Designing Your Retirement Program to Attract and Retain Key Employees

A major component to any successful business is its ability to attract and retain key employees. Studies indicate that an employer’s retirement program is high on the list of factors considered by key employees when choosing an employer, second only to current compensation. With creative planning, an employer’s retirement program can be tailored to fit the specific needs of the employer’s key employees. When practicable, the preferred method for targeting retirement benefits toward key employees is to do so through the company’s “qualified plan” (i.e., pension, profit sharing, 401(k), or employee stock ownership plan). All qualified plans have three common characteristics: the employer receives a current deduction for amounts contributed to the plan, the employees covered under the plan do not realize taxable income until amounts are withdrawn, and assets in the plan grow tax deferred until withdrawn.

Because of the significant tax benefits offered under qualified plans, such plans are subject to nondiscrimination rules that generally prohibit offering benefits to the key or “highly compensated” employees that are greater than the benefits offered to the “non-highly compensated” employees. Although the most common method for demonstrating compliance with these nondiscrimination rules is to give all employees the same percentage contribution, an alternative to that approach is to use the “cross-tested” method of making plan allocations.

Under a cross-tested plan, key employees are placed in a separate job classification from the non-key employees, and are given employer contributions that are sometimes up to five times the percentage given to the non-key employees. For example, a cross-tested plan might designate two classes of employees, “management” versus “non-management,” and may in a particular year give the management class an employer contribution equal to 25% of wages, while the non-management class receives a contribution equal to 5% of wages. As long as the average age of the management class is higher than the non-management class, the allocations can be considered nondiscriminatory under IRS rules.

Occasionally, the cost of making contributions to the non-key employees’ accounts under a qualified plan can completely offset the benefit of making contributions for the key employees, even under the cross-tested method. That is often the case if the employer has a large number of non-key employees who qualify for the plan, or when the average ages of the non-key employees are the same as or greater than the key employees. When that is the case, the employer should consider using a “non-qualified” deferred compensation plan to attract and retain its key employees.

Unlike qualified retirement plans, non-qualified plans do not offer the employer a current deduction for amounts contributed to the plan. Moreover, assets in a non-qualified plan do not grow tax deferred. However, the major benefit of adopting a non-qualified plan is that contributions need only be made for the select group of management or key employees targeted by the employer.

Because non-qualified deferred compensation plans are not subject to the same nondiscrimination rules as qualified plans, employers are free to include within these plans certain features that would otherwise be impermissible in the qualified plan arena. For example, many non-qualified deferred compensation plans provide that the key employees who benefit under the plan will lose all benefits if they compete with the employer upon termination of employment. Others provide for long vesting schedules that exceed the maximum vesting schedule permitted under qualified plans.

Non-qualified plans are designed as either “defined contribution” plans or as “defined benefit” plans. Under the defined contribution plan approach, the employer credits the key employee with a specific dollar amount each year. That amount is usually determined either as a percentage of the key employee’s wages, or as some percentage of the company’s profit. Under the defined benefit plan approach, the employer promises the key employee a specific benefit at retirement. For example, a typical defined benefit design in a non-qualified plan will provide that the key employee will receive at retirement an annual benefit equal to 1.5% of the key employee’s final annual wages, multiplied by the number of years that the key employee works for the employer.

Targeting retirement benefits toward an employer’s key employees can produce a win-win result, regardless of whether the plan is qualified or non-qualified. The key to designing an effective and efficient retirement program is to understand the limitations and benefits of each plan design, and then implement the design most suited for your needs.