Comparing Equity Awards and Nonqualified Deferred Compensation

When using traditional equity-based compensation programs, employers are becoming more concerned about accounting impacts, stock dilution and compensation control, while employees have to consider the issues of market volatility, diversification and tax timing.  By considering nonqualified deferred compensation (NQDC) plans, employers can provide solutions that address these concerns, while still providing meaningful incentives to key performers. 

When looking at compensation designs, the employer wants to effectively incent performance while meeting both revenue and expense goals. The employee wants to be rewarded for performance while exercising some control over the amount, the timing and the taxation of compensation.

In the 1990’s, the use of stock options were more popular, especially in the high-flying technology sector. Options were “win-win” for both the employer and the employee. From an employer point of view, stock options were a cashless benefit, and employers were not required to recognize any expense on their books for the options granted at fair value. Dilution was less of a concern for other shareholders during the time of rapidly rising stock values. From an employee point of view, the stock price was always rising, ensuring a windfall upon exercise. In addition, the employee could control compensation amounts and tax timing by managing when the options were exercised. In contrast, during this time, NQDC plans were only offered by the largest companies and a typical plan design offered earnings crediting on contributions at a fixed interest rate.

That was then.

With the dot.com implosion in 2001, many stock options went “under water”, having no value to the employee. This issue resurfaced again for many other industries during the “great recession” of 2008 to 2010. Back-dating scandals brought corporate governance under the microscope. In an era of steady or declining stock prices, diversification became more of an issue for employees and dilution became a much larger concern for existing shareholders. And, to make a bad situation worse, unfavorable accounting guidelines came into place requiring companies to book compensation expense on stock options even if issued at fair value. (Ironically, the more volatile a company’s stock price is, the higher the expense that needs to be recognized at the time of grant.)  To address the accounting and market volatility issues, companies began offering other equity-based arrangements such as restricted stock and performance units. These, however, also presented similar diversification, dilution and compensation control issues.

As a result, companies began looking at other ways to accomplish corporate objectives including utilizing NQDC arrangements. NQDC plans have come a long way since the 1990s. Administrative efficiencies have brought the cost of plans down to where smaller businesses can effectively utilize them. Now NQDC recordkeeping platforms can offer a wide range of investment choices, as well the ability to set up and maintain multiple accounts with different distribution elections.

For employers, using an NQDC arrangement has several distinct advantages:

• Through the use of employer contributions, NQDC plans can offer effective incentive-based compensation designs. These contributions can be completely discretionary, allowing employers maximum flexibility in plan design.
• Not only can the company control the amount of incentives available, it can also control the vesting of these incentives. This can turn NQDC into an effective way to retain key performers as well.
• By offering company stock as an investment option (often called “phantom stock”), employers can give plan participants an equity-like experience without diluting existing shareholders.
• Well-designed NQDC plan financing can help reduce or eliminate the impact of market volatility on a company’s balance sheet and income statement.

For plan participants, NQDC plans can offer features that are equally as advantageous:

• Based on plan design, participants can diversify their “deemed” investments in the plan without incurring current taxation on their account balances.
• Plan sponsors will typically allow participants to defer compensation from their current base and bonus pay, allowing them to save additional amounts above qualified plan limits. This can help address the retirement gap experienced by highly compensated employees who will not have enough retirement income simply from Social Security and qualified plans.
• NQDC plans allow participants to choose the form of distributions made from the plan, usually in the form of a lump sum or installment payments, and distributions are not taxed until actually paid.
• NQDC plans can also allow participants to set up time-specific, in-service distribution accounts, allowing them to save on a tax-deferred basis for other purposes such as a child’s education.

As with equity-based compensation programs, NQDC plans are not for everyone. The employer does not get a current tax deduction for contributions to the plan; distributions are deductible when paid. Also, only “top-hat” employees may be covered in the plan. Under the Employee Retirement Income Security Act (ERISA), only “highly compensated or management” employees may be covered, typically including no more than 10% of the total employees in a company. And, also under ERISA, NQDC plans must be “unfunded,” with any assets financing the plan subject to company creditors in the event of bankruptcy.

Both NQDC plans and equity-based awards have their place in creating meaningful incentive packages for key employees. While equity-based awards may present employees with significant upside potential, they can also potentially act as a meaningful de-motivator for key performers if they do not appreciate in value. Equity awards may also create significant expense on an employer’s books, even if the awards decline in value or become worthless. 

NQDC arrangements can give the employer the flexibility to both reward performance and have a more predictable expense pattern. They can provide the same meaningful level of compensation and appreciation potential, while providing the opportunity for both diversification and compensation and tax timing for employees. And, given the inherent flexibility and best practices in design and administrative services, NQDC plans can support a wide variety of employers and their key employees.

Gary Dorton is vice president, Employer Solutions & Services, with the Principal Financial Group in Des Moines, Iowa.  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.