Deferred Compensation Plans Offer Advantages You Have Yet to Explore
Several months ago I wrote about how a salary continuation plan could be used to supplement your retirement, or as part of the sale of your business. Since that time I've received dozens of phone calls from contractors wanting more information. This month I thought I'd give you an outline of three different types of deferred compensation plans and their relative advantages.
First of all it's important to know that deferred compensation plans are not really defined in the Internal Revenue Code. Rather, they belong to a universe of fringe benefit plans which are known as "non-qualified." That is they're not heavily regulated in order to be "qualified" for certain favorable tax treatment.
Examples of qualified plans include 401K, profit sharing, money purchase, traditional defined benefit pension, etc. All of these plans allow the employer to take a deduction for any contribution to the plan, and at the same time do not require the employee to recognize the contribution as income. In addition, while the money is in the plan, it is allowed to grow on a tax-deferred basis. The only drawback to a qualified plan is that the IRS requires that all eligible employees be included in the plan, and you must offer a similar plan to every company you and your partners control. The net effect is that these plans can be quite expensive if you have to make large contributions for a large number of employees.
Many contractors have some type of qualified plan, but they've discovered that the plans generally end up giving more money to their employees than they get to keep for themselves. In addition, the owners and the other highly paid key employees are often limited as to how much they can contribute. It was this sense of unfairness that led to the creation of deferred compensation plans.
Non-qualified plans do not have to be awarded to all your employees, thus they're the preferred method for rewarding a few selected key employees in order to encourage them to stay with you and keep your plumbing business profitable. The three basic deferred compensation plans include cash plans, phantom stock plans, and stock appreciation rights.
Deferred Compensation Cash PlansThese are the most common types of plans because nothing speaks to an employee more clearly than cash. Under this type of plan you essentially have two choices. Choice one is a defined contribution type plan that says in effect, "I will put a set amount of money into a plan for you and you can have whatever it grows to if you stick around for 'X' number of years." A typical example would be $5,000 per year with vesting after five years.
A second choice would be a defined benefit type plan where you might say to an employee, "I will give you $25,000 in five years if you are still here. If you leave before that time, you'll get nothing." If you decide to fund for this plan, you'll probably want to make deposits on an annual basis, and we can only estimate the amount to be contributed, because you can never know exactly how well the investment will do. The primary advantage to this type of plan is that it puts a definite value in the employees mind, and acts as a strong incentive to stay. If another contractor were to try and hire him away, he would need to offer a large signing bonus to make up for the lost income, and that's not likely to happen.
Phantom Stock AgreementWith this type of plan, you're giving your employee phantom stock, that is, stock that doesn't really exist. The advantage is that you're treating him like a shareholder, and hopefully he's working and thinking like an owner, without actually making him an owner. As a rule, giving someone stock does focus them on the business, but there are many negatives. They now have a say in the business. They have a right to the financials, they need to be consulted about many of the day-to-day decisions of the business, and worse, if they should leave on bad terms, getting them to sell back the stock at a reasonable price is always difficult.
With a phantom stock agreement you could give an employee phantom stock equal to 5% of the company. They would be entitled to 5% of any dividend, and what's more, after they had vested, they would be given cash equal to the then current value of 5% of your company. An employee who receives phantom stock will have a strong incentive to improve the value of the company as much as possible over the course of the agreement.
My only objection to this type of plan is that you're giving someone the equivalent of 5% of your company in cash. I doubt they had a lot to do with getting the value of the company to where it is today, yet they'll be rewarded for equity that already existed. It's a good idea to reward them for the increase in value that they create, but I would not reward them for value that existed prior to their hiring. A better alternative would be the Stock Appreciation Rights Plan.
Stock Appreciation Rights PlanThis type of plan is closest to the stock options plans that are rewarded to senior managers at almost every public company in America today. When a person is given a stock option, it is rewarded at the current stock price, which means it is essentially worthless. It also generally comes with a waiting period of two years before it can be exercised, and is good for only five or 10 years after that period. Let me illustrate.
Say that on September 28, 1998, the value of your stock was $10 per share and that you're a public company. That means anyone could buy stock at $10 per share, whether they were a key employee or not. Let's also assume I grant you 1000 options at $10 per share which can be exercised beginning September 28, 2000, and are good for 10 years after that. What I've given you today has no value. The options can't be used for two years, and they have no value today. Again, anyone can buy the stock at $10 per share so no one needs my options today. The only reason I gave them to you was to encourage you to increase the value of my stock, and if you do this, you will be rewarded because then the options will be worth something.
Lets fast forward to September 28, 2000. Today you wake up and see that your options can now be exercised. You open up the newspaper and see that the stock is at $20 per share. You have the right to buy 1000 shares of stock at $10 per share and could immediately sell it for $20 per share netting a quick profit of $10 per share. With options on 1000 shares, your options are now worth $10,000. Of course, you do not have to exercise them now; you could decide to wait until the stock price is even higher. After all, the options are good for another 10 years.
Many of America's finest executives have worked diligently for their stock options, and these options have become an important part of their compensation package. In this example, the options worked well. I rewarded you for increasing the value of my stock. However, if the value of the stock goes down, or stays relatively flat, the key employee will have options with little or no value and may actually use that as an excuse to leave, which defeats the purpose of granting the options in the first place.
Any of these plans can be used to reward a key employee, and the cash plan can be an excellent way to increase an owner's retirement savings.