NQDC Plan Employer Bankruptcy Risk: The Mariner Wealth Advisors Checklist

The costly assumption: a deferred balance is as safe as a 401(k)

Hypothetical: Victor is 58, an SVP of operations at a consumer-goods company, and expects to stop working in three years. His wife Jeanette, 60, is a retired school principal with a pension. Victor has $1.8 million in a nonqualified deferred plan and treats it like his 401(k). On top of it he keeps $700,000 of employer stock.

Their net worth is $4.5 million: the $1.8 million plan, the $700,000 of stock, $1.5 million in 401(k)s and IRAs, and $500,000 of home equity. Employer exposure is $1.8M + $0.7M = $2.5 million, about 56% of the total.

Now suppose the company failed. Creditors recover 20 cents on the dollar (an assumption for illustration), so the plan returns $360,000 and loses $1.44 million. The stock goes to zero, and that's another $700,000. Total loss: $2.14 million, about 48% of net worth.

That's the price of the assumption. A 401(k) is held in a trust separate from the employer. A nonqualified plan is a line on the employer's balance sheet.

Jeanette's school-district pension is a quiet strength here. It doesn't depend on Victor's employer at all.

Why do nonqualified deferrals sit with general creditors?

The plan has to stay unfunded and subject to the employer's creditors, or the deferral would be taxed right away under the IRS constructive-receipt and economic-benefit rules. That exposure is the price of the tax deferral. You postpone the tax, and in return you take the employer's credit risk.

Top-hat plans, meant for a select group of management, are exempt from ERISA's funding and trust requirements. That's why they can stay unsecured without breaking the law.

Section 409A adds another layer. It taxes money set aside for participants when the employer's financial health weakens, so a company in trouble can't legally move your balance out of creditors' reach.

The payout choice also sets how long you stay exposed. Our article on deferred comp lump sum vs installments covers that trade-off.

Myths about deferred comp in a bankruptcy

Most executives we talk to believe at least one of these. Each one feels reasonable, and each one is wrong in a way that costs money.

• Myth: a rabbi trust protects me. Truth: it guards against a change of heart by management, not against insolvency. Its assets go to creditors if the company fails.
• Myth: the PBGC insures it. Truth: the PBGC insures defined benefit pensions, not nonqualified deferred compensation.
• Myth: my balance sits in index funds, so it's mine. Truth: the funds are a bookkeeping measure. You own a claim, not shares.
• Myth: I can take the money out if the company looks shaky. Truth: Section 409A generally prohibits accelerating payments, with narrow exceptions such as some plan terminations.

How large is the exposure? Victor and Jeanette's stress test

Look at the last column: the loss falls with each block of stock sold, but never below $1.44 million, because the deferred balance stays put.

Today exposure is $2.5 million (56%). Selling half the stock cuts it to $2.15 million (48%), and selling all of it cuts it to $1.8 million (40%). The stress-test loss drops from $2.14 million (48%) to $1.79 million (40%) to $1.44 million (32%). The 20% recovery is an illustrative assumption, not a typical figure.

These figures come before capital gains tax on the stock sales. Victor's basis is low, so before Mariner Wealth Advisors recommends any sale, we work out what the tax would cost him.

As an SVP, Victor may be limited to open trading windows or a prearranged 10b5-1 trading plan, and that can stretch the selling out over several quarters.

How much deferred comp plus company stock is too much?

Once your deferred compensation plus employer stock passes about 30% of net worth, stop new deferrals and diversify the stock first. Section 409A generally won't let you take the deferred balance out early, so the stock is the part you can actually change.

Victor still sits at 40% after selling every share. The balance only shrinks once payouts begin in three years.

The rule has a limit we won't hide. When the deferred balance alone is above 30%, no sale brings you under the guide quickly. The rule keeps exposure from growing, and payouts then reduce it slowly.

We would rather pay a known capital gains tax than keep two claims on one company, because a bankruptcy hits both at once.

• Pro: selling all the stock cuts the stress-test loss by $700,000.
• Pro: it's fully in Victor's control, unlike the deferred balance.
• Pro: proceeds can be spread across the broad market.
• Con: capital gains tax on low-basis shares.
• Con: possible trading-window restrictions.
• Con: you miss any rise in the stock.

How Mariner Wealth Advisors reviews deferred comp risk, step by step

The review is short and numbers-driven. We base it on decades of research and broad diversification. Your company's next quarter doesn't enter into it.

• Step 1 (you): send the plan document, the latest deferral statement and a brokerage statement showing employer shares.
• Step 2 (advisor): add up all employer exposure, including deferred balances, stock and unvested awards, and show it as a share of net worth.
• Step 3 (advisor): run a stress test with an assumed recovery rate and the stock at zero, then give you a one-page summary.
• Step 4 (you and advisor): decide on the next deferral election and a stock-sale schedule inside trading windows. Repeat the review when the employer's financial condition changes.

A checklist for your plan document and your employer's finances

Run through this list once a year, and again after any bad news about the company.

• Plan terms: is there a rabbi trust, does a change-in-control clause trigger payout, and are payouts made from general assets?
• Employer signals: credit-rating downgrades, a dividend cut, covenant waivers on debt, or an auditor's going-concern note in the annual report.
• Your side: the share of net worth tied to the employer, the years until payouts start, and other income such as a spouse's pension.
• Timing: the date of the next deferral election and the next open trading window.

What should you ask, and what should you do this week?

Start with two small tasks. Download the plan document and search for the words 'rabbi trust' and 'general creditors.' Then add up deferred balances plus employer stock and divide by net worth. If the result is above about 30%, flag the next election before its deadline.

Then bring these questions to your advisor:

Mariner Wealth Advisors can run the stress test with your actual statements, by video or phone. Send the documents through the request form.

• What share of my net worth would I lose in a bankruptcy at a low recovery rate?
• Which employer stock lots carry the smallest tax cost to sell?
• Should I stop or reduce next year's deferral?
• How does my payout schedule change how long I'm exposed?