The Nonqualified Deferral Plan (NQDP) is one of the most popular nonqualified
benefits offered to company executives today. The main reason for its
popularity is the ever-growing popularity of qualified 401(k) plans. Since
the early 1990's, 401(k) plans have become a standard benefit in most
businesses for the following reasons:
- Employees participate in accumulating funds for their own retirement,
thereby reducing the moral and financial burden on the employer.
- 401(k) plans allow employees to actively participate in the
- 401(k) plans are easy to understand.
Most NQDP's (but not all) follow the
format of a qualified 401(k) plan. These plans allow key executives to defer a
significant portion of their compensation, over and above the dollar limit set
for elective deferrals under a qualified 401(k) plan ($13,000
for calendar year 2004), and allocate it across a set of hypothetical
The terms hypothetical investment or phantom investment are
used because the executive's contributions are
not actually invested in the funds shown on the
participant statement. In fact, the contributions remain the property
of the company (or a trust). Due to tax and legal restrictions
(see ERISA, Constructive
Receipt Doctrine, Economic
Benefit Doctrine), the plan
document is structured so that the contributions invested will be paid
to the executive, along with investment earnings, as if such contributions
were actually invested in the funds selected. In other words, the company
is obligated to pay the hypothetical accumulated amounts
to the executive, but must have the freedom to invest the contributions
at their discretion, possibly not investing them at all. Please refer
to Designing a Plan and Funding a Plan for a more detailed explanation.
Some NQDP's will allow large deferrals, but will not offer a variety
of investments. For simplicity, these plans will credit a rate of interest,
usually based on the performance of an outside index, to deferral account
Irrespective of the investment crediting method, NQDP's generally take one
of three forms:
401(k) Mirror Plan
A 401(k) mirror plan is set up to look and feel just like the company's
qualified 401(k) plan. Key executives will be invited to participate in
a plan that allows the same investment options as the qualified 401(k)
plan. These plans mirror the features of the qualified plan with respect
to options such as changing elections and transferring balances.
401(k) Excess Plan
Also known as an overlay plan, this type of plan allows the executives
to allocate deferrals to the NQDP, over and above their maximum contribution
to the qualified 401(k) plan ($13,000 for the calendar year 2004,
indexed for inflation). The range of hypothetical investment options may
be as broad as the mirror plan, or limited to a basic interest rate crediting.
The key here is that the excess plan is coordinated with the qualified
A common coordination is to deny the right to make contributions to
the NQDP plan until the executive has made the maximum elective deferrals
under the qualified 401(k) plan. The IRS has ruled favorably on this type
401(k) Wraparound Plan
Another type of coordination involves the restrictions applicable to qualified
401(k) plans. As stated above, an executive may not defer more than a
statutory dollar amount into a 401(k) plan each year ($13,000 for
calendar year 2004). However, the maximum amount may be less in any
particular year, if the 401(k) plan violates the statutory ADP (Actual
Deferral Percentage) test. In essence, this test is a discrimination test
which is designed to limit the extent to which elective contributions
of highly compensated employees exceed those of lower paid employees.
The coordination works as follows: The executive defers a specified percentage
of compensation under the NQDP plan, and specifies that from this deferred
amount, the maximum contribution would be made to the qualified 401(k)
plan, after the 401(k) ADP testing is completed.
Flexibility is the operative term when it comes to structuring
The majority of plans will permit the deferral of a portion of the participant's
base salary. Many plans also permit the deferral of a portion of bonus
compensation, and other compensation components, such as director's fees,
Most plans will offer a choice of accounts for investment of deferrals.
The accounts will be earmarked for variety of purposes, such as:
- A retirement account for retirement savings.
- A post-retirement medical account for accumulating funds for health
insurance after retirement.
- An education account to accumulate funds for dependents' education.
An account is a repository, or container for investments. Each account may
contain a variety of investments - basically, any of the investments that
the plan makes available (stocks,
bonds, insurance, mutual funds, etc.).
- A participant may elect to split his deferral across the accounts
in any proportion desired.
- Each account may or may not contain
matching contributions (i.e.,
the employer will match a portion of the participant's deferrals), with
its own vesting schedule.
- The participant may choose the same or different investments for each
- Each Account will have its own distribution options
(time and method of payout).
Most plans offer a variety of investment options, with the majority of
plans offering investments that mirror the return of the company's 401(k)
investment options. A number of plans simply offer a competitive interest
rate credit on the participant's deferral (i.e., Moody's Corporate Bond
Index Rate + 5%).
that offers more than one investment choice will generally allow the
participant to manage their account(s) by permitting the transfer of balances from one
investment to another.
The participant may select the time and method of payment for each year's
deferral election, from a list of available choices for each applicable event, such
as retirement, death, or in-service withdrawal. For example, a plan will
generally allow funds to be distributed upon retirement to be paid out
in lump sum, or as annual installments over 5, 10, or 15 years. In-service
withdrawals could be paid out in four installments (i.e.,
funds for a child's education).
What is Needed to Set Up a Plan
Please refer to the Implementing a Plan
page for additional information and sample forms.
Implementation of a plan requires the following:
Sponsor - The plan needs an official sponsor. The sponsor is the
The plan needs an agreement. This will be the plan document, which will
outline the specifics of the plan design, including:
- Plan purpose
- Plan benefits
- Participant rights
- Sponsor and Employer obligations
- The choice of hypothetical investments available to participants
- How earnings are credited to a participant's account
Trust - The sponsor may desire to set up a trust. The sponsor
establishes the trust as a vehicle to accumulate assets to support the
payment of benefit obligations under the plan. The trust receives contributions,
makes investments, and makes distributions according to the terms of the
One form of trust, a Rabbi Trust,
protects plan participants
from being denied payment due to a change in management
or hostile takeover. Another form of trust, a Secular Trust
, will further secure the benefits for the
participant, but will potentially result in some undesirable tax consequences.
of Labor (DOL) Letter - A letter must be filed
with the Department of Labor within 120 days of establishing the plan.
Announcement Letter - potential participants must be informed of the
benefits of joining the plan.
Form and Beneficiary
Form - Each potential participant
must complete a form which will state the amount of the deferral to be
made, along with a selection of desired investment options, and the time
and form of distribution. The participant may also elect a beneficiary or
beneficiaries, who will receive the participant's account balances upon
Insurance Consent Form
-If life insurance is to be used as an informal funding
vehicle, then the consent form must be completed. This form will give
permission to the sponsor to purchase life insurance on the life of
a plan participant.
- NQDP plans require sophisticated systems to record and
track the activity of the participants' deferral account balances. Such
activities might include:
- Allocation of participant contributions across investments
- Transfer of funds from one investment to another
- Distribution processing
- Generation of benefit statements and management reports
Click here to see a demo of Deferral.com's administration system.