Evaluating a deferred compensation plan.

• Author: Ellentuck, Albert B.
• Position: Case study - Statistical Data Included

Facts: Tom Henderson, an executive, wants to retire in approximately five years. Tom is currently in the 39.6% marginal tax bracket, but anticipates being in the 28% bracket during retirement years. Tom is evaluating a deferred compensation plan that his employer, Community National Bank (CNB), designed to provide him with additional funds at retirement. Under the proposed arrangement, the parties would implement a five-year deferred compensation plan, commencing Jan. 1, 2001 and ending Dec. 31, 2005. At the end of each calendar year, CNB would accrue an amount equal to 10% of Tom's annual base salary. The deferred compensation would be credited on CNB'S books to a deferral account in his name. The entries to Tom's account are only memorandum entries; no actual funding occurs, because this is an unsecured promise plan payable from the company's general assets. Each December 31, CNB would accrue as credited earnings an amount equal to 7% of the previous year's December 31 balance in the deferral account. (Seven percent was chosen, because this is the rate Tom can earn on outside investments). The deferred compensation due to Tom would be paid in installments on Jan. 1, 2007-2009. Each installment would equal one-third of the deferred benefit as of Dec. 31, 2005, plus the appreciation (i.e., interest) for the year. If employment is terminated by reason of death, disability or discharge, the account balance would be paid in three annual installments commencing 30 days after termination. If Tom dies before receiving payment of his entire deferral account, the unpaid balance in the account would be payable to his designated beneficiary (or to his estate, if no beneficiary has been designated). The payment schedule to the beneficiary or estate would be the same as it would have been to Tom had he lived. Issue: Would this deferred compensation plan be advantageous to Tom?

Analysis

Whether the plan is beneficial depends on a mix of economic, tax and financial considerations. However, Tom's adviser can use the following five-step approach to evaluate the proposed arrangement.

Step 1: Evaluate the risk of deferral. The deferred compensation arrangement is unfunded (i.e., paid from the employer's general assets rather than from assets restricted and secured for compensation), Ownership Of the deferred amounts remains with CNB; its creditors can attach the funds. While Tom believes the company, under current ownership, can and will pay the deferred...