Non-Qualified Deferred Compensation (NQDC) plans are a powerful tool for incentivizing and retaining key employees. They offer virtually unlimited flexibility in methodologies, objectives and rewards to suit a company’s strategies and goals.
What is “unqualified?”
Quite simply, NQDCs are discriminatory. Some owners shy away from that term, but discrimination isn’t automatically illegal. Illegal discrimination in the workplace is when an employer or manager treats an employee unfairly due to their race, color, religion, sex, national origin, age (40 or older), disability, or genetic information.
Non-qualified plans discriminate because they aren’t offered to everyone. The Employee Retirement Income Security Act (ERISA) sets standards for employee benefits. Retirement and health plans must be offered equally to all employees. It does not apply to incentive compensation. As long as the requirements for participation don’t include one of the factors in the paragraph above, it is perfectly legal to discriminate between employees.
There’s a catch, of course. ERISA also allows employers to set aside benefit costs as a pre-tax expense, thus reducing taxable profits. NQDCs have no such advantage. They can be expensed when paid, but the accrual of benefits earned under that plan is a liability rather than an expense.
Therefore, employees should be informed that these plans are unfunded. They are dependent on the company’s ability to pay them when they are due. We will discuss funding and payment in the next article.
What should be incentivized?
The term “deferred” indicates that NQDCs should be used to recognized performance over a period of time. Typical targets include growth in company value, improvements in cash flow or profitability, revenue growth, employee turnover, brand reputation, acquisitions, customer satisfaction and geographic expansion.
Goals can be mixed, prioritized or laddered. For example, vesting may be tied to the employee’s tenure, plus payout levels tied to profitability. Bonuses can accrue based on growth in revenue or profits, with the percentage of payout linked to new products or territorial initiatives.
Half of the awards may be tied to company goals, with the other half linked to individual or departmental objectives. A percentage of any award may be tied to EBITDA, with another percentage dependent on safety benchmarks and another tranche to leadership development.
NQDCs often include virtual equity measures, such as Stock Appreciation Rights (based on a percentage of the growth in value of the business) stock options or phantom stock.
In all cases the recipients of any awards should have a scorecard that plainly outlines their qualifying metrics and time frames.
Who should receive NQDCs?
The complexity of variables indicates that recipients should have several qualifications. First, they must be in a position to affect the outcomes desired. Their decisions should have a direct impact on the incentive calculation.
Second, they need day-to-day visibility into the components that make up the goals. Handing them numbers at the end of the month has little effect if the recipient doesn’t know which levers to pull to make those numbers happen.
Finally, the employees who receive NQDCs should be “keepers.” These plans are not suited for remedial behavioral modification. They are to reward those who are critical to the organization’s success. Ideally, the company wants them to continue performing their duties at a high level for the rest of their career.
Note: This article and the following one (on vesting and funding) are intended as an overview for advisors to business owners. Non-Qualified Deferred Compensation is complex and should be designed with the help of legal and tax advisors.
John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.
Good article, thanks John.