Making Adjustments to Nonqualified Plans Not So Easy During Financial Crises

As the financial effects of the COVID-19 pandemic hit businesses, some may look to their retirement benefits to cut costs. Employers may consider cutting back or suspending match contributions to qualified plans as an avenue for cost savings, and those that sponsor nonqualified plans may be considering what they can do as well.

Mark West, national vice president of business solutions with Principal Financial Group in Des Moines, Iowa, says he is getting questions from some nonqualified plan sponsors about whether they can stop contributions they’ve been making. Similar to the rules for qualified plans, if the plan document says an employer contribution to a nonqualified plan is discretionary, plan sponsors may stop those, he says.

However, if a match or other employer contribution is specified as required in the plan document, nonqualified plan sponsors will have to continue to make those this year. Nonqualified plan documents may be amended but, West says, depending on what the current document says about plan amendments, plan sponsors would likely be required to continue employer contributions in 2020 and wouldn’t be able to stop them until 2021, or as permitted per the plan terms.

Mike Shannon, senior vice president of Newport’s nonqualified consulting team, further notes that while employers are required by Department of Labor (DOL) regulations to fund deferrals to a 401(k) plan as soon as is practicable, there is no obligation to contribute to a nonqualified plan’s rabbi trust or plan financing unless the plan or trust require it—typically after a change in control occurs.  Most plans do not normally require contributions, so the deferrals and matching contributions to the plan should not impose immediate cash demands on the employer. However, the company would have to contribute eventually to maintain the company’s funding target.

Regarding payments to executives of amounts from which they defer into nonqualified plans, Ruth Wimer, a partner at law firm Winston & Strawn in Washington, D.C., points to the provisions of Internal Revenue Code (IRC) Section 409A, which governs nonqualified plans. She and her colleague, Michael S. Melbinger, also a partner at the firm, have written an article about Section 409A considerations for decisions related to COVID-19.

Wimer says if a bonus was promised and the plan sponsor didn’t pay that bonus, it’s not necessarily a violation of 409A. She says it is again a question of whether the employer has a bonus plan and whether bonuses under the plan are categorized as discretionary. If the bonus plan describes a specific formula and the employer decides not to pay it, the executive could take the employer to court under state law, Wimer explains. If the bonus plan says the bonus is discretionary, the “employee is out of luck.”

“Let’s say the employer has a bonus program with a nondiscretionary formula that says, should you increase profits in any month by X% you will get a bonus in the amount of Y. And, suppose the profit target is achieved in one month, but the company is doing badly now and doesn’t have the cash to pay the bonus. Under the Section 409A short-term deferral period, if the bonus is paid by March 15 [within 2 1/2 months], there is no violation, but if it is not paid until a year later, it can be,” Wimer says. She notes that under 409A, there are specific ways employers would have to show they are unable to pay the bonus and avoid paying the employee-imposed 409A penalty.

Wimer also explains that if a bonus earned in a previous year was deferred by the employee under terms of the nonqualified plan until 2020 and the employer didn’t pay, that would be a violation of 409A.

West says his firm hasn’t seen companies being unable to pay bonuses, partly because many were paid by March 15 due to the “short-term deferral” provisions of 409A. However, if a bonus payment is supposed to be made by June 1 and the company can’t do so at that time, as long as the bonus is paid in 2020, there won’t be a 409A violation.

Nonqualified Plans As a Source of Money for Participants

West says he is also getting questions from nonqualified plan sponsors about whether participants can change their deferrals or take unscheduled distributions. He’s gotten a few questions about whether provisions of the Coronavirus Aid, Relief and Economic Security (CARES) Act also apply to nonqualified plans, and the answer is “no.”

He says many deferral elections for 2020 were made in December and these elections are irrevocable, so participants will have to continue their deferrals. However, under Section 409A, if a participant can show an unforeseeable emergency has caused a financial hardship for him, his spouse, dependent or beneficiary, he can petition the administrative committee of the plan to either cancel deferrals or get a distribution.

“You would have to show a financial impact that is detrimental to you and if the plan document includes unforeseeable emergency provisions, the administrative committee may allow you to stop contributions or get a distribution,” West explains. He says his firm is seeing more willingness to accept such requests during the pandemic.

In one situation, an executive who experienced a 10% drop in compensation was not deemed to have experienced an unforeseeable emergency that caused a financial hardship, West says. In another, an executive experienced a similar drop in compensation and his spouse had lost her job. Looking at the perspective of the participant along with that of his spouse and dependents, the committee granted the request.

West adds that administrative committees also determine how much participants can take as a distribution if all criteria is met—usually the amount to satisfy the need plus pay taxes on the distribution. Unscheduled distributions are taxable as ordinary income.

Wimer explains that it is much more difficult to get an unscheduled distribution from a nonqualified plan than it is from a qualified plan. There has to be an unforeseeable emergency, which she believes COVID-19 satisfies, but the participant also has to prove he is in dire circumstances and has bills he cannot pay because he has no assets anywhere else to pay those bills.

“For example, if a participant is used to getting a $1 million commission, but gets one-third of that now, he probably can still pay bills and has plenty of money in the bank, so he couldn’t get a distribution from his nonqualified plan,” she says. “I would not rule out the possibility of someone being able to get a distribution from his nonqualified plan, but he would have to not have assets elsewhere and have substantial bills.”

Wimer adds that no loans are allowed from nonqualified plans.

She says the rules are slightly more generous for stopping deferrals into a nonqualified plan. For example, if an executive gets a hardship withdrawal from his qualified plan, he could stop deferrals into his nonqualified plan for the rest of the year.

“The reason everyone is interested in compliance with these rules is a violation results in a 20% penalty,” Wimer notes.

If a plan fails to comply with 409A, the assets are subject to immediate income tax at the time of failure. All assets are accelerated at the same time, and a 20% additional penalty tax, plus an interest penalty on the tax that would have been paid if the participants had claimed the compensation as income when it was originally deferred, applies.

West says there is some question about participants getting access to funds from a plan that is grandfathered under rules before 409A was passed. In those plans, there is a little more flexibility. For example, he says, some plans contain what’s called a “haircut” provision—if a participant was supposed to receive $100,000, he could ask for a 15% “haircut” and currently receive $85,000 instead.  

Effects of COVID-19 on Nonqualified Plans

West points out that if a nonqualified plan sponsor decides to terminate its plan, all participants will get a distribution. However, plan sponsors are not allowed to elect to terminate their plan proximate to a downturn in the financial health of the company, so that could be a hurdle in terminating a plan now. If a plan sponsor is able to terminate its plan, participants must be paid no sooner than 12 months and within 24 months after termination and no new plans can be put into place for three years.

Further to this point, Shannon notes that furloughed and laid-off employees may not have separated from service as defined by the nonqualified plan if the employer and employee reasonably anticipate a return to service once government-mandated shelter-in-place orders expire. However, employers should be mindful that a furloughed employee may have a separation from service after six months unless the participant has a contractual or statutory right to re-employment extending beyond the six-month period. In some states, furloughed or laid–off employees may be able to collect unemployment benefits, including an additional $600 federally funded benefit. The receipt of COVID-19 unemployment benefits by a furloughed employee would not necessarily indicate that a participant has separated from service.

West has also been questioned about the effect of compensation cuts on nonqualified plan eligibility. Plans are for a select group of management or highly compensated employees. He says if an executive’s compensation drops below what is considered “highly compensated” under the plan, he is still eligible to participate this year because eligibility is based on criteria being met at the time he started participating. He may not be eligible to participate next year, however.

Plan sponsors may have a different eligible pool of employees going forward, West notes. For example, if the plan criteria is that the top 10% of employees ranked by pay are eligible to participate, not only could employees drop out of this pool because of pay cuts, but if the company has cut its workforce from, say, 500 employees to 350, fewer employees will be eligible.

West says some best practices are becoming clear. For example, most nonqualified plans are designed for the election of a percentage of compensation or bonus to be deferred rather than a flat dollar amount. “If a participant elected a $3,000 per paycheck deferral, that may be a problem—if that is now all he is making. The deferral doesn’t automatically adjust as it does when it’s a percentage of pay,” he says. “We’ve always encouraged using a percentage election for deferrals. Somewhat for this reason, but it is clearer now why this is a best practice.”

PLANSPONSOR will be launching a survey of nonqualified deferred compensation plan sponsors next week. The survey was developed with Newport retirement services and will include a special section about how companies are responding to COVID-19 issues related to their deferred compensation arrangements. Respondents to the survey will have access to the full report of findings, including insight and analysis that will not be available to the general public. For more information about how to participate in this opportunity, please contact brian.okeefe@plansponsor.com.