Investment Menu Lineup Considerations for: Nonqualified Deferred Compensation Plans

In today’s knowledge economy, attracting and retaining talent is an essential component of business success. Retention has become a challenge, with workers more willing than ever to “vote with their feet” when they are dissatisfied with their company. This creates important considerations as companies evaluate their remote work policies, benefits packages, and compensation.

The conundrum is most acute for highly paid and highly specialized workers, where finding the right candidate is essential and can sometimes take years. Given that attracting these workers in the first place is difficult, retaining them is paramount. This has led employers to design compensation packages that align their incentives with the company’s. These factors help explain why it’s estimated that 98% of Fortune 1000 companies now offer a nonqualified deferred compensation (NQDC) plan to at least some of their key employees (2022 Newport / PLANSPONSOR Executive Benefits Survey).

Potential Tax Savings

Deferred compensation plans are highly valued by participants because these plans are among the most flexible options for tax-deferred savings. Deferring taxes can be a powerful contributor to wealth accumulation, as even small differences in compound growth rates can lead to very large differences in wealth accumulation over an extended period time. For example, simply utilizing a tax-deferred account can increase compound returns by 1.5% per year on a fully liquidated basis, which over 20 years would mean 31% more accumulated wealth*.

Indeed, these estimates can understate the potential benefits of tax-deferral, as income taxes on deferred compensation are generally not assessed until it is paid to the participant. If the participant elects to defer the receipt of their NQDC benefits until after retirement, they may be taxed at lower effective tax rates, depending on the election timeframe, given the typically lower and somewhat more adjustable reported income levels in that stage of life (net taxes on retirement income can be brought down, for example, by utilizing tax-exempt municipal bonds instead of other types of investments).

Plan Structure & Investment Options

Unlike qualified retirement plans, where employee funds are segregated from company assets, nonqualified deferred compensation remains a liability of the company until it is paid to the participant (or their beneficiary). This also means that any assets used to hedge the liability remain the company’s property, and that any taxable investment gains from those assets will flow to its taxable income. Consequently, companies should consider how their funding and administration choices for NQDC plans will affect their own financial dynamics.

That decision can have implications for how participant options are presented, and what type of advice and support participants should receive as they seek to allocate their deferred compensation among a menu of notional investments.** To the extent a sponsor elects to fund these liabilities, they may elect to liability match with actual investment products, potentially even actively managed alternatives, which can in turn be presented as notional investment options for participants.

DIY vs “Do-It-For-Me”

When designing a menu of notional investment options, sponsor should consider that the degree of interest in and comfort with financial markets will vary among their participants. “DIY” participants prefer a degree of manual control over their notional asset allocation and portfolio construction decisions, and often choose to select from the menu of options themselves to target their own risk profile and unique goals. This may include offsetting risk-factor concentrations they have elsewhere (for example, specific economic sectors that their wealth position is highly sensitive to, such as exposure to the industry they work in) or things like targeting environmental, social and governance (ESG) outcomes where applicable.

On the other hand, “Do-It-For-Me” participants will not have a strong sense of how to appropriately allocate their deferred compensation or will simply prefer not to have to deal with the hassle. For these participants, it is important to have options that effectively manage their notional asset class and, where applicable, product level notional allocations, most typically in risk-targeted multi-asset notional portfolios. Examples of these types of strategies include target date funds.

Morgan Stanley Can Help Align Menu Construction with Client Profile

A well-designed deferred compensation plan will maximize the potential benefits for both types of participants, while balancing the associated costs for sponsors, including, taxes, and potential profit and loss volatility that flows to their income statements until the NQDC benefits are paid to the participants (or their beneficiary).

An essential element in reaching this balance is creating sufficient choice for participants among the notional investment options, such that both those with differing risk tolerances and circumstances, and those with differing preferences for “do-it-yourself” and turnkey have access to well-diversified options that suit their needs. For example, some participants may have a longer time horizon before they need the NQDC benefits and will be better served by growth-oriented notional investment strategies, while others may have a shorter time horizon that is better served by conservative strategies.

Morgan Stanley at Work can design results-oriented menus of notional investments that can be delivered either as self-serve investment lineups or in packaged turnkey solutions for “do-it-for-me” investors. Exhibit 1 outlines our approach to delivering value for investors across the many layers of our investment process. This ranges from designing asset allocations appropriate for the current market environment, investment horizon, and risk level, to the manager selection decisions that utilize extensive research and the quantitative tools that we have developed and refined over many years to help clients select cost-efficient, quality managers whose styles and exposures complement one another in multimanager portfolios.

Considerations for Sponsors

Many sponsors choose to informally fund these plans to hedge their deferred compensation liability, reduce associated income statement volatility and provide greater assurance to participants that the funds will be available when promised. (Unlike a qualified retirement plan and depending on how the NQDC plan is informally funded, assets are generally subject to the claims of the sponsor’s creditors.) Informal funding may also help reduce the cost of NQDC benefits to the sponsor through the growth of underlying funds and may also provide a degree of tax benefit to the sponsor, depending on the underlying investment vehicle.

Investments in Corporate Owned Life Insurance (COLI) and mutual funds are the two most common approaches to informally fund plan benefits. Variable COLI policies can be taken out by the company on employees (with their consent) as a tax-advantaged vehicle to help informally fund the NQDC benefits, which can be invested in a variety of subaccount asset classes of the issuing insurance company’s separate account. COLI generally offers tax deferred growth of the cash value of the policy, as well as income tax-free proceeds in the event of the employee’s death, subject to certain requirements (a possible hedge against key-person risk to the company). The drawbacks of COLI include its complexity, lesser liquidity, and narrowed universe of available subaccount investment options, as well as additional administrative costs and fees, particularly if loans or withdrawals of assets are made.

In choosing which vehicle (or combination of vehicles) to use to informally fund NQDC benefits, sponsors will want to consider a variety of factors. Companies with persistently low or zero tax liability may want to avoid the fees and complexity of COLI, as they would not benefit from its tax benefits. Similarly, companies with only a small number of participants may not find the additional cost of COLI to be worth the concern.

Conclusion

While NQDC plans offer significant benefits to participants, particularly due to their flexible plan design options and potentially large tax savings, it can be difficult for plan sponsors to navigate the complexity associated with offering a NQDC plan. We advocate an approach that considers the goals of both participants and sponsors from beginning to end, from building notional investment menus to structuring potential informal funding and payout options.

By leveraging the depth of experience and expertise from across Morgan Stanley, we can help you deliver a deferred compensation package that is well-suited to the needs of both your participants and your bottom line. Talk to a Morgan Stanley Financial Advisor about evaluating your current NQDC plan or considerations to offer a new plan.