5 Best Practices to Follow When Designing NQDC Plans

5 Best Practices to Follow When Designing NQDC Plans

The IRS imposes limitations on qualified plan contributions, putting highly compensated employees (HCEs) at a disadvantage when saving for retirement. Nonqualified deferred compensation (NQDC) plans were designed to provide a supplemental benefit for HCEs, but in addition to helping executives plan for retirement, NQDC plans can be put in place by banks to retain and recruit top executive talent by providing a long-term incentive and retention strategy.

While NQDC plans have many benefits, if your NQDC strategy isn’t designed properly, it can have a negative impact on shareholder value and lack the retention characteristics it was intended to generate. Here are 5 best practices your bank should keep in mind when designing a nonqualified compensation strategy for your executives.

1. Avoid exposing your bank to unknown future liabilities with your NQDC plan design

Having an unknown liability for your bank is one of the one of the largest risks associated with non-elective NQDC plans. Although projections provide for some forecast of expense, there remains an unidentified expense that can negatively impact budget forecasts, mergers, and shareholder value.

Any plans that tie benefits to a percentage of the executive’s final pay can create unnecessary tension between the board and executives, whether they are lifetime plans or 10-15 year plans. As executive salaries continue to escalate (as is common towards the end of an executive’s career), a modest increase in salary can exponentially impact benefit accruals. These late-career raises end up costing the bank great expenses due to the present value of future benefits that must be accrued. The closer an executive gets to retirement, the more expense must compressed into a tighter timeframe, because companies must account for the majority of the expense during employment.

Despite their popularity over a decade ago, lifetime benefit payments are no longer in vogue (and for good reason). Banks do not have the ability to absorb mortality risk for white collar executives. Furthermore, having lifetime benefit plans can complicate an acquisition since acquires don’t know what to expect with the associated unknown risk.

Banks that use NQDC retirement benefits properly have great success with their goals of retaining and recruiting the desired talent. These banks are successful because they design plans in which the benefit expenses are fixed on day one, limiting the bank’s future liability expense. Additionally, there are new design strategies that can be used to offer a lifetime benefit without the bank absorbing the mortality exposure. NQDC plan advisors can be helpful with sorting through complicated design strategies.  

2. Leverage vesting for retention in your nonqualified compensation strategy

When vesting is included in the design of an NQDC plan, it can be a powerful tool for retaining executives, but you have to be careful not to make it too generous. After all, if an executive can just retire early and collect the benefit, the NQDC plan loses its retention value. When used properly, NQDC plans act as “golden handcuffs,” meaning the executives receive the benefit upon normal retirement (and other termination events are covered within the supporting plan documents).

Accelerated vesting can dilute the purpose and intent of compensation plans designed to retain executives.  We have seen a number of banks retire talent too early–or worse, see their key employee leave with a benefit only to compete down the street.  Stability in leadership is vital in today’s fast-paced and evolving community banking industry.  Early retirement can also have a significant impact on the accrual schedule, causing undue burden on the bank’s earnings.

Prior to setting a vesting schedule, make sure the directors and executives understand the purpose of these plans and have a clear understanding of the accrual impact.  This will help the bank generate the most value for the participants and shareholders.

3. Don’t ignore the hidden expense of §280G

Is a change of control in your bank’s future? If you have Supplemental Executive Retirement Plans (SERPs) or other NQDC plans, they can become potential liabilities if your bank does not properly plan for this event. IRC Section 280G carries consequences for banks that sell. If your benefits are to vest and be paid in full (which will be accelerated due to the change in control), you may end up owing tax to the IRS—despite limiting 280G language that exists in other agreements such as an employment agreement.

Although there is no way to circumvent 280G, there are NQDC plan design strategies that help lessen or even eliminate the issues related to this code section. If you have not had a 280G Analysis conducted, even if you don’t have the intent to buy or sell, arranging one is wise. The analysis can establish a benchmark of understanding related to potential IRS penalties and the cost to the bank and shareholders.

4. Protect the beneficiaries and the bank

Almost without exception, community banks want to lock down their executive management teams by providing NQDC retirement benefits, and as part of that design, executives want to be assured that their beneficiaries are protected.

Protecting beneficiaries can become a burden for banks, so what can you do to mitigate the costs? Bank owned life insurance (BOLI) protects the bank and the executive’s beneficiaries in the event of premature death. If the benefit plan accelerates payment in the event of the participant’s death (which most do), or if there is an insurance obligation paid to the beneficiary, BOLI is most commonly used to mitigate any shortfall of accrual expense or to satisfy the insurance component.  Although other forms of insurance have been used in the past, they not as widely used and are typically not as efficient or provide the same income earning benefits as BOLI.

5. Understand the true value behind NQDC plans

NQDC plans should be looked at on a comprehensive level, not as a standalone component of compensation. Banks try to deleverage risk in every area, and comprehensive NQDC plans play a role in mitigating risk, but not all banks understand their true value. When their design takes a balanced approach to total compensation, NQDC plans are ripe with value to the bank, executives, and most importantly, to the shareholders.

According to a research paper published by Boston University School of Law, inside debt (NQDC) actually incents executives to look toward the long term. Because NQDC plans can last 15 or 20 years into an executive’s retirement, they inspire executives to focus on building company value to drive long term earning and sustainability. Furthermore, NQDC plans can mitigate or complement illiquid stock grants for thinly traded or closely held companies. Without the ability to liquidate equity holdings, many executives may be forced to work longer than anticipated, hindering succession plans; they also may try to position the bank to sell at an inappropriate time. NQDC plans are therefore a part of your overall business strategy that should not be taken lightly.

Work with NQDC plan advisors to design your nonqualified compensation plan with intention

NQDC plans are an excellent tool for executive retention, but they must be designed thoughtfully so that you do not fall into the most common traps. Working with a compensation consultant can help you approach your NQDC strategy with a forward outlook to the ultimate impact to the bank, executives, and shareholders. Taking a thorough and comprehensive approach will ensure you have the ability to retain and recruit the talent necessary to make your bank successful.