Page 314 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

300 The Complete Guide to Executive Compensation

Plan Types
As stated, retirement plans are of three types: defined benefit, defined contribution, and a
hybrid, or combination, of the two. The defined-benefit plan specifies the amount of annuity
that the employee will receive after reaching a certain age and/or service requirements, and
the contribution is determined annually to meet this annuity amount. The defined-contribu-
tion plan specifies the amount of money to be set aside each year; the value of such money at
the time of retirement will be a factor of the market value of the investments made. In other
words, in one case, you know how much you will get, but the ultimate cost is unknown until
the assets are valued. In the other instance, you know how much is being set aside each year,
but you don’t know how much it will be worth when you retire. Defined-benefit plans
encourage individuals to stay with the company; defined-contribution plans do not penalize
the person for leaving.
Since the future benefit can be projected under a defined-benefit plan, one must estimate
the probability of that future benefit being paid (the individual may have left the company)
expressed in the present-value equivalent, after factoring in investment performance. The
better the performance, the lower the company contribution. Some estimate that the contri-
bution can be reduced 4 percent for every quarter percent improvement in investment
performance.
If plan benefits are related to pay received by the employee, an assumption must be
made as to the level of future pay increases (This is more critical for final pay than career-
earnings plans since the former affects all years of prior service). If the plan is integrated
with social security, future increases in social security benefits must be estimated, but only
to time of estimated retirement. It is not permissible to reduce benefits after retirement
because of increases in social security payments. In addition, assumptions must be made
about how many people will leave the plan before becoming vested, when the vested
employees will leave and begin drawing benefits, and how long they will live (and continue
receiving benefits). Finally, any administrative expenses that will be charged to the plan must
be estimated.
Qualified defined-benefit and defined-contribution plans are of limited appeal to execu-
tives because of limits in effect to retain the tax-qualified status. First, there is a limit on the
amount of compensation that may be considered for plan purposes. While this amount may
be adjusted for changes in the cost of living, it is far short of what many executives are being
paid in salary and annual incentives. Second, there is a maximum on the annual benefit that
may be received and the annual amount that may be contributed on a combined basis by
employer and employee. Third, there is an additional limit on the amount of pretax contri-
bution that can be made, and even though indexed for cost of living, it is only a fraction of
the amount allowable for plan purposes as highlighted above in the first limit. Furthermore,
plans must be tested to ensure they are not “top heavy” (i.e., a disproportionate benefit is
given to key employees). Key employees are defined by income and/or percent of company
stock owned.
Therefore, the real value of qualified defined-benefit and defined-contribution plans to
executives is not the benefits received from the qualified plan but rather the plan formula
before the qualified limits are imposed. The difference between the qualified benefit and the
plan formula typically will be made up by a nonqualified benefit for executives. These are
called 415 plans because they refer to the limit imposed by Section 415 of the IRC.