Executives have an array of benefits that can be very effective in meeting their financial goals. One of those benefits is deferred compensation plans or, more technically, Nonqualified Deferred Compensation Plans. These plans typically are offered as an executive benefit to highly compensated individuals because 401(k) plans don’t allow highly compensated individuals to save as large a percentage of their incomes as most other employees.
Each plan is different, so it’s important to read the plan information before you elect. It’s equally important to work with a financial advisor who is experienced in handling deferred compensation as part of an overall comprehensive financial plan. Here are a few key things to think about and look for as you consider using your deferred compensation plan:
- Non-qualified deferred compensation plans carry risk. In most cases, the company promises to pay the amount you deferred plus applicable growth, but creditors of the company would step in front of you if the company went bankrupt. This means you could lose this benefit if the company fails.
- Make sure you know what happens to your deferred compensation if you leave the company. Many plans pay out deferred compensation upon separation from the company. This can be particularly concerning if you leave for a new job, assuming the new job comes with a higher salary and a signing bonus. Also, remember you could be receiving lump sum payments for vacation or vested equity compensation from your former employer at the same time. All of this could mean paying substantially more tax on the deferred compensation than if you had not deferred it at all. If you think your current job is a short stop on your career path, you may want to avoid making heavy use of the deferred compensation plan.
- Understand the deferral periods available to you, and be careful not to defer income into higher income years. This is one of the more common mistakes I see when working with clients. When executives elect to use deferred compensation plans as they enter the peak earning years of their careers, but only defer the compensation out one to three years, it most likely will mean a few years of extraordinarily high income. This could mean substantially higher taxes.
- Consider how you might combine deferred compensation with other executive benefits. If you have restricted stock, you might defer an amount of base compensation or cash bonus to offset the amount of restricted stock that vests in any given year. Note that there is risk of stock price fluctuation, which could reduce the impact of this strategy or create more limited cash-flow than expected. As a side note, an experienced financial advisor to executives will help closely track equity compensation activity and vesting.
- Closely review the investment options available to you in the deferred compensation plan. Make sure the investment elections you make match your goals for the money in the deferred compensation plan. As an example, let’s say Erin is an executive for XYZ corp. Erin is 57 and is going to retire in three years. She has been deferring 10% of her base compensation until retirement. Once she retires the plan will pay out her deferred compensation over five years, at which time she’ll pay tax on it. Erin is planning to use those funds for her spending the first five years of retirement since she’s paying tax on it and other income sources like Social Security and old pensions won’t be started yet. Since Erin will use those funds in the near future, they should be invested more conservatively. More risky assets should reside in parts of the portfolio that won’t be accessed for a long time.
- Another thing to think about is risk pooling. Most executives have minimum company stock holding requirements they must meet. If your company allows it, holding company stock in your deferred compensation plan may be a good way to pool your company risk into one bucket.
These are a few things to think about when it comes to deferred compensation. None of these strategies is the perfect choice for everyone. Every person’s situation is unique and requires an individual approach.
The team at Foster Group has decades of experience when it comes to planning and investment strategies for executives. Give us a call if you’d like to talk about a comprehensive plan that will help maximize the potential of your benefits package and investments so you can stay focused on your biggest asset, your earning potential.
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PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/info-disclosure/. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.