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Deferred Compensation
Deferred compensation is any type of compensation that is put aside to be paid by an employer to an employee at a later date. It normally represents only a part of the employee’s regular compensation and is usually put into an account or simply promised by the employer in the future. Standard types of deferred compensation that are familiar to most workers include retirement plans, pension plans, and ESOPs or employee stock option plans. In all cases, this is compensation that the employee has earned but also agreed not to receive until a later date.
The main purpose of deferring compensation is to simultaneously defer tax payments on income earned. When employees don’t receive their compensation immediately, it’s not taxed immediately. It can therefore be used in full to generate investment income and taxes are only paid when it is accessed in the future. This is normally after retirement when people generally are in a lower tax bracket than when they’re working. This can make deferred compensation a form of tax arbitrage.
Qualified Deferred compensation
Deferred compensation can be qualified or non-qualified. Qualified deferred compensation refers to plans that are controlled by government bodies such as ERISA (the Employee Retirement Income Security Act of 1974) in the US. These plans are strictly controlled and have annual contribution caps.
They include 401(k) retirement plans and 403(b) plans, their counterpart for employees of churches, schools, and nonprofit organizations. Once employers contribute to these plans, the funds belong to the employees and cannot be returned.
ESOPs may also represent deferred compensation if the stock options awarded to employees are vested, meaning they only become available after a certain period of service to the employer.
Non-Qualified Deferred Compensation
Non-qualified deferred compensation (NQDC) plans are not limited by government bodies and have no contribution caps in place. However, they still defer payment to the employee until either retirement or a later date agreed to in the employee’s contract. These plans are usually only offered to high-income earners who reach their 401(k) contribution caps and would like to put more money away for retirement. While this can be beneficial, it also comes with risks. NQDC plans don’t require the transfer of funds immediately, so they’re considered credits. If the company promising these credits goes bankrupt before they’re paid, the employee’s funds could be lost.
Advantages of Deferred Compensation
Deferred compensation is often advantageous for both employers and employees. Its benefits include:
- Tax benefits: Deferring tax payments on earned compensation is the main reason for the widespread use of deferred compensation plans. Essentially, compensation that is not received directly as income cannot yet be taxed. Instead, it can be invested in full to generate further income (though investment profits are taxed). By deferring income in the form of a pension or retirement plan, an employee also defers the tax payments on that income, usually until they’re in a lower tax bracket.
- Long-term financial planning: Deferred compensation can be seen as a form of forced saving. When people have more money available, they tend to spend more, which can leave them without in the future. By deferring the receipt of their compensation until later, usually after retirement, people can save more for the future and reduce their financial risks.
- Employee retention: Vested stock options and NQDCs can be offered strategically by employers to both attract talent and keep employees with them longer. By offering compensation that can only be accessed after a number of years of service, the employer incentivizes the employee to stay, essentially buying their loyalty.
Challenges and Risks of Deferred Compensation
While deferred compensation has some obvious advantages, it’s not without risks and challenges for both employees and employers. These include:
- Regulatory compliance: Employers must learn and follow the specific rules set out for the use of deferred compensation. These rules outline contribution caps, payment schedules, triggers for payment, and other guidelines that employers must follow or face punishments.
- Potential for financial loss: Any form of deferred compensation that does not securely put funds into accounts or investment vehicles owned by the employee can be risky. If a company goes bankrupt or its stock price plummets, the employee can lose some or all of their funds.
- Delayed access to funds: One challenge for employees is the opportunity risk that delaying access to their compensation can create. Some employees will have to forgo investment opportunities, purchases, or even emergency use of their funds because they do not yet have access to them.
Best Practices for Managing Deferred Compensation
When managing deferred compensation, it’s important to consider employees’ personal needs and finances. High-earning executives will likely want to defer much more of their compensation for retirement savings. It’s also crucial to set clear rules for when employees can access their funds and what types of events (e.g., retirement, years of service, or changing employers) can trigger payment.
Deferred Compensation for the Future
Deferring compensation allows employees to save on taxes and put money away for the future. It can also help employers incentivize and retain their workers. While most employees use qualified plans, some employers will offer NQDC plans to help their employees put away as much as possible.
FAQ
Normally, employees don’t pay tax on compensation until they receive it as income. By deferring compensation, they may be able to defer paying taxes until they are in a lower tax bracket and, therefore, pay less.
Employers should consider how much income their employees can afford and want to have deferred. They can also consider employees’ risk profiles as funds promised in NQDC plans are normally tethered to specific investments that can differ in volatility.