NYLEX Benefits - Benefit Plan Security

Benefit Plan Security

Security of Nonqualified Benefits

Nonqualified benefit plans involve unfunded promises with the executive-participant having the status of an unsecured creditor of the company. The employee’s benefit depends on the financial solvency and, to some extent, the trustworthiness of the sponsoring employer.

Unlike a qualified plan where assets to fund the executive’s benefits are protected by a special trust designed to insulate him or her from the employer’s creditors, a nonqualified plan must be “unfunded”. This unfunded status is required in order to avoid current taxation of the employee, even though benefits may not be payable until some future date.

It should come as no surprise that executives have sought to enhance the security of their retirement benefits. Several approaches have been developed to help ease the concerns of participants in nonqualified benefit plans.

Rabbi Trusts

The rabbi trust takes its name from the beneficiary in the initial IRS ruling approving this type of arrangement. A rabbi trust is a grantor trust established to hold the assets intended to pay the nonqualified benefits. In order to avoid current taxation of the plan participant, assets in a rabbi trust must remain subject to the claims of the employer’s general creditors in the event of the employer’s insolvency or bankruptcy. However, by making the trust irrevocable, it offers the participant the protection, short of the company’s bankruptcy or insolvency, that the assets will only be used for the payment of the intended benefits.

For most purposes, the rabbi trust’s activities are considered as those of the sponsoring company’s and the trust’s activities are included in the employer’s income tax return. The IRS has developed a model rabbi trust document, which companies generally follow in order to make sure they are complying with the safe harbor requirements established by the Service.

Secular Trusts

Secular trusts are similar to rabbi trusts, but offer the additional benefit of insulating plan participants from the creditors of the employer company. Specifically, benefits are protected not only from an employer’s change of heart or change in control, but also from a change in the employer’s financial condition.

This additional level of protection comes at the cost of current taxation of the employee-participant, even though actual receipt of benefits is deferred until a later date. For this reason, secular trusts generally are used only in special situations, such as where a company’s financial condition makes employees unwilling to bear the risk that the employer will default on its benefit promise.

Non-trust Arrangements

Non-trust security arrangements generally do not set aside specific assets to pay promised benefits. Instead, they rely on a third party to make the payments should the employer be unable to do so. Employer-provided security arrangements have been frowned upon by the IRS, which has contended that such arrangements result in current taxation to the employee. Employee-arranged security devices sometimes are available, although the cost may be high relative to the protection they offer. Furthermore, third-party guarantees rely on the financial solvency of the guarantor. In the appropriate circumstance, third party arrangements may be worthwhile.