Beyond the 401(k)
The little-used wraparound plan could be key to attracting top talent
New Brunswick Savings Bank, a midsize chain of New Jersey banks with $6.4 million in net income, aspired to be one of the state's leading commercial lenders. But to do so, it needed to attract and keep top banking talent. Its larger regional and national bank competitors could use their size and presence in the marketplace to compete for talent. What New Brunswick Savings decided it needed was a top-flight executive compensation package.
But all New Brunswick had to offer was a qualified tax-deferred 401(k) retirement plan for the entire company. Trouble was, ever since tax reform had knocked the limit on income deferral down from $30,000 to a paltry $7,000 in 1987 (with slight increases every year based on the Consumer Price Index), 401(k) plans weren't so attractive a tax shelter to highly compensated employees. What's more, in 1987, New Brunswick's executives weren't able to defer the full $7,000 since the company failed to meet the Internal Revenue Service's super-stringent requirements for 401(k) plans.
Susan Angelo, New Brunswick's vice-president of human resources, needed a solution. "We had already set up a separate plan to let our board members defer taxable income from their director's fees," she recalls. "I hoped there was a comparable plan we could set up that would appeal to our executives." Indeed, there was. It's a state-of-the-art executive compensation plan known as the 401(k) wraparound, so named because it adds a layer of income-and tax-deferral enhancements to 401(k) plans. The companywide 401(k) remains available to all employees, but the wraparound is reserved for highly compensated executives.
Although not widely used, wraparounds provide enormous benefits for companies and their key employees -- not the least of which is that these plans are considered nonqualified by the IRS, which means they mostly escape the purview of often onerous ERISA pension regulations.
Angelo liked the wraparound idea but had one major reservation. "Since so many of our benefits -- such as life insurance and pensions -- were tied to nondeferred [rather than gross] salary levels, I didn't want our executives to reduce their salaries so low for tax purposes that they wound up suffering otherwise."
Angelo worked out a compromise with a consultant at Philadelphia-based Noble Lowndes. Beginning in 1988, New Brunswick's executives could not only defer part of their salaries in the company's traditional 401(k), but also put all or a part of their bonuses in the 401(k) wraparound. Because the amount of the contribution is not limited, depending on the size of the bonuses, wraparound contributions could be substantially larger than the income-deferral levels permitted by the bank's traditional 401(k). The wraparound's flexibility is its biggest advantage, since companies can tailor their plans to meet specific executive priorities. At New Brunswick, Angelo made some informal surveys of the firm's top executives, who were mostly in their forties, and found that they were more concerned about funding their children's college educations than they were about saving for retirement. She and the Noble Lowndes consultant designed the wraparound so executives would have access to their funds as soon as their kids were ready to enter college -- rather than waiting until age 59½, as required by the IRS for a regular 401(k).
Therein lies the beauty of a nonqualified plan like the 401(k) wraparound. There are absolutely no penalties for distribution of funds before retirement age; all executives face is a normal tax bill for any funds that are distributed at the predesignated time. "There's no reason why a company can't design different cash-withdrawal requirements for every one of its key executives, depending upon their lifestyle needs," says Kevin J. Gregson, a senior consultant with Noble Lowndes.
Unlike traditional 401(k) plans, it doesn't matter how many executives choose to participate in a wraparound, because nonqualified plans have no participation requirements -- so long as the benefit is offered only to highly paid key employees. (For simplicity's sake, rely on the IRS's definition of who within your organization is considered highly compensated, something your accountant or benefits officer can tell you. Don't try to include a low-paid spouse or you'll risk tax liabilities and fines to all participants.)
Best of all, because the wraparound tax-deferral plans are perennially popular with executives, companies don't have to offer costly financial incentives to convince them to sign up, as they typically do with traditional 401(k) plans. New Brunswick, for example, matches 50% of employees' contributions to the traditional 401(k). But without any added incentive, some of the bank's qualifying executives chose to defer at least part of their bonuses in the first two years of the wraparound's operation.
Wraparounds have another great appeal for savvy business owners. They can be structured along a variety of financial models, according to such key issues as the strength of a company's cash flow, the desirability of tax deductions, the magnitude of current expenses, and so on. Because of its strong cash flow, New Brunswick didn't need to set up a plan that gave it a current tax deduction. So it set up a straightforward deferred-compensation plan. "But companies that need these benefits can structure their wraparounds to help their bottom lines as well as their executives'," says Gregson. (For other ways to design a wraparound, see "Designer Options," below)
To Angelo, the strongest selling point is the ease of getting wraparounds up and running. New Brunswick spent less than $10,000 and less than three months to design and install its plan.
Angelo introduced the plan to the bank's key executives during a brief question-and-answer session, supplemented by a plan document from Nobles Lowndes. Within a couple of weeks, interested executives had filled out the necessary paperwork to join up. Now, administering the program is as simple as contacting executives once a year to see if they want to defer their bonuses again, and if so, by how much. "The only slightly tricky thing is that, according to IRS rules, executives can't defer money once they've earned it," Angelo emphasizes. "So that means in November 1990 the executive has to make a decision about a bonus he won't earn until 1991 and wouldn't otherwise receive until 1992."
Once Angelo gathers the new information, she doesn't have to worry about the wraparound for the next 11 months. Wraparound funds are kept separate from the company's other 401(k) investments.
A potential risk facing wraparound plan users, says Gregson, is that it be deemed a case of "constructive receipt," a somewhat ominous IRS term indicating an executive hasn't really deferred any income but only gone through some paperwork motions. To prove that the executive is not in constructive receipt of income, you need to take two important precautions: (1) the company, not the executive, should decide where deferred income is invested. At New Brunswick, the money goes into one of the bank's 60-month certificates of depostit. (2) The plan must state that if the company goes bankrupt, creditors have a right to all funds in wraparound accounts. Some states' bankruptcy laws put employees at a higher level than other creditors. They should waive that right if they participate in the plan.
Admittedly, that's a risk. But if a company is in such financially precarious shape that executives are unwilling to bet against bankruptcy, there's no other choice but to award perks outright, regardless of their immediate tax consequences.
Want to know the biggest advantage of a 401(k) wraparound? If you don't have the cash yet to administer or fund a full-scale 401(k) plan, you can wrap around your key executives now. Then, when you're able, set up another benefit plan to take care of the rest of your employees.
Consider which 401(k) wraparound best suits your needs
So you're interested in a 401(k) wraparound, but don't know which kind to choose. Here are some options to consider, based on your company's financial conditions and priorities:
* The basic deferred-compensation plan. If your main consideration is recruiting and retaining executives, this is the plan for you. The executives defer their income, the company manages the money, and there aren't any tax consequences for the company or the executive until income is distributed from the wraparound.
* The trust. Here the company isolates the wraparounds from its working capital by placing the funds in special investment accounts administered by independent trustees rather than the company's financial officer. One caveat: trusts are costly to set up and manage. If you're interested, there are several types of trusts to consider, depending on your company's tax bracket and cash flow, as well as your executives' tax situations. Consult a benefits specialist about the best plan for your needs.
* The promissory note. If your company hasn't got the cash to fund a wraparound -- perhaps because it's still in a start-up or a capital-intensive phase -- you can set one up with a promissory note, which obligates you to pay the plan a certain sum at a specified date. But think twice before making the offer to a top-flight executive, who may worry that a new or volatile growth company could run out of cash before the note came due. If cash is tight, consider forgoing the wraparound entirely and offering phantom stock.