Phantom Investments vs. Real Investments

Participant accounts in a Nonqualified Deferral Plan (NQPD) are referred to as phantom or hypothetical investments because they are only a measure of the amount owed the participant - the participant's account will be credited with gains or losses based upon the activity of the hypothetical investments.

The plan sponsor is not obligated to invest the contributions according to the participants' investment selections. In fact, they are not obligated to invest the contributions at all. The IRS has issued a number of Private Letter Rulings that deal with this issue. In general, they state that the employee may express a preference for investments, but the employer cannot be obligated to invest according to the employee's preferences. In other words, the employee suggests an investment preference. Although participant accounts will accumulate as if their contributions were invested in those preferences through a phantom or hypothetical investment account, the employer must be free to invest the deferrals as it sees fit.

If the company were obliged to follow the participant's selection, the plan may be considered funded for ERISA purposes, and violate the ERISA top hat exemption. If the exemption is violated, the plan would be subject to a great many of the qualified plan provisions of ERISA, without the benefit of deductible contributions.

Real investments indicate that the deferred compensation is actually utilized to purchase securities. The company retains the money deferred by the participant and uses it to purchase actual investments that may mirror the aggregate investment allocations elected by the participants. As the corporation realizes gains through dividends received and trades affected, the corporation will incur immediate taxation without any offsetting deduction until the participant receives distributions. The company can book the income tax expense as a loss, or the company can pass this cost along to the participants in the form of reduced net earnings or direct charges to their account balances. Reducing participants' earnings or balances will make the program less attractive.

NOTE: When a company makes real investments, they must not actually attribute ownership to the participants, which would require ERISA compliance.

In summary, phantom investments give the plan a mechanism for tracking performance when calculating gains or losses on a participant's deferrals. No money is actually invested in these funds. Real investments take the participant deferrals and actually purchase the investments that the participants have selected. Although real investments do have transactional costs associated with them, they provide an asset that mirrors the liability created by the participant account balances.

Please refer to Funding a Plan, for a more detailed discussion of sponsor alternatives for financing a nonqualified deferred compensation plan.



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