How to Select a Nonqualified Benefit Provider

Don’t just dust off the last 401(k) RFP

Nonqualified deferred compensation plans (NQDC) are an increasingly critical part of executives’ retirement income. Expert handling of these specialty arrangements for the company’s valued top managers may not be possible if the company’s benefits manager begins the NQDC provider hiring process with a request for proposal (RFP) originally designed for a previous 401(k) search. 

Changing tax codes, funding and benefit security alternatives, and emerging estate preservation opportunities are just a few of the areas of expertise benefits managers should expect their NQDC provider to know. In the process of searching out firms with this level of expertise, benefit managers too often rely on the company’s standard RFP boilerplate, which was probably adequate for selecting a 401(k) firm. This is not, however, the right tool to delineate the most qualified NQDC firm. 

It is also often assumed that once the RFP document is put together, it should be sent to firms including those whose primary business is handling 401(k) programs. But, in this case, what’s good for the goose isn’t necessarily all that good for the gander. Companies who fail to see a difference in the levels of expertise assume that 401(k) providers are just as up-to-date on NQDC plans as those companies that specialize in those programs. However, with constant changes in legislation and the resulting federal regulations, implementing and maintaining a company’s NQDC program requires a provider that is not only up-to-date on the latest regulations but also steeped in experience with the plan’s many moving parts. 

Of course, RFPs will continue to be the mainstay for many companies’ procurement efforts. Therefore, to help managers navigate away from some of the inherent complications in the standardized RFP, this article identifies a number of common pitfalls benefits managers can avoid in their search. 

Treating a NQDC Like a 401(k)
In all truth, the approach of treating a NQDC plan like a 401(k) can be fraught with traps. Due to the differences between qualified and nonqualified plans, the NQDC’s effectiveness can be compromised by using this tactic. First, nonqualified plans are typically offered to only the company’s top-level executives. Benefit managers need an expert provider who can be trusted to interact with the top executives and articulate the added flexibility/options associated with nonqualified plans (not just a “call center” where representatives are not required to be experts in any particular client’s plan). Second, nonqualified plans are less secure than 401(k) plans and therefore require a provider who understands funding/securitization alternatives and can help tailor those to a company’s specific financing objectives. Providers vying for the job should be required to identify their expertise and know-how in these areas. 

Most important, the general concern is that the firm hired must recognize and keep up with the differences in oversight functions between NQDC and 401(k) plans. Qualified plans are governed primarily by ERISA, while the rules for nonqualified plans are often diffuse. The impact of Sarbanes-Oxley and the most recent deferred compensation legislation, the 2004 American Jobs Creation Act which created Section 409A, can further muddy the water as interpretations of the resulting guidance need real expertise in the deferred compensation area. To this end, your provider-to-be must be able to demonstrate the capability of being up-to-date with the latest government regulations that now impact these plans. Many managers seem to think it would be simple to piggyback on the qualified plan in order to provide nonqualified plan administration. However, because the plans address different needs for their participants, and are subject to different regulatory measures, there are complexities that are typically missed by the untrained eye — until the hidden costs or missed benefits for the executive, or the corporation, ultimately become apparent.

It’s important to note that the new 409A regulations alone have imposed significant changes on nonqualified deferred compensation plans. This is a perfect example of how critical it is to have an experienced nonqualified plan provider on board. To properly address the impact of 409A, most providers are tracking pre- and post-409A account balances separately, have carefully crafted communication materials to educate participants on the changes without overwhelming them with information, and have added creative plan provisions to maximize the plan’s value to participants under the new regulations. Given 409A’s stiff penalties for violations, the lack of an expert provider in this case could be devastating. 

Nonqualified plans should also involve a specialist to ensure they are implemented and administered properly. Just as a company wouldn’t hire their nonqualified plan provider to administer a 401(k), it is also illogical to think of hiring a 401(k) provider to administer a nonqualified plan. Many companies base their decision on a simple cost comparison. Instead, they should base the decision on a cost/benefit analysis, weighing the costs against capabilities, expertise, services, etc., of the provider. A provider who is able to structure an effective plan funding strategy, for example, may end up saving the company a significant amount in taxes and other funding costs. However, if the provider selection is based solely on plan administration fees, these savings will not be factored into the decision-making process. 

Reaching a Critical Audience
A solid RFP must also require providers to demonstrate that they can design plan provisions and craft communications materials that effectively reach this sophisticated audience, not simply offer mass communications brochures designed for employees at all levels within the company. Quite often nonqualified plans will have special features to handle key issues not addressed in qualified plans. Additionally, keep in mind that more and more these specialized benefit packages are being used as critical executive recruitment and retention vehicles for the firms. 

Small Errors Can Result in Big Losses
Is hiring a firm whose expertise is deferred compensation really that important to your company? Let’s look at one example of the vulnerability. The example relates to recent changes in the deferred compensation requirements brought about by federal updates as a result of the 409A tax code. It reflects the potential negative impact that could result if the company fails to satisfy these latest requirements. 

The example below shows an executive at age 50 who defers $1 million per year for five years, and then takes a lump sum distribution at age 60. Assuming that the executive earned 8 percent on the deferrals each year, the total pre-tax lump sum distribution amounts to $9.3 million. Assuming a 35 percent tax rate, the executive could expect to receive $6.0 million after taxes. However, if the administrator/company violates the new distribution test in 409A, the new penalties to the executive are draconian. Instead of receiving $6.0 million, the executive would be hit with an additional $5.4 million in taxes, penalties, and interest. The net after-tax distribution to the executive would be $674,000, versus $6.0 million.

How could this happen? In this instance, a combination of penalties and lost interest eliminated the majority of the account balance for a participant whose firm had effectively violated the rules of 409A and its distribution requirements. The retirement plan had projected a 10-year period of deferrals and earnings, then, too late, found significant errors. One needs only to add to this catastrophe the risk of possible lawsuits and a potential career ending situation for the HR executive in charge of the NQDC plan. To this end, it’s easy to see that bringing on the most seasoned NQDC team shouldn’t be treated in a commoditized approach. 

Conclusion
All in all, developing an executive compensation package that is highly perceived by the company’s executives can only be achieved with the expertise of advisers who keep up-to-date with the changing rules and dramatic shifts in thinking today. Finding this level of guidance is possible via the RFP process if a benefit manager has a greater understanding of what to ask and what to look for when engaging a firm.