Using Nonqualified Deferred Compensation to Attract and Retain Key Employees

By Randy Cook, Partner, Saalfeld Griggs PC

A major component to any successful financial services employer 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 employer’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amounts contributed to the plan, the employees covered under the plan do not realize taxable income until amounts are withdrawn, and the investment growth on plan assets is tax deferred until withdrawn.

Because of the significant tax benefits offered under qualified plans, such plans are subject to stringent nondiscrimination rules that often make it difficult to target key employees with benefits greater than those given to the non-key employees. In many instances, the cost of funding the key employees at a higher level is increased funding for the non-key employees, which in turn can completely offset the benefit of funding the key employees. 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 “nonqualified” deferred compensation to attract and retain key employees.

Unlike qualified retirement plans, nonqualified plans do not offer the employer a current deduction for amounts contributed to the plan. Moreover, assets in a nonqualified plan do not grow tax deferred. However, one major benefit of adopting a nonqualified plan is that benefits can be targeted toward a select group of management or key employees without running afoul of any of the nondiscrimination rules applicable to qualified plans. The other major benefit is that the key employees who accrue benefits under these plans are not taxed on those benefits until they are distributed.

Because nonqualified deferred compensation plans are not subject to the same qualification 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 nonqualified 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. Still others provide that benefits will be forfeited if the key employee engages in misconduct that is considered harmful to the employer.

Nonqualified plans are typically designed as either a “defined contribution” plan or as a “defined benefit” plan. Under the defined contribution plan design, 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. The amounts credited each year are also typically credited with earnings and losses based on an investment vehicle identified in the plan document. Under the defined benefit plan design, the employer promises the key employee a specific benefit at retirement. For example, a typical defined benefit design in a nonqualified plan might 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 worked for the employer.

Nonqualified deferred compensation plans technically must remain “unfunded” and “unsecured” in order for the key employees to avoid current taxation of the promised benefits. However, most nonqualified plans are “informally funded” by the employer so that the accrued liability on the company’s books is offset by a corresponding asset. Unlike with qualified plans, any amounts that are contributed by an employer to informally fund a nonqualified plan must remain assets of the employer, subject to the employer’s general creditors.

Targeting retirement benefits toward an employer’s key employees can produce a win-win result, regardless of whether the plan is qualified or nonqualified. 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.


Saalfeld Griggs PC, an OBA Associate Member, is a law firm serving financial institutions throughout Oregon and Washington with legal matters involving Creditors’ Rights & Bankruptcy, Litigation, Employment Law, Real Estate & Land Use, Estate Planning, and Employee Benefits & Executive Compensation. Randy Cook is the partner in charge of the firm’s Employee Benefits & Executive Compensation Practice Group. Learn more at