Deferred Compensation Four-Part Series – Part Three: Deferred Compensation Risks: Change of Control in Acquisition, Bankruptcy, and Irrevocability of Distributions and Investment Options

Jul 3, 2022 | Blog, Newsletter

Introduction:

Deferred compensation plans are complicated, overlooked, underused. Yet, these plans are one of the best opportunities to save A LOT on taxes. Like a nuclear power plant, they’re old, misunderstood, and some only remember the few events when they’ve melted down, but they have amazing tax saving power!

Because there’s little formal industry education, there’s a lot of client confusion. Also, many peers keep asking what the heck is “x” within this deferred compensation plan?

I love these plans but hate seeing disastrous client financial results without starting with eyes wide open.

Welcome to our series all about deferred compensation.

****PLEASE NOTE, this is an employer provided plan, this is not a plan an individual can open.


Four-Part Series:

Part One: Deferred Compensation Plans 101 – Cliff Notes

Part Two: Should I Defer My Compensation? How Do I Invest It?

Part Three: Deferred Compensation Risks: Change of Control in Acquisition, Bankruptcy, and Irrevocability of Distributions and Investment Options

Part Four: Deferred Compensation: Financial Planning Opportunities and Tradeoffs


Part Three: Deferred Compensation Risks: Change of Control in Acquisition, Bankruptcy, and Irrevocability of Distributions and Investment Options

Many participants are surprised when things go wrong in a deferred compensation plan. Some of the next items are outside of their control, but many are not. Let’s go through the largest risks. 

  1. Change of Control & Acceleration of Income
    1. Acquisition target: Does the firm offering the plan have a low likelihood of being bought?
      1. Why? If the firm is bought, the acquiring firm can pay-out all…Yes, ALL deferred compensation after 12 months. And, all payments need to be made within 24 months with a “change of control.” In many cases, creating more taxes than if you just didn’t participate in the plan.
        1. Example, A client defers salary of $50,000, and elects to receive it in ten years, at the forecasted 12% tax bracket. The company is acquired—Surprise! Now all deferred compensation on top of the regular $250,000 compensation is paid out. Then, they are laid off. Now severance, RSU/PSUs immediately vest, and vacation time are all paid. All at once. Increasing their marginal tax bracket even further! More taxes!!! 
  1. Bankruptcy?: Does the employer have a low likelihood of going through bankruptcy?
    1. These plans do not follow ERISA qualified rules. Therefore, these non-qualified benefits are the client’s employer’s assets, not yours. Wait, What?
      1. In bankruptcy, participants are paid in line as a general creditor behind other liabilities. Usually, not first.
      2. Many times, income is deferred at least a decade later, so an employer’s sector, bond rating, executive participation in the plan, and other factors need to be considered.
        1. Many bankruptcies have involved deferred compensation plans: Washington Mutual, Pacific Gas and Electric, General Motors, Avaya, Kodak, Chrysler, Caesars, Lehman Brothers, and Enron. These employers reduced or terminated benefits completely.
    2. What if you want added protection? What are your options? There are companies that will pool the bankruptcy risk with participants of other companies’ deferred compensation plans. Firms like StockShield pool participants in different industries to diversify company risk. This trust is put together for a protection period of 5 or 10 years. The payout to the participant in the bankrupt company serves to offset the loss they face from in a plan.
  1. Irrevocability or Inflexibility of distributions and investment options: Can the client and their financial plan afford less flexibility, and non-revocable investment options?
    1. Less flexibility outside the 5-year rule
      1. Many times, clients elect to defer compensation in an enrollment period without knowing many elections are irrevocable, or at best inflexible. They rush the election during the enrollment period. Remember, lump sum elections are not available for this redeferral, and many participants regret this election in the future when this spikes their marginal tax bracket. Don’t do this.
      2. With irrevocability or limited changes, no loans, and “rollovers,” there is a lot less flexibility compared to a qualified retirement plan.
        1. 5-year change rule, changes in the distribution schedule, force clients to defer the compensation 5-years or more in the future, from the original election. And, in many cases, if a lump sum distribution is elected for an account year, it is fixed, and cannot be changed.
    2. Leaving before age “x.”
      1. Separating employment before age “x”, whether you quit or get fired, could accelerate the income upon termination. Your plan may have different provisions related to the type of job termination, such as involuntary compared to voluntary.
        1. For example, your plan has a provision that all benefits are paid on termination under age 50. You are let go at age 48, and all benefit years are paid out. Spiking your tax bracket.
    3. Investment elections are locked, or have fixed times you can change them.
      1. In many plans, investments can’t be changed once an employee leaves, or within a fixed time frame, like 12-months before distribution.

 


 

As you can see there’s a lot of things you can control, and many you can’t. But in all cases planning ahead and knowing the facts are key.

Stay tuned for Part Four: Deferred Compensation: Financial Planning Opportunities and Tradeoffs where we explore how to think about financial planning with deferred compensation.

 

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