2. in a deferred compensation account is
not restricted by age (for example,
contributions to a 401(k) plan generally
cannot be distributed if an employee is
still employed unless he or she has
reached age 591/2
), but by a vesting
schedule or the achievement of specific
performance measures. For example, an
employer can design a plan that pays
out everything five years after the
deferral occurs.
Example
The design details of deferral plans are
unique to each company, encompassing
considerations as diverse as the maturity
of the market, the complexity of the sales
mode and the level of competition for
top talent.
For example, Company A added a deferred
compensation program to its sales reward
package with the goal of promoting
retention of high-performing employees and
attracting new salespeople. Because long-
term client relationships were a key aspect
of sales in that industry, recruiting seasoned
salespeople was difficult. The company
wanted a package that would be attractive
to new employees, but also serves to help
retain its long-tenured existing salesforce.
Those needs were addressed through the
introduction of a deferral program that
allowed employees to defer a portion of their
compensation, which was then partially
matched by a company contribution.
As shown in Figure 1, a typical salesperson
entitled to a payout of $200,000 (USD)
could opt to receive $150,000 in cash and
put the remaining $50,000 in a deferred
account, to which the company would add
a matching contribution of $25,000. To get
the match in this example, the employee
would have to achieve 150 percent of
target performance. The deferral and the
match would be paid out if the employee
remained employed for five years. If the
employee were to leave earlier, he or she
would still receive the $50,000 deferral at
termination, but lose the $25,000 match.
For example, if the deferral year was 2007,
the deferrals for 2007 would be paid out
immediately after the end of 2012.
Figure 1 assumes the 2007 deferrals all
occur at the end of 2007 and shows the
results at the end of five years. Assuming
an 8-percent return for five years, the
account would have grown to about
$110,100, a $35,100 increase. For a
seasoned and somewhat older employee
for whom wealth building is a priority,
the program offers an excellent return
on a five-year investment. Assuming a
35-percent combined state and federal
tax rate, the employee would have had
only $32,500 (USD) to invest if he or she
had elected instead to receive the $50,000
initially. Assuming this amount could
have been invested at a 5.2-percent rate
(the 8-percent rate less 35 percent for
taxes), it would have grown to $41,876
at the end of five years. By deferring and
receiving the match, the employee would
end up with $71,565 (the $110,100 payout
less taxes). This is about a 71-percent
greater payout.
Creating a Win-Win
Providing opportunities to defer
compensation offers advantages to
the employee and the employer.
For the salesperson, the company
match provides an immediate upside
to the award, while the deferral and the
match grow tax-free over time. Although
the current payout of cash is reduced,
the deferral and match are provided on
a pretax basis, reducing the tax bracket
for the salesperson and resulting in a
higher long-term level of compensation.
For the company, the key benefit of
deferral is increased retention. The vesting
period for the matching funds creates a
potentially lucrative carrot to keep key
contributors on board. Moreover, because
the match of the deferral is tied to
performance metrics, the program helps
ensure that the company is paying for
real performance. From an operations
standpoint, deferral plans do not result
in any increase in dilution, and the impact
on cash flow can be offset by choosing
the right funding mechanism.
Sticking Points
Like any type of compensation program,
there are downsides to deferral. For some
prospective and current employees,
deferral plans may be an unfamiliar vehicle
that requires a change in mindset from
the “instant gratification” of immediate
payouts. That issue is best addressed by
effectively communicating the tax and
investment benefits of the program.
Employees will need to pay FICA taxes
(1.25 percent) on the deferred amount
at the time the funds are deferred,
although FICA taxes on the match are
workspan 11/0640
FIGURE 1: ACHIEVING 150% OF TARGET PERFORMANCE
Current
$200,000
$150,000
$50,000
$25,000
$40,000
$80,000
$150,000
Year One Year Five
$200,000
$225,000
$270,000
(+20% increase)
Proposed Deferred Assumes 10% annual return on investment
Cash Distribution
Deferred Contribution
Cash Contribution
3. workspan 11/0642
not due until the funds are distributed.
On the company side, extra effort
must be invested to ensure that a deferral
plan rewards the desired behaviors and
continues to be a good fit with the orga-
nization’s business and sales models.
In some cases, corporate culture may be
threatened by the extension of a perk
long reserved for only the highest-level
executives, which is why many companies
create separate deferral programs specifi-
cally for their salesforces.
Tax Rules, Including Section
409A and ERISA
Many employers already provide 401(k)
plans for their sales personnel. Nothing
prevents an employer from providing
both types of plans to its sales staff.
While certain technical issues must
be addressed if the employer wants to
coordinate contributions between the two
plans, they can be avoided if the two
plans are not integrated. In other words,
the decision to participate in the 401(k)
plan does not affect the decision to
participate in the sales deferral plan,
and vice versa.
In addition, nonqualified deferred
compensation programs are now governed
by IRC Section 409A. This legislation
was a major step forward for companies
by providing definition and legitimacy
to nonqualified deferred compensation
arrangements, although it reduced some of
the historic flexibility in these arrange-
ments. While all the details of 409A
exceed the scope of this article (and most
deferral plans are finding that they can
comply with 409A with minimal changes),
a few of the details pertinent to the
deferral program described above should
be noted.
One significant detail is that 409A
regulates the timing of the deferral elec-
tion. As applied to the deferral program
described above, the easiest way to comply
with 409A would be to require that
the deferral election be made before the
start of the calendar year. For example,
a salesperson might elect that by Dec. 31,
2006, all compensation in excess of
$150,000 in 2007 would be deferred. The
deferred amounts would be payable Jan. 1,
2013, five years after the year of deferral.
Can the employee elect that the deferral
of the amounts above $150,000 be contin-
gent on the employer committing to the
match? Not directly, but the same result
can be indirectly achieved through careful
drafting. For example, suppose the match
was triggered by sales earnings of more
than $150,000. In this case, a deferral
election with respect to sales compensation
above $150,000 only applies when the
salesperson is eligible for the match.
Finally, it should be noted that the
Employee Retirement and Income Security
Act (ERISA) limits unfunded deferred
compensation plans to employees who
are considered highly compensated or
management. So long as the deferred
amounts are automatically paid out after
a certain period of years, it would appear
that the plan is not subject to ERISA
(ERISA generally applies to plans that
defer income until the termination of
covered employment, which would not
be the case here). However, if the plan
allows the deferrals to be further deferred
to the end of employment, it may be
necessary to monitor the composition of
the eligible group to ensure compliance
with ERISA.
Structural Considerations
There are different approaches to
integrating a deferred compensation
element into a company’s overall
compensation structure. Some companies
fully embed the deferral plan into their
current compensation program to ensure
continuity. But embedded plans may lock
a company into plan-design decisions,
or add a level of complexity when changes
are sought to other aspects of the sales
compensation program.
That’s why some companies opt for the
flexibility of stacking their deferred
compensation plan on top of their basic
pay program. However, that approach can
be difficult to administer globally and may
be perceived as an “add on” that is not
fully integrated into an employee’s total
compensation or impacted by performance.
Worth a Look
Deferred compensation is the “new glue”
that provides an additional means of
retaining and rewarding valued sales
employees. It is a worthwhile consideration
for a company engaged in a war for sales
talent, or one that is adapting equity
programs to new expensing, dilution
or other considerations, or desiring a
greater focus on performance-driven
rewards that offer opportunities for
long-term wealth creation.
EDITOR’S NOTE:
For more information on deferred compensation,
see “The Seven Step Process to a More Effective
Nonqualified Deferred Compensation Plan” by
David Fisher in the April 2006 issue of workspan.
ABOUT THE AUTHORS:
Dave Gordon and Jim Sillery are managing
directors at Pearl Meyer & Partners, the compensation
practice of Clark Consulting. They can be reached at
dave.gordon@pearlmeyer.com and
jim.sillery@pearlmeyer.com.
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