In today’s tight labor market, recruiting and retaining the best people can make a huge difference towards the success of any business.
Providing employees with financial perks such as competitive pay, a retirement plan with matching funds and health insurance has become something that many organization offer to all of their employees. The fact that your company offers them doesn’t separate you from your competition who wants your best people!
This is one of the important reasons small businesses offer nonqualified benefit plans. They feel doing so will enable them to compete for talented employees in a way that focuses their benefit dollars on enhancing their competitive edge. Thus, the small business objectives that are met through nonqualified plans typically involve the organization’s ability to:
- attract talented key executives from their competitors
- retain key executives who are already part of the organization
- reward high achievers so they feel appreciated
- maximize the impact of business resources available to provide employee benefits with maximum impact
Let’s look at what each of these objectives involves.
Attracting Key Talent
It is not unusual in many industries for a few extremely talented individuals to gain industry-wide recognition for their talents and their ability to produce meaningful business results. Attracting such individuals to fill key spots in a small business organization can be challenging, particularly because a small business is unlikely to have pockets as deep as those of large, publicly traded firms.
A nonqualified plan can be the important element in a compensation package that would allow a small, emerging business to successfully lure an effective executive from an industry leader that provides a wide range of benefit plans. While the emerging company may offer an executive the possibility of significant wealth in the years ahead, it typically doesn’t provide employee benefits comparable to those of an industry leader or the stability normally associated with a large public company.
To overcome some of the executive benefit limitations characteristic of a small company, it may use a nonqualified plan to tailor a supplemental benefit plan solely for the executive that it is trying to attract. Furthermore, it can shield those benefits from business creditors or a possible future management change by using a trust instrument.
Retaining Key Executives
Just as nonqualified plans can be used to attract key talent, they can also help ensure that a key executive is motivated to remain with the business. Although any special benefit provided to a key executive may be sufficient to retain him or her, one nonqualified plan in particular—a supplemental executive retirement plan (SERP)—performs this function most effectively and does it so well that it is often referred to as “golden handcuffs.”
An employer that wants to help ensure that a key executive will remain with the company will often provide a SERP specifically for the executive or for a group of executives it wants to retain. The enormous flexibility of nonqualified plans permits an employer to design the plan using a wide range of benefits. Under the terms of such a plan, an executive could continue to receive a portion of salary—50 percent or 60 percent of salary, for example—for 10, 15, or more years after retirement. Such SERP benefits would be received along with any regular pension benefit. The golden handcuffs become evident if the executive were to leave the firm before retirement. In such a case, he or she would normally forfeit all of the SERP benefits.
Rewarding High-Achieving Executives
Although various forms of incentive compensation may be used to reward a particular executive, current income continues to be the principal method. However, while an employer usually must pay a high-impact executive a salary commensurate with the results he or she achieves and the standards in the industry, current income does have certain motivational limitations.
For example, if an executive is currently earning $100,000, an increase of $25,000 in annual salary may be quite motivating—at least for a period of time. However, if the executive is currently earning $500,000 in annual compensation, an increase of $25,000 in annual salary is likely to have far less motivational impact. Furthermore, the motivation level of even the first executive who is now earning $125,000 will probably wane before too long, particularly if the next raise is less than $25,000.
The progressive nature of the U.S. income tax system also limits the motivational impact of current income increases. The top federal personal income tax rate is currently 39.6 percent, and most states levy a tax on earned income. The two income taxes can easily result in a composite marginal tax bracket of 40 percent or more. As a result, salary increases may not be so attractive for highly compensated executives. For example, assume an executive is at a 40 percent (combined federal and state) income tax bracket. A $25,000 raise may amount to only about $15,000 after state and federal taxes; $10,000 of the increased compensation is lost in income taxes, and an additional 1.45 percent is taken in the hospital insurance portion of Social Security taxes. If that additional income is invested—as opposed to being spent—and earns a 6 percent annual taxable return, the net return will be about 3.6 percent after taxes.
The limited motivational impact of current income increases is another reason why small business employers—and their key executives—value attractive nonqualified benefit plans.
Maximizing the Impact of Employee Benefit Resources
Although business organizations of all sizes want to achieve the most cost-effective allocation of their benefits budget, doing so is often more important to small businesses because of their relatively smaller budgets. Nonqualified plans may offer that cost-effectiveness for many small businesses. Nonqualified plans enable businesses to set selected executives apart from their colleagues and often provide additional motivation to other executives to excel.
Identifying a key executive and establishing a nonqualified plan specifically for him or her makes a powerful statement about the executive’s value to the firm, and the message is not lost on the participating executive. The selectivity offered by nonqualified plans enables the employer to gain maximum motivational impact from its benefit dollars because it can include a high-achieving executive without the need to include anyone else.
Principal Nonqualified Plan To Recruit, Retain and Reward Key Employees
Nonqualified plans are available in various forms. The four principal nonqualified plans differ from each other in terms of the benefits they emphasize. Thus, certain nonqualified plans emphasize death benefits while others emphasize retirement income. Likewise, some nonqualified plans enable an employer to recover its costs while others enable the employer to take a current income tax deduction (generally as compensation to the executive rather than as a plan contribution).
The four principal nonqualified plans are:
• supplemental executive retirement plans (SERPs)
• executive bonus plans
• group carve-out plans
• split dollar plans