THE EXECUTIVE COMPENSATION THREAT TO RETIREMENT.

• Date: 22 September 2022
• Author: Wiedenbeck, Peter,Stein, Norman

INTRODUCTION 78
                I. TOP HAT PLAN MEMBERSHIP AND ITS CONSEQUENCES 85
                A. Legislative History of the Top Hat Plan Exemption 88
                B. Administrative Implementation and Judicial
                Interpretation 92
                C Top Hat Plans and ERISA's Policies 100
                D. ERISA Advisory Council Study 105
                II. NONDISCRIMINATION AND ITS LIMITS 115
                A. Targeting the Tax Subsidy 117
                B. Nondiscrimination and Redistribution 122
                III. INTERACTIONS 130
                A. Divergent Functions of "Unfunded" Benefits 131
                B. Divergent Functions of "Highly Compensated" 137
                IV. THE UNINTENDED NQDC TAX EXPENDITURE 147
                V. SOLUTIONS 155
                A. Disclosing Risks to Top Hat Plan Benefits 155
                B. Restricting Top Hat Plan Eligibility 157
                C Mandating Accrual-Based Taxation 163
                CONCLUSION 164
                

INTRODUCTION

The United States spends more than $200 billion annually subsidizing retirement savings in tax-qualified retirement plans. (1) That subsidy is delivered in the form of preferential tax treatment, specifically tax deferral. Congress has long understood that such a tax-based incentive for saving, if delivered on an individual basis, would yield perverse results: higher income individuals, who face larger tax liabilities, obtain the most benefit from tax deferral, yet these are the people with sufficient resources to save adequately without assistance. Since 1942, the central condition imposed on a pension, profit-sharing or stock bonus plan seeking favorable tax treatment is the requirement that the plan not discriminate in favor of highly compensated employees with respect to either participation (meaning the workers covered by the plan) or the contributions or benefits provided. (2) (Plans that satisfy the requirements for favorable tax treatment--that qualify for special tax privileges--are called "qualified plans.") (3) The nondiscrimination rules produce a complex, covert and clunky cross-subsidy intended to encourage firms to extend retirement savings to low- and middle-income employees--those workers who often lack sufficient discretionary income to save adequately on their own, and whose personal income tax exposure is too modest for tax deferral to lure them to save. (4)

To the extent that highly paid workers save for retirement on a tax-advantaged basis outside of qualified plans, the redistributive force of the nondiscrimination rules is blunted. It was for that reason that Congress restricted tax-favored savings through individual retirement accounts (IRAs), which, because they are personal rather than employer-sponsored savings vehicles, do not induce redistribution. (5) But there is a new threat to the retirement savings of most Americans: the unmonitored expansion into middle management ranks of a traditional tool of executive compensation, the so-called "top hat" pension plan. (6) Top hat plans are unfunded deferred compensation programs for a "select group of management or highly compensated employees." (7) If a top hat plan is properly structured, the plan's participants are not currently taxed on the value of benefits earned each year, nor on any investment income credited to them. Taxation is deferred until actual receipt of benefits. (8) From a participant's perspective, this delayed inclusion mimics the taxation of qualified retirement plan benefits, fostering an impression of comparable value.

Despite this superficial resemblance, top hat plans do not receive the same tax treatment accorded qualified retirement plans because top hat plan earnings are currently taxable and the employer's deduction is deferred until distribution. (9) These disparities cause investment income credited to the participant to be taxed at the rate applicable to the employer rather than the employee-participant's rate. If the employer's marginal rate is nearly the same as the employee's, then the combined tax burden of the employer and the employee will be comparable to that borne by individual after-tax savings. (10) In contrast, if the employer's tax rate is lower than the employee's, tax savings can be obtained from top hat pensions. (11)

Top hat plans are excused from certain labor law protections that ERISA, the Employee Retirement Income Security Act of 1974, (12) imposes on retirement plans, whether tax qualified or not. In particular, a top hat plan is exempt from minimum vesting standards, minimum funding rules and fiduciary obligations. (13) Thus, a participant's interest in a top hat plan may be substantially less secure (exposed to greater risks of loss) than her interest in a retirement plan protected by ERISA.

The inapplicability of those labor law protections also controls tax timing. Top hat plan classification effectively functions as the gateway to avoiding pre-distribution taxation of benefits. (14) But for the top hat plan exemption, advance funding would generally be required, (15) and the participant's interest in plan assets would be protected from the employer's creditors by operation of law. (16) An interest in assets shielded from the employer's creditors constitutes "property" for income tax purposes, triggering taxation as soon as the interest is no longer subject to a substantial risk of forfeiture. (17) And because ERISA's mandatory minimum vesting rules would apply, the participant's interest would become nonforfeitable by operation of law in short order, ordinarily once the employee has performed no more than five years of service. (18) Thus, the value of a participant's stake in a nonqualified retirement savings arrangement that is not an exempt top hat pension will ordinarily be taxed to the participant long before receipt. (19) No significant tax savings can be garnered from this state of affairs.

Top hat plans actually pose a triple threat to the retirement savings system. This article shows how three interconnected pathologies undermine core retirement policy objectives.

First, top hat plans expose participants to risks of benefit loss that ERISA was designed to eliminate. (20) In particular, top hat plans are exempt from ERISA's labor law worker protections--including the anti-forfeiture rules (vesting), advance funding, spousal protections and fiduciary obligations (21)--apparently on the view that top executives call the shots and can look out for themselves. But the definition of top hat plan is fuzzy, and over the decades since enactment of ERISA, top hat plans have increasingly included middle-management employees who are not in a position to protect themselves by negotiating their compensation package.

Second, a top hat plan participant not only avoids current taxation as benefits are earned, but the total tax burden on her savings is also reduced if the employer's tax rate is lower than her own. Since 2018, the corporate income tax rate has been a flat 21%, while the progressive rate schedules of the individual income tax go up to 37%--actually 40.8% once account is taken of the surtax on net investment income. (22) Hence, saving through a top hat plan potentially offers tax savings to any corporate employee whose marginal rate exceeds 21%. (23) Moreover, even if the prescribed individual and corporate income tax rates were aligned, many corporations face an effective tax rate of zero in many years because net operating loss deductions may be available to shield investment earnings from tax. (24) In short, a huge swath of the population could benefit, taxwise, from top hat plan participation if they wanted to save more for retirement than they can under a qualified plan. Top hat plan saving, in other words, is now partially to fully subsidized for workers earning upper-middle or higher levels of compensation. Yet, top hat plans are not subject to the nondiscrimination regime that is the bedrock of the qualified retirement plan system.

This situation presents a risk that top hat plan saving might substitute for increases in qualified retirement plan benefits. (25) While top hat plan saving is preferable to individual after-tax saving for many well-paid employees, qualified plan saving, under which investment returns are fully tax exempt, can be still more beneficial. (26) At first glance that might seem to alleviate substitution risk. Unfortunately, it does not. The choice between saving for retirement through a top hat plan versus a qualified plan is not left to the employee: the employer must be willing to offer these programs, and the employer sets their terms and conditions. Consequently, the employer is positioned as gatekeeper, able to grant or withhold access to these differently taxed saving opportunities. If the employer determines that top hat plan coverage is more cost-effective than increasing qualified retirement plan benefits, the company can direct savings for a "select group of management or highly compensated employees" into top hat pensions. The considerable burdens imposed by the tax law's qualification requirements--most importantly the nondiscrimination rules--may make top hat plan saving relatively more cost effective from the employer's perspective. In contrast, broadly distributing retirement saving (under the demands of the nondiscrimination rules) may require increasing total labor compensation costs. (27)

Third, beyond evading redistribution, this cost-containment strategy comes fraught with externalities. With nonqualified deferred compensation (NQDC) now subject to lower tax rates than the individual would face outside the plan, revenue losses attributable to top hat plan savings mount. The tax regime applicable to NQDC--hitherto overlooked or excused from annual tax expenditure reckonings--cries out for expert quantification and focused assessment. (28) The grand irony is that rank-and-file employees, whose pensions are not enhanced when their employer offers retirement savings through a top hat plan, pay income taxes that finance (in part) the favorable tax treatment enjoyed by their "select" highly compensated coworkers.

After almost 50 years, there is still no clear definition of "select group of management or highly...