Understanding Nonqualified Retirement Plans

Since nonqualified plans are not governed by ERISA rules, they can be tailored to a specific company's or individual's needs.

If you are a highly compensated employee or owner of a business who wants to provide extra incentive and retention benefits for your highly valued employees, a nonqualified retirement plan could be an appealing option.

These plans come in many shapes and sizes: defined benefit excess plans, defined contribution excess plans, voluntary deferred compensation plans, and supplemental executive retirement plans (SERPs). One key benefit: Nonqualified plans are not registered with ERISA and are not subject to its limitations. However, these plans are also not protected by ERISA, and executives who participate in them should be aware of their drawbacks as well as their benefits.

Contributions

Since nonqualified plans are not governed by ERISA rules, they can be tailored to a specific company's or individual's needs. Accordingly, contribution limits, employer matches, and vesting schedules will differ significantly from plan to plan. And even within the same company, plan specifics may vary from individual to individual. For example, a Senior VP-level plan is likely to differ from the CEO's plan.

But most nonqualified plans do have certain common features. Contribution limits for nonqualified plans have no legal caps and are often significantly higher than qualified plans. Like qualified plans, contributions to nonqualified plans are tax deferred, and taxes are not paid until funds are distributed.

However, contributions are not technically owned by plan participants until they are paid. Fund liabilities -- including employee contributions -- represent an unsecured promise to pay on the part of the employer, which can present issues in the event of a sale of the company or if it goes bankrupt. Depending upon the plan's investment structure, you may find yourself at the end of a line of creditors making dibs on what you thought were "your" plan assets.

Funding Structure

Nonqualified plans are typically funded in one of three different ways: "Pay-as-you-go," mutual funds, and life insurance.

  • "Pay-as-you-go," or self-fund plans, fund plans directly from operating cash. This type of structure is seldom used nowadays as it poses significant cash flow issues to the sponsoring company and offers little in the way of guarantees that the company will meet its funding obligations in the future.
  • In a plan funded by mutual funds, plan funds are held in a trust, typically a "rabbi trust," which is invested in mutual funds. The trust will often invest in the same mutual funds available in the company's qualified plan, thus "mirroring" the qualified plan and offering participants identical fund selection and weightings. Plans structured this way offer simplicity to plan sponsors and a certain amount of security to plan participants, whose plan benefits are assured even if the company is acquired or management tries to renege on its promises.
  • Perhaps the most popular funding mechanism is through corporate-owned life insurance (COLI). In this arrangement, employers fund plans with life insurance. Although COLI-funded plans can be complex, they offer tax-free growth, can be cost effective, and are attractive to sponsors seeking to match assets with liabilities created by deferred compensation plans.1

Distributions

Unlike qualified plans, distribution options under nonqualified plans are determined entirely by the sponsoring company, not ERISA. A given employer may limit your choices on how and when you receive distributions. Certain plan structures, such as those set up within the framework of a life insurance policy, may permit more flexibility than others.

While employee contributions to most plans are typically 100% vested from day one (although not owned until paid), vesting schedules are often imposed for the employer contributions. Oftentimes, payout periods are stretched out long enough to encourage the executive to remain with the company sponsoring the plan.

Unlike qualified plans, nonqualified plans do not permit you to roll over plan assets into an IRA or another nonqualified plan when changing jobs. Instead, you must begin receiving payouts -- and pay taxes on them -- when you leave the company. If this occurs between the ages of 62 and 65 while you are simultaneously receiving Social Security, you could exceed earnings limits imposed by the Social Security Administration and lose some of your Social Security benefits.

1Certain taxes may apply if the sponsor company is subject to the alternative minimum tax.