Deferred compensation plans are a promise by an organization to pay specific benefits (typically in a lump sum) to an executive in the future. These arrangements commonly involve vesting provisions where the executive must remain employed with the organization for a specified period and/or achieve specific performance goals. In non-profit organizations, once a substantial risk of forfeiture no longer exists (deemed to be upon vesting), the plan’s value is immediately includable in the executive’s income.
The executive enters in to a contractual arrangement with the organization agreeing to forgo current income in exchange for the organization’s promise to pay certain benefits in the future. These plans can be structured as (1) defined benefit arrangements or (2) defined contribution arrangements. A defined benefit approach places all the financial risk on the organization and is becoming increasingly less common.
Defined contribution plans “target” a benefit amount to be paid at a specified time. This requires the organization to make assumptions about several factors including the executive’s life expectancy. Still, no specific amount of retirement cash flow is guaranteed to the executive. This approach places all of the financial risks on the executive.
- Pre-retirement and post-retirement rate of return assumptions are crucial to set realistic expectations;
- With life expectancies increasing it is essential to ensure that life expectancy assumptions are reasonable;
- Given the obligation to make the payment at a future date, the organization records a benefit liability reflecting the amount projected to be due at the vesting date; and
- The organization recognizes expenses annually until the executive vests in the benefit.
Regulations Sections 457(f) and 409A of the Internal Revenue Code (the “Code”) govern these arrangements. The regulatory environment tends to make these plans less flexible than other options. However, the extended vesting provisions that usually accompany these arrangements are effective in encouraging retention of key executives.