There is an old Chinese curse “May you live in interesting times.” Well, that certainly has come true during the last several weeks. We have seen the reemergence of the “Gang of Six,” the creation of a “Super Committee,” the political system at its worst with the debt ceiling debacle, nauseating stock market swings and the unimaginable downgrading of US sovereign debt.
One certainty that will emerge from all this is that either taxes will rise or entitlements will fall or both. What will that mean to the individual facing retirement? Several wealth managers were referenced in an August 8 Wall Street Journal article because of an interesting approach they are taking with their clients. They are instructing their clients from ages thirty to the mid-sixties to reduce from 25 percent to 50 percent the amount they expect to receive from Social Security. One such manager has gone as far as instructing his clients under the age of fifty to not count on any social security benefits.
There is a savings crisis in the United States, although it has improved since the panic of 2008. The ever-present 401(k) plan may stop the erosion of retirement benefits but will not be enough to fund current life styles. More companies are reducing or canceling their defined benefit pension plans. In other words you will have to rely on your own efforts to generate your retirement benefits.
You need to now focus on creating your own entitlement. A voluntary deferral of your current earnings into a nonqualified deferred compensation plan is once again gaining traction in the corporate world. A corporation will sponsor a nonqualified plan but the individual in most circumstances will be doing the funding with pre-taxed dollars. These plans can discriminate concerning participation and in fact cannot be made available to those who are not highly compensated or part of a select group of management. You can contribute up to 100 percent of your compensation to such a plan These plans have certain limitations in that the sponsoring company can’t deduct the deferrals until they are physically paid out and the deferrals are not protected against the insolvency of the sponsoring company. If a participant is comfortable with the fiscal soundness of the sponsoring company then participating in such a plan also allows for more flexibility than encountered in a 401(k) plan including distributions prior to age 59 ½ without penalty or periodic distributions for specified needs such as college tuition.
A sponsoring corporation that is concerned about retaining its key personnel could match with unvested contributions in one of these plans with the vesting occurring at retirement so that there is an incentive to stay with the company. This retains the company’s best talent. Also, as previously written in this column, these plans may also be used to protect a company in the event there is a need to claw back compensation pursuant to the Dodd-Frank provisions.
The tax benefit under this plan is that you are able to invest pretax dollars as opposed to after tax so that growth will be significant because it will be on a gross amount, not the net. So if tax rates rise at the time of deferral and subsequently go down (as has happened in the past) at time of retirement when you receive distributions then you have managed to achieve a beneficial arbitrage. Depending on what assets are made available for investing it is possible to defer tax on the growth just like in a 401(k) plan. The way this is achieved is through the use of Corporate Owned Life Insurance a key investment strategy in nonqualified plans.
What the individual has accomplished in participating in a nonqualified plan is to create his or her own entitlement and insure that one’s retirement will not need to rely on the Social Security safety net. So perhaps we can now change the curse to “May you live in a comfortable retirement,” and after all, how bad can that be?
Michael G. Goldstein is president and CEO of Summit Alliance Executive Benefits, LLC, and a national authority on executive compensation, taxation, estate planning and corporate law.