Employee Benefits & Pensions

SERP Shifts and Sec. 409A

In recent years, many companies have transferred executives’ retirement benefits from nonqualified to qualified plans, using a technique commonly known as a “supplemental executive retirement plan (SERP) shift.” Doing so provides the executives with greater financial security and more favorable financial treatment, and also often results in tax and accounting benefits for the employer. With the enactment of Sec. 409A, which places severe constraints on the design of nonqualified deferred-compensation (NDC) plans, these arrangements need to be scrutinized to ensure that they comply with the new law. Fortunately, the IRS’s Sec. 409A proposed regulations (REG-158080-04, 10/4/05) allow leeway for the continued use of SERP shifts.

Background

The type of SERP most frequently involved in a SERP shift is joined to a qualified defined-benefit plan. Typically, the SERP’s benefit formula will be the same as the qualified plan’s, but will take into account compensation in excess of the maximum ($225,000 in 2007) that a qualified plan may consider. The SERP benefit will then be reduced by the amount the participant is entitled to receive under the qualified plan. A retired executive thus will receive two checks: one from the qualified plan, and the other from the employer to satisfy its liability under the NDC plan.

To “shift” benefits from the NDC plan to the qualified plan, the executive’s benefit entitlement under the latter must be increased. The SERP liability will then automatically decrease to reflect the larger qualified plan offset. It may not be possible to shift the entire liability, because the nondiscrimination rules and other qualified plan restrictions limit benefit increases for highly paid employees, but shifting a large portion of the liability is very often feasible. 

Effect of Sec. 409A

Sec. 409A complicates matters, because it requires participants in NDC plans to elect at the outset when and in what form benefits will be paid, with very limited ability to make changes later. Qualified plans, by contrast, usually give participants great flexibility to change the timing and manner of distributions, almost up to the moment of actual receipt. A SERP shift could be viewed as an evasion of the Sec. 409A rules. In effect, the rigid NDC plan payout schedule is jettisoned in favor of the more lenient qualified plan rules. 

Prop. Regs. Provide Clarification

The Sec. 409A proposed regulations clarify that such a shifting of benefits is permitted, because (1) in certain situations, there is no deferral election; and (2) there is no acceleration of payment associated with the transfer of liability when the qualified plan benefits offset the NDC plan.

Prop. Regs. Sec. 1.409A-2(a)(8) provides that changes in a qualified plan formula are not deemed to be a deferral election. For instance, there is no deferral election when NDC benefits are (1) calculated based on the same formula as the qualified plan, but without regard to the Code’s qualified plan limits or (2) offset by qualified plan benefits. Moreover, even if the changes increase the amounts deferred under the plan, a deferral election does not exist as long as the time and form of payment do not change.

This rule applies, however, only when the nonqualified SERP initially provides for offsetting benefits by accruals under a qualified plan. Further, a SERP cannot be amended to add a qualified plan offset, unless the offset applies only to SERP benefits attributable to future service.

If, however, a company’s NDC plan is not linked to a qualified plan as previously described, only benefits accrued in the future may be shifted to a qualified defined-benefit plan to offset the NDC plan liability. In these instances, future accrued benefits paid only from the qualified plan assets are not subject to Sec. 409A. The resulting NDC plan, with lower future accrued benefits, continues to comply.

Prop. Regs. Sec. 1.409A-3(h)(3) states that there is no acceleration of payment if the NDC plan benefits are offset by some or all of the qualified plan benefits. A qualified plan amendment does not constitute an acceleration of payment, even though the benefits deferred under the NDC plan are decreased.

From Thomas Veal, J.D., Chicago, IL, and Laura T. Morrison, J.D., LL.M., Washington, DC