Non-qualified plans must be technically and legally unfunded.
According to the IRS, if plan benefits are formally funded the
participant is in constructive receipt of the money and is, therefore, subject
to current taxation. However, many
companies informally fund their non-qualified plans by designating assets
to correspond to the benefit liabilities. As long as the company's designated assets are still within reach
of its general creditors; the plan is considered unfunded.
Companies that self-fund
non-qualified benefit plans simply pay benefits out of general assets as they
come due, then deduct them as a business expense.
This self-funded approach is a short-term solution for a
long-term liability. As a result
of the non-qualified plan, current management sees no impact to cash flow or
management compensation. (Profits are impacted by the FASB requirement to book an accrued
expense.) As current management
retires and the successor management team takes over, those new managers
will see an impact on cash flow and management compensation, not from their own
benefits, but from payments to the retired executives.
(A self-funded plan can be compared to
the Social Security system in this respect.)
Future managers then find themselves paying for benefits to
former executives who are no longer vital to the company.
It may be a short step to a company “change
of heart”— when management cancels the plan.
Executives can have much greater assurance that their
non-qualified benefits will be paid if funds are set aside currently.
While a company has the option to
cancel a plan, it is less likely to do so if the plan has been informally
Since legislated limits prevent companies from funding full benefits for executives
on a qualified plan basis and the self-funded approach doesn't plan ahead for a
non-qualified plan's long term liabilities, companies can look to three
informal funding alternatives: a sinking fund, annuities, or Corporate Owned
Life Insurance (COLI).
If an employer sets up a sinking fund, the corporation invests in
specific assets and pays
the promised benefits from the earnings on those assets.
In order to generate sufficient
earnings to pay both the income taxes on fund earnings and the executive
benefits, the employer must invest in higher risk, taxable investments.
Although the impact is less than a
self-funded plan, a sinking fund still has a negative impact on the employer's
An employer also has the option to purchase an annuity
at the time an executive
retires. The employer is at risk
for the ultimate cost of the annuity; the cost depends on the interest rates
available at the time the executive retires and the corporation buys the
annuity. The executive's risk of
actually receiving benefits, which was based on the employer's ability or
willingness to pay, is transferred to the issuer of the annuity.
The purchase of an annuity is an
expense to the employer and has a negative impact on net worth.
A company that funds its
non-qualified plan with COLI buys life insurance policies on the lives of plan
participants and names itself as beneficiary.
When a participant dies, the employer receives the tax free
death benefit, recovering the policy premiums, the after-tax cost of benefits
paid, and even the after-tax cost of funds spent on premiums and benefits
(proceeds are included in
alternative minimum tax calculations).
addition to cost recovery, COLI offers employers the advantage of tax-free
investment earnings. Some
non-qualified plans are designed to use policy cash value, which is not taxed
as it grows, to pay retirement benefits. Also, for accounting purposes, the growing cash value acts as an offset
to plan liabilities, and produces a positive earnings impact after a few plan
years. Funding non-qualified
benefits with COLI also helps the company reassure shareholders. While
disclosing the non-qualified executive benefits in the proxy, the company can
state that policies have been purchased which will recover the plan costs. This
sends the message that the non-qualified
plan will have little impact on earnings and long-term shareholder value