To retain key employees, make their jobs too good to leave. Arrange “golden handcuffs” agreements with key managers to reward loyalty and promote retention. A golden handcuffs strategy can make a management position so attractive that it would be financially irresponsible to walk away.
The classic golden handcuffs arrangement is a “top hat” program – a non-qualified deferred compensation plan (NQDC) designed solely for management employees. As a non-qualified plan, it does not have to comply with the bulk of ERISA regulations – and there are no Internal Revenue Service reporting requirements. The business must still file a simple statement with (and provide plan documents to) the Department of Labor within 120 days of setting up the plan. Doing this relieves the firm of having to file Form 5500s with the IRS. It also frees the top hat plan from having to produce a summary plan description.
Golden handcuffs agreements can substantially reward fully vested executives. Most are discreetly offered as extensions to employment contracts. Typical arrangements include:
*401(k) mirror accounts. Executives can defer X% of salary and/or bonus annually into these NQDC plans. In this way, they can bolster their retirement savings using pre-tax dollars. They can potentially improve their long-term tax picture by deferring some of their compensation to a future date when tax rates may be lower. The company may offer a match – perhaps the company kicks in 50¢ for each $1 deferred. The money can be withdrawn at retirement or some other future point.
*Supplemental executive retirement plans (SERPs) funded entirely by the employer. Upon retirement, the SERP assets can foster a pension-style income for the key employee.
*Stock options/grants that vest over a certain period, perhaps complemented by subsequent options/grants. A savvy high-earning key employee could elect to defer most or all of his or her annual salary, so that instead of regular income tax, he or she faces a lesser burden of paying capital gains tax on the income from the options.
To fully reap benefits like these, a key employee must fulfill the designated terms and conditions of the agreement. Usually this requires staying in the executive position for X number of years and/or completing a specific major task. An executive can commonly select a designated beneficiary for an NQDC plan or a SERP.
If the key manager quits or jumps ship before becoming fully vested, he or she could lose the matching dollars contributed to the plan by the company. There will also be the matter of having to deal with a lump sum of income and a big tax bill.
How do companies fund top hat plans? Many businesses use corporate-owned life insurance (COLI). Other options include a private annuity contract, company stock, or even earnings from a company investment portfolio.
You may be wondering how a life insurance policy can be tapped to make payments to a living individual. It can be done, and SERPs are commonly funded this way. Here’s how it works: cash value is taken from the policy up to basis, followed by policy loans. Unless the policy is a modified endowment contract, this shouldn’t generate any taxable income for the corporation that has bought the policy.
Golden handcuffs arrangements are commonly unsecured. This means that if a company goes belly-up, the arrangement may amount to an empty promise. Bankruptcy or cash flow problems may delay, reduce, or curtail payments to a key manager. Additionally, a company could undergo a change of control; acrimony between a key manager and ownership could even result in a change of mind. Some firms address these risks by establishing trust funds related to the arrangement.
Can unincorporated businesses have top hat plans? Yes, but they are much more suitable for corporations, C corps in particular. Since top hat plans are unsecured, a business implementing one really needs to be well-established and have steady cash flow. While a proprietorship, partnership, or S corp can set up an NQDC plan for employees who hold no percentage of ownership in the company, the owner(s) of such firms are commonly unable to defer taxes on their shares of business income.
A golden handcuff arrangement can be useful tool for big companies. It can make key managers feel appropriately rewarded – and cause them to think twice if they are tempted to leave.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.