The 401(k) Wraparound: An Attractive Benefit for Top Executives
The statutory yearly limit on tax-deferred contributions to a 401(k) plan is $8,475--not much for a highly compensated executive. That maximum contribution is even less at companies where lower-paid employees contribute too little to the pension plan, triggering federal nondiscrimination rules. This can have a devastating impact on the efforts of a company to recruit and retain the best top executives. However, there is a compensation package that overcomes the shortcomings of a 401(k): the 401(k) wraparound, a salary-deferral plan tailored to a company's special needs. [As an alternative, a company can establish a supplemental executive retirement plan (SERP). Such a plan, however, can only provide extra pension benefits. A 401(k) wraparound gives the employee the option of using the funds as an additional pension, as a savings plan or as both. For more information on how SERPs work, see JofA, Nov. 90, pages 94-99.] Here's how a large West Coast manufacturer designed its 401(k) wraparound: The company's board of directors identified 35 key executives as plan participants. The company placed no limit on how much the participants could defer, and it agreed to match the deferrals at $.50 on the dollar, up to 10% of annual income. To discourage top management turnover, a seven-year vesting period was imposed. The company guaranteed a return on the deferred income based on Moody's bond index; depending on company results, the bonus could be as much as 5% above the index. DISCRIMINATION ALLOWED In short, the company broke through every limitation on 401(k) plans imposed by the Employee Retirement Income Security Act (ERISA). This was possible because a 401(k) wraparound is a nonqualified benefit plan, not subject to the provisions of ERISA--and, as a result, not protected by it either. Although the employees face some risk, since the deferred income is not secured as it would be in a qualified plan, there are offsetting benefits: * Discrimination allowed. The employer can pick and choose who is eligible for the plan. The president of one subsidiary may be included, while another top executive, for whatever reason, can be excluded. In addition, directors can participate in the plan. * No limit on salary deferral. Deferrals for wraparound plans are usually between 10% and 15%, but an executive may defer much more. * Flexibly scheduled payouts. The Internal Revenue Service requires only that the payout be specified in advance and occur after a "substantial passage of time." Thus, one executive can begin receiving deferred income as family college expenses begin to mount while another may opt to wait until reaching normal retirement. Because these plans are so flexible, they often are difficult to draft and administer. Nearly every aspect of the plan--percentage eligible for deferral, amount matched by the corporation, vesting period and payout policy--is subject to negotiation between each individual in the plan and the company. CONSTRUCTIVE RECEIPT Such flexibility presents some problems, however, because an incorrectly structured plan can run afoul of IRS requirements. For example, the IRS requires participants who want to void taxes on deferred income to decide how much money to set aside before "constructive receipt" of the funds. For the most part, that means they must indicate before the end of each plan year how much they want to defer in the coming year. The sponsoring employer also has to ensure the payout of funds occurs only according to the agreed-on schedule. In poorly run plans, individuals have been known to simply go to the human resources department and ask for, say, $10,000 of their deferred compensation. …