternative to participation in companies' 401(k) plans. However, this approach succeeds only if tax-exempt investments are used or if Albertson's is sustained. Although Albertson's does not keep the employer whole, it does at least get the employer close enough to justify using nonqualified deferred compensation as either a top-hat plan or in general as an executive perk.

RELATED ARTICLE: EXECUTIVE SUMMARY

* MANY PENSION ADVISERS recommend that employers remove highly compensated employees from their 401(k) plans to avoid failing the actual deferral percentage test or to avoid the need for testing at all.

* IN PLACE OF 401(k) PLANS, nonqualified plans can be offered to highly compensated employees. However, the price of such a move can be staggering.

* IN ONE EXAMPLE, an employee defers $8,000 of compensation and a $2,000 employer matching contribution, which are invested to earn 8% a year; the cumulative cost to the company over 40 years could be $819,778.

* THE EXAMPLE MAKES many assumptions about earnings growth and tax brackets and does not deal with the effect of additional Social Security taxes. However, no matter how it's looked at, the cost of non-qualified deferred compensation to the employer is very large.

EXHIBIT 1-3

[TABULAR DATA OMITTED]