Deferred compensation plans are arrangements by which a part of an employee’s compensation is paid at a later date, or put into investment instruments that the employee can only access at some point in the future
Benefits and Hazards of Deferred Compensation
There is a large variety of deferred compensation plans, arrangements by which a part of an employee’s compensation is paid at a later date, or put into investment instruments that the employee can only access at some point in the future. There are two basic reasons for deferred compensation. From the employee’s point of view, it reduces or at least postpones his income tax liability. For employers, deferred compensation helps to manage payroll costs and can be used as an incentive for better employee performance.
Types of Deferred Compensation
The most common type of deferred compensation plan is the “defined contribution plan”:
A portion of the employee’s pay is deducted and invested on his behalf, usually in some form of mutual fund.
These are familiar to workers in the US as the “401(k)”, named after the section of Internal Revenue Code that pertains to them. The deferment from the employee’s salary is made before income taxes are withheld, which is a benefit to both employees and the employer. Employees do not pay taxes on their investments until they withdraw them sometime in the future, and employers are able to reduce the amount of withheld taxes they must remit to the government. Many employers also match all or part of the employee’s contribution, providing an extra incentive for employees to participate in the program; this helps to reduce the company’s transactions costs for maintaining the investment package.
In the US, 401(k) programs have the added security of being protected by law from creditors in case of the company’s bankruptcy, although the value of the employees’ investments can fluctuate; in the wake of the 2008 financial crisis, millions of US workers saw the value of their 401(k) savings drop as stock markets plummeted.
Other kinds of deferred compensation packages not covered by the same regulations as 401(k) programs are more risky, although they generally offer higher returns.
Non-401(k) programs are generally only offered to the highest-earning employees who also pay the highest rates of income tax. The main reason for these kinds of programs is that there are legal limits on the amount of money that can be deferred into a 401(k). The main risk is that there is much less regulation of non-401(k) programs, and they are not protected from bankruptcy. Many workers in the US discovered they had lost their investments in the wake of the financial crisis when their employers declared bankruptcy.
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Stock purchase plans and stock option plans are also common forms of deferred compensation:
In a stock purchase plan, the company establishes a trust to receive employee contributions, which are converted to shares of the company’s stock.
Stock purchase plans are regulated in much the same manner as 401(k) programs, the only real difference being that instead of contributions being invested in an array of mutual funds, they are only reinvested in the company. The plan is popular with employers and employees alike; for employers, the stock purchase program is reflected in better cash flow and tax savings and is seen as a useful tool to increase employee productivity. Employees benefit by gaining an ownership stake in the company, and some small degree of control over the growth in value of their investments.
Stock option plans differ in that the employee is not actually compensated in the form of stock, but “earns” options to purchase the company’s stock at a low fixed price in the future.
A stock option plan has most of the same benefits as a stock purchase plan but allows the company to keep control over its shares for a longer period. Employees in rapidly-growing companies benefit the most from stock option plans; a well-known recent example is Facebook, which launched a highly-publicized – and unintentionally controversial – IPO in 2012. Facebook employees who had exercised their options prior to the IPO were able to profit handsomely from the high price Facebook shares fetched in the market, but their returns were reduced somewhat by a condition that they hold their shares for a time before selling them; Facebook’s share price dropped rapidly after the IPO, so employees who waited too long to sell shares saw very little profit, or even lost money in some cases.
Another less well-known version of a stock-based deferred compensation plan is called the “phantom” stock plan:
It provides employees benefits similar to those they would receive from owning company stock, without actually giving stock to the employees.
For example, employees might be compensated in “stock credits” equivalent to shares of stock, from which they can receive bonus payments based on the stock’s performance or dividends paid. Because phantom stock plans are hard to regulate and do not provide many benefits to employers as conventional purchase or option plans.
What Should Employees Look for in Deferred Compensation Plans?
Because deferred compensation programs are based on investments that can lose as well as gain value, employees considering a compensation offer should make sure they understand the details of the deferred compensation package. 401(k) programs are the most highly-regulated and most secure but vary in the specific funds or investment instruments they contain. In the 2008 financial crisis, many 401(k) holders watched their investments vanish because a large number of 401(k) funds were heavily invested in popular but ultimately worthless mortgage-backed securities.
For stock-based deferred compensation plans, the biggest issue is what part of the employee’s compensation the plan is supposed to represent since it is very difficult to quantify the future value of stock. Employees should ask for details about whether a certain level of returns or other incentives is guaranteed, and what limits are imposed on stock purchases or sales. Compensation is compensation, whether deferred or not, and it is up to an employee to decide whether or not what he can expect to earn, in whatever form he will receive it, is a fair exchange for his work.