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Tips For Restructuring Executive Deferred Compensation Plans Under New Legislation

The American Jobs Creation Act of 2004 created a new section in the Internal Revenue Code that specifically deals with nonqualified executive deferred compensation plans.  New rules for executive compensation arrangements are effective January 1, 2005, but also apply to existing arrangements modified after October 3, 2004.  Treasury guidance has given employers until December 31, 2005 to bring existing arrangement into compliance with the new rules. However, arrangements must be operated in good faith compliance with the new rules during 2005.  The most significant changes required to be made this year by the new legislation will relate to elections regarding the form and timing of distributions under the plan.  This ALERT is intended to provide employers with tips in thinking about restructuring the distribution alternatives under their plans. 

The new legislation requires that participants elect the form in which they will receive their benefits at the time of deferral and greatly inhibits their ability to change the form of retirement distributions. However, the new legislation, adds considerable flexibility with respect to scheduled date distributions.  Thus, as people begin to understand the new rules, we can expect to see a move away from distributions which are contingent on retirement or termination of employment toward distributions made on a scheduled date elected by the executive.  This will be true even for more traditional plans structured only to provide benefits on retirement.

1.  Retirement Benefits Now Difficult to Change

The new legislation severely limits flexibility with respect to forms of distributions upon retirement or termination of employment.  This is because most plans only offer one choice regarding form of payout of retirement benefits and typically require that the benefits commence on termination of employment.  Under the new legislation, the election with respect to form of payout must be made at the time of deferral of the first dollars which are paid into an account.  Thus, if only one choice of payout is offered upon retirement, the executive must make that choice upon first entering the plan.  Thereafter, the executives may not change the form of payout of retirement benefits unless he further defers commencement of such benefits until at least five years after retirement.  Most plans do not currently allow participants to defer commencement after retirement which in effect prohibits executives from making any change to the original form elected for retirement benefits. 

2.  Possible Changes to Retirement Benefit Structures to Increase Flexibility

a)   Offer More than One Retirement Account

It is possible to had some flexibility to retirement benefit elections by allowing participants to have more then one retirement account so that if they originally elected a lump sum payout, they might later elect a different form of payout for amounts contributed to the plan after the election to change the form of payout.   Thus, for example, if an executive has elected to receive benefits over 20 years upon entering the plan, the plan might allow the executive to later change that election to receive benefits based on contributions to the plan after such election to 10 years.  In this case, the plan would maintain two retirement accounts for the executive.  One would hold all amounts contributed to the plan prior to the change in payout form and would continue to be paid out over 20 years.  The other would contain all amounts contributed after the change and would be paid out over 10 years.  After the change, a participant would be able to elect each year to have amounts deferred in that year go into the 20 year payout account or the 10 year payout account, but the participant would not be able to move money between the two accounts or change the form of payout of either account unless he elected to delay commencement of benefits under that account by at least 5 years.

b)   Allow Delay in Commencement of Retirement Account

Unless a plan allows participants to delay the commencement of benefits after termination of employment, it will be impossible for a participant to change the form of payout with respect to amounts already credited to a retirement account.  This is because the new legislation does not allow a participant to change the form of payout unless the commencement of benefits is delayed by at least 5 years.  If the plan does not allow such a delay, then no change is possible.  Thus, many employers are changing their plan structure to allow a delay in commencement of at least 5 years after termination of employment.  Some employer are changing distribution alternatives with respect to retirement accounts to, in effect, convert them into scheduled date accounts by allowing participants to elect to commence their retirement benefits either on retirement or on a specified date or age.  This new hybrid structure takes advantage of the new flexibility offered under recent legislation for scheduled distributions accounts discussed below.

3.  New Flexibility for Scheduled Date Distributions

Plans previously offered very limited scheduled date distribution alternatives.  Such elections were generally irrevocable and were superseded by retirement elections in the event that termination of employment preceded the scheduled date.  Under the new legislation as currently understood much more flexibility is offered for scheduled date distributions.  Scheduled date distributions may be changed at any time up to 12 months before the scheduled date as long as the date is pushed out by at least 5 years.  By use of scheduled date distributions, employees may elect an early date and then roll deferrals forward in 5 year increments.  However, offering maximum flexibility to participants will require changes in the way plans are structured and accounts are administered:

4.  Possible Changes to Scheduled Distribution Structures to Increase Flexibility

a)  Allow Retirement Payouts From Scheduled Accounts

Flexibility may be added by restructuring plans to allow employees to elect to spread the payout of a scheduled date distribution over the same period of years offered for retirement distributions and to have such payout election continue to apply after termination of employment.  Thus, an employee who is uncertain about the form in which she wants to receive her retirement benefits might elect and unscheduled withdrawal at age 57 and then 12 months before such date she would have the option (assuming the plan was structured appropriately) to elect to receive her retirement benefit on or after age 62 over any period of years available under the plan. It would even be possible for the same participant to decide at age 61 to further defer some or all of the benefits elected for distribution at age 62 by another 5 years.  Thus, the use of scheduled withdrawal accounts, as apposed to retirement accounts can add considerable flexibility.

b)  Allow Multiple Scheduled Distribution Accounts

Another alternative is to allow participants to make multiple scheduled date distributions.  Thus, for example, a plan may allow a participant to make up to 5 lump sum scheduled date distributions beginning at age 65.  The participant's benefits would be divided between 5 accounts each holding 20% of the participant's funds.  At age 64 the participant would be about to elect to receive some or all of the funds in the first account at age 65 and roll the rest to age 70.  Each year the participant could decide how much of the money in the account coming up for payment to take in the following year and how much to roll 5 years.  Thus, participants might have maximum flexibility during retirement to take funds from their accounts as desired.  This same structure might also be offered during employment if the employer desired to provide maximum flexibility in earlier years as well.   Although the new legislation prohibits unscheduled withdrawals which allowed participants to receive their funds at any time by paying a penalty, the new legislation as currently understood allows plans to be structured to effectively allow participants to take up to 1/5 of their funds out each year with no penalty. 
Historically deferral plans have been structured around distributions which are contingent upon retirement or termination of employment.  However, based on the current interpretation of the new rules, we can expect to see plan designs move from retirement distributions to scheduled date distribution elections offering the greatest flexibility to executives both before and after retirement.

We would be happy to help you evaluate the alternatives for restructuring you executive compensation plans. If you would like us to do so or have further questions, contact Marla Aspinwall at 310.282.2377.

This client alert is a publication of Loeb & Loeb LLP and is intended to provide information on recent legal developments. This client alert does not create or continue an attorney client relationship nor should it be construed as legal advice or an opinion on specific situations.

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