Businesses sometimes arrange what are called “golden handcuffs” or “golden handshake” agreements with key managers to reward loyalty and promote retention. A golden handcuffs strategy can make a management position so attractive it would be financially irresponsible to walk away.
The classic golden handcuff arrangement is a “top hat” program — a non-qualified deferred compensation plan (NQDC) designed solely for management employees. As a NQDC plan, it doesn’t have to comply with the bulk of ERISA regulations. And there are no IRS reporting requirements. The business still must file a Form 5500 with the U.S. Department of Labor. If the business sends the department a letter notifying it of the presence of the plan, no further filing is necessary.
Most golden handcuffs arrangements are discreetly offered as extensions to executive employment contracts. Typical arrangements include:
401(k) mirror accounts (NQDC plans) into which an executive can defer a portion of salary and/or bonus. There could be a company match — perhaps 50 cents for each $1 deferred. _The executive can bolster his or her retirement savings using pre-tax dollars.
SERPs (supplemental executive retirement plans) funded entirely by the employer. Upon retirement, SERP assets can offer a pension-style income for the key employee.
Stock options with a vesting period of three years or less, perhaps complemented by subsequent options down the line. This also could take the form of restricted or phantom stock.
Many key managers owe sizable income taxes corresponding to their considerable salaries. In the sweetest scenario, the key employee defers most or all of his or her annual salary. Instead of regular income tax, he or she faces a lesser burden of paying capital gains tax linked to the income from the options.
To fully reap benefits like these, a key employee must fulfill the terms of the agreement. Usually this requires staying in the executive position for a certain number of years and/or completing a specific major task. Most NQDC plans also provide a death benefit to a designated beneficiary if there are still benefit payments remaining for the employee at the time he or she died.
If the key manager quits or jumps ship before becoming fully vested, he or she could lose the matching dollars contributed to the plan by the company. There will also be the matter of having to deal with a lump sum of income and a big tax bill.
How do companies fund such plans? Many businesses elect to do this with corporate-owned life insurance. Other options include a private annuity contract, company stock or even earnings from a company investment portfolio.
How can a life insurance policy can be tapped to make payments to a living individual? Loans are made against the cash value of the policy or policy withdrawals are made. Such loans are commonly tax-free. Withdrawals are also tax-free to the extent of the premiums paid toward the coverage.
COLI funding offers the business the potential for tax savings and cost recovery. If a 45-year-old executive puts away $15,000 annually into an NQDC plan for 20 years at 7 percent interest, in 20 years he or she will end up with $658,000. If those assets enjoy tax-deferred growth with COLI funding of the plan, the business can save 35 percent (nearly $120,000) in federal taxes on the gains in that period. If the executive passes away at age 78 with the company still owning the life insurance policy, the company would collect a $2.3 million death benefit.
NQDC plans are commonly unsecured. This means if a company goes belly up, the agreement could amount to an empty promise. The company also could undergo a change of control. Acrimony between a key manager and ownership might result in a change of heart.
A top hat plan is usually not a good idea for a small family business due to tax reasons. When a closely held business sponsors a NQDC plan, it can’t deduct employee contributions to the plan until the year in which the employee recognizes income. If it sponsors a qualified retirement plan such as a profit-sharing plan or a 401(k), it can deduct contributions before the employee has to recognize them as income.
Golden handcuffs can make key managers feel appropriately rewarded — and think twice if they’re tempted to leave.