The Ideal Solution - A 457(f) Plan

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1 Cammack LaRhette s 403(b) Curriculum series provides timely articles to plan sponsors offering qualified 403(b), 401(a) and 457 plans. Qualified plans, such as 403(b) plans, may impose income restrictions on highly compensated university employees which prevent them from deriving quality of life retirement benefits. This article discusses how tax-exempt organizations like universities can supplement existing qualified plans to include these types of executive benefits. To enhance qualified retirement plan benefits, leading educational institutions combine 403(b) with other qualified plans, and supplement them with nonqualified retirement plans. Tax-exempt universities typically turn to two types of nonqualified alternatives Eligible 457(b) and Ineligible 457(f) plans. Although viable, 457(b) plans are also subject to IRS cap limits under IRC 457(e) (15) limits, and hence do not work as an alternative for an employer funded SERP. Plan sponsors can, however, develop flexible supplemental 457(f) retirement plans to create comprehensive and competitive packages for senior university employees on a selective basis. Nonqualified 457(f) plans have unique qualifications placed upon them, if they are implemented at tax-exempt organizations. Problems of highly compensated employees Highly compensated university employees may be restricted from deriving a substantial portion of their retirement income from qualified plans, due to retirement plan limits and rules prescribed by the IRS, such as: Limits on 457(b) / 403(b) / 401(k) contributions Limits on the compensation that can be taken into account for qualified plans Limits on employer contributions to qualified plans Reverse discrimination As a result of the various IRS limitations, highly compensated employees may expect on average to receive 30% to 40% of final average salary at retirement from their qualified plans, as compared to 60% to 70% for less compensated employees. As a rule, highly compensated employees may need approximately 70% target retirement income in order to retire comfortably. The need for 457(f) plans While sensitive to cash flow constraints in today s economic environment, tax-exempt universities are eager to offer attractive benefits. The changing landscape of tax laws and regulations requires that university employers design supplemental retirement plans that are in compliance, yet are still able to deliver on three fronts - attracting, retaining and motivating key employees. Both tax-exempt and for-profit employers typically use qualified retirement plans to deliver benefits. Contribution limits restrict qualified plans and 457(b) nonqualified plans effectiveness. Therefore, 457(f) plans have proliferated, as a vehicle to supplement and deliver a flexible, comprehensive benefit solution.

2 Nonqualified 457(f) plans have become a vital tool for adapting to constantly revised tax laws and factors such as: Changes in personal income tax rates Qualified plan contribution limits Minimal number of tax deferred investment opportunities Greater percentage of final compensation required in order to retire securely Tax-exempt universities can utilize nonqualified 457(f) plan solutions as long as the plans are compliant with ERISA regulations, IRC 409A (discussed below) and the provisions of IRC 457(f). Since forthcoming regulatory changes may eliminate certain previously accepted nonqualified retirement plan practices in the tax-exempt arena, new 457(f) plans must be carefully designed, to remain compliant with IRS regulations, especially IRC 409A. Provisions of IRC 409A With the passage of the American Jobs Creation Act (AJCA) of 2004, Congress created 409A of the IRC, which applies to non-qualified deferred compensation (NQDC). This legislation was a direct response to perceived abusive compensation practices at companies like Enron and WorldCom. IRC 409A impacts all NQDC plans except 457(b), as it restricts the timing of deferral elections, limits permissible payment events, restricts changes to the time and form of payments, and curtails certain funding vehicles. Some key provisions of IRC 409A are: Generally, a service provider must make a deferral election in the taxable year before the year in which the services are performed. Section 409A requires payments of deferred compensation to be made at a fixed date, or under a fixed schedule, or upon any of the following five events: separation from service, death, disability, change in ownership or control, and an unforeseeable emergency. A plan may generally not permit the acceleration of the time or schedule of any payment. The time and form of distribution must generally be elected at the time of the initial deferral election, and any re-deferral must be made for at least another five years. Employer considerations Any benefit plan, whether qualified or nonqualified, should further organizational goals by providing comprehensive benefits to key employees. In designing a nonqualified 457(f) plan solution for key employees, some other key objectives of university employers are: Attracting new talent Retaining the current pool of employees Rewarding and motivating employees Enhancing a compensation and benefits package Supplementing benefits provided through qualified plans Reducing administration costs Implementing plans with the lowest cost and greatest impact

3 Participant considerations A nonqualified plan is implemented for the benefit of key employees, so must address their objectives and concerns. The overall compensation and benefits strategy will only be successful if it focuses on participants needs. Some employees concerns to consider are: Tax deferral opportunities Performance-based compensation Benefit security Access to benefits Minimization of risk of forfeiture Supplemental retirement income Reduced tax impact Understanding 457(b) Eligible and 457(f) 'Ineligible' nonqualified plans Plan sponsors need to understand the differences between 457(b) and 457(f) plans to determine which plan may better fit their needs. In some cases, both plans may be necessary. 457(b) Eligible nonqualified plans Like other elective deferral qualified plans, 457(b) plans allow employees to defer additional compensation on a pre-tax basis up to the deferral limits of IRC 457(e)(15). These plans usually offer investment choices to participants. Participant account balances have tax-deferred growth potential, with ordinary income taxes due on distributions. Universities typically consider 457(b) plans prior to implementing a 457(f) plan, for the following reasons: Participants may defer compensation up to IRC 457(e)(15) limits Participant accounts are not subject to the 457(f) risk of forfeiture The plan is not subject to IRC 409A rules The employer may informally fund the plan investments, giving participants greater control over their deferrals 457(f) Ineligible plans Plan sponsors may consider a 457(f) plan in lieu of, or in addition to a 457(b) plan. Under Section 457(f) of the IRC, nonqualified supplemental retirement plans of tax-exempt organizations must conform to specific standards and limitations that do not apply to similar plans sponsored by forprofit employers. Under the strict provisions of 457(f), a participant employed by a tax-exempt organization will forfeit all rights to receive income in the future from a nonqualified plan, if substantial future services are no longer required. If a participant becomes vested in the future income from a nonqualified retirement plan, that income will not be subject to forfeiture. In the first year that the participant's receipt of the benefits is not subject to a substantial risk of forfeiture, the full amount of the future benefit is included in the participant's taxable income for the year, even if the participant does not actually receive it. In Notice , the IRS announced its intent to issue new guidance for IRC Section 457(f) plans. The final IRS regulations are forthcoming. For plans designed in the interim, however, care must be taken in the design of provisions that may be affected by the IRS s pending guidance. The final regulations will focus on two primary components of IRC Section 457(f): (i)

4 the exemption from IRC Section 457(f) for bona fide severance pay plans (under IRC Section 457(e)(11)), and (ii) the definition of substantial risk of forfeiture (under IRC Section 457(f)(3)(B)). The final guidance will thus impact several important aspects of 457(f) plans, with the possibility of some transitional relief to comply with new provisions: 1. Elimination of non-competes constituting a substantial risk of forfeiture 2. Elimination of rolling vesting provisions that allow for re-deferrals 3. Prohibition of voluntary pre-tax employee deferrals subject to substantial risk of forfeiture Nonqualified 457(f) plan solutions The flexibility of 457(f) plans lets employers create retirement plans that are unique to the organization s needs, and that supplement other existing plans. As all 457(f) are highly customizable, it is feasible to design these plans with features and provisions tailored to the needs of participants and the plan sponsor. 457(f) plans allow for employer pre-tax contributions to accrue to the benefit of participants and have the following characteristics: Employer contributions to the plan are made on a pre-tax basis for the benefit of the participant The participant does not have any cost basis in plan contributions Benefits become fully taxable upon vesting at a later date The participant is subject to the risk of forfeiture on unvested benefits The participant is an unsecured creditor The plan has a higher retentive element, serving as golden handcuffs 457(f) Plan designs The scope of 457(f) in delivering supplemental retirement benefits is very wide and these plans may be designed in either of the following key configurations: 1. Nonqualified defined benefit plans 2. Nonqualified defined contribution plans Nonqualified defined benefit (DB) 457(f) plans A DB plan provides the participant a specified percentage of final average compensation, similar to a pension plan. The benefit may be targeted as a total percentage, offset by the employer's qualified plan benefits. The employer has considerable flexibility in specifying what benefit amount is to be provided, whether by a formula, or as a specific dollar amount. The tax-exempt organization may informally fund the future liability by making contributions to a sinking fund, which may be invested in various financial vehicles. At retirement, the participant begins to receive his/her retirement plan benefit; the benefit received is taxable as ordinary income upon vesting. At the time the benefit is to be paid, the employer withdraws monies from the investment vehicle in order to pay the retirement benefit. Under a defined benefit plan, the employer is subject to investment risk, since the benefit to the participant is stated as a formula, regardless of the performance of the underlying investments. If vesting of the benefit takes place prior to actual receipt of benefits, at each vesting point a distribution is taken from the account, to cover the participant's taxes due on the incrementally vested benefit. This serial vesting design is meant to mitigate or reduce the risk of forfeiture. The

5 executive continues to accumulate tax-deferred appreciation potential on the vested account balance, without subjecting these earnings to the 457(f) risk of forfeiture. The distribution for taxes helps to reduce the tax impact at retirement, as only the future appreciation is taxed. In order to reduce the risk of forfeiture, retirement plan benefits may be vested periodically in increments, although actual distributions may be delayed until retirement. Nonqualified defined contribution (DC) 457(f) plans Under a DC plan, the employer makes specified annual contributions into a participant s account, based on a formula or metrics designed by the employer. The employer may informally fund the obligation, utilizing a funding vehicle. Based on certain annual rate of return assumptions, determined at the plan inception, the employer specifies the annual contributions that would help achieve the targeted retirement benefit. As a result, the contribution amount is fixed, but the final benefit amount may vary. The participant may then be given some control over the investment of the contributions. The participant s ultimate retirement benefit amount depends upon the performance of the selected investments. At retirement, the participant begins to receive the retirement plan benefit based on the value of the investment account at that time, and the benefit received is taxable to the participant as ordinary income. The tax-exempt employer withdraws monies from the funding vehicle in order to pay the participant's retirement benefit. If at any time the participant becomes vested in a portion of the account balance, taxes are owed on the vested amount. Under this type of plan, the participant is subject to investment risk, since the benefit received at retirement is dependent on the performance of the selected investments. In order to reduce the risk of forfeiture, plan benefits may be vested periodically in increments, although actual distributions may be delayed until retirement. The importance of administration systems Plan sponsors must thoroughly evaluate the capabilities of the 457(f) administration system of the plan administrator. Due to the intricacies of IRC 409A, a participant must select multiple distribution dates for maximum flexibility in the timing and receipt of nonqualified retirement benefits. Only a sophisticated nonqualified administration system can handle potentially unlimited distributions, and allow the participant control over the timing for financial planning purposes, with each participant s account allocated among different investments.

6 Chart A illustrates the flexibility of a sophisticated nonqualified administration system, whereby a participant may make elections into multiple accounts, with each account having a different payout year. Case Study The following case study illustrates the usefulness of 457(f) plans. The example relates to a private tax-exempt university, which structured a unique solution to help meet a challenging need for its president. In this case, the university president had accumulated 15 years of service with the organization, and was a key driver of the university s newfound success on a national level in all metrics applicable to academic institutions. The problem The university wanted to retain its dynamic president, given his successful track record and value to the organization. Thorough surveys of peer institutions revealed that a total retirement income benefit of 60% of final average compensation (FAC) would be competitive and consistent with those provided for other university presidents. Using detailed actuarial assumptions, the FAC for the president was estimated to be $950,000. The retirement income available for the president from traditional qualified plans was projected to measure only $90,000 or 9.5% of FAC; benefits available from a split dollar arrangement added another $220,000. Similar posts at other institutions had richer retirement benefits. The 457(f) solution - By implementing a nonqualified 457(f) plan, designed as a Target-offset Supplemental Executive Retirement Plan (SERP), the university was able to provide the needed level of retirement income to the president in a cost effective manner. The retirement income of 60% of FAC was the target ($570,000) provided under the 457(f) plan, with offsets for benefits received from traditional retirement plans, Social Security and other welfare benefit plans such as deferred compensation, as well as split dollar insurance plans. The 457(f) SERP income would thus comprise a balance of $260,000 that could not be provided under other plans. Because 457(f) plans are nonqualified retirement plans, there are no statutory limits on employer contributions. Conclusion This article introduces the key concept of utilizing 457(f) nonqualified retirement plans to enhance benefits packages at tax-exempt universities. In order to attract, retain and motivate highly talented employees, university employers have the opportunity to implement 457(f) nonqualified plan strategies, complementing their existing 403(b) plans or other qualified plans. Michael E. Nolan is President and CEO of The Nolan Financial Group and is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer, member SIPC, located in Chevy Chase, MD. He has over 20 years experience in the design, funding, communication and administration of nonqualified executive benefit retirement plans. His articles have been published in The Journal of Compensation and Benefits, Directorship and Barron s. He is a frequent speaker at industry meetings such as the annual convention of The Advanced Association for Life Underwriters and The American Bankers Association. He may be reached at nolanm@nolanfinancial.com. This information should not be construed as legal or tax advice. You may want to consult a legal or tax advisor regarding this material as it relates to your organization s circumstances. CRN