As a board member of a public sector employer, you may feel that you are blessed with an excellent CEO that has leadership, vision and management skills. Unfortunately, in today’s economic environment, the public sector CEO can demand benefits and incentive pay commensurate with the private sector. How do you compete?
Public entities are at a competitive disadvantage when competing against private sector employers for highly skilled leadership and management employees. Public sector employers cannot offer their employees benefits such as ownership, stock options, restricted stock or phantom stock, to name a few of the executive compensation tools available to private sector employers. Faced with the possibility of losing quality management personnel, public sector employers should consider the use of a longevity award program based upon the provisions of IRC § 457(f).
Retaining top level leadership and management employees for the public sector has become increasingly difficult given the public sector’s inability to compete with private sector pay and benefits. Private sector employers are able to tie compensation to a company’s profitability, and use a number of specialized benefit programs to defer recognition of income and taxation to the employee. As a result, many top level public sector employees are either recruited away from the public sector, or seek other employment opportunities which provide incentives for their gifted leadership, management capabilities, and entrepreneurial skill.
Loss of senior management also impacts public sector employers in other ways. Maintaining continuity of leadership over time maintains recruiting and business advantages gained by the reputations of these managers, maintains institutional knowledge, and provides for smoother transitions when elected officials change. In addition, many public employers find that these employees have kept their services and operations on the cutting edge of developments in the fields of interest of the employer.
IRC § 457(f) is a unique deferred compensation program, in addition to the normal deferred compensation programs, which provides an incentive for the employee to stay with the employer. In simple terms, an employer can award deferred income to a specific individual, and that deferred income can take many forms. Examples include an annualized rate of return, a predetermined amount, negotiated contributions and interest, investment gains on funds set aside, or employee salary reduction contributions. The deferred compensation must, however, remain subject to a “substantial risk of forfeiture,” which is usually tied to future services. It is not necessary to fund the deferred compensation obligation currently, but it is a contractual obligation of the public employer, subject to forfeiture requirements. Upon fulfillment of the employees obligations, the funds are dispersed and become taxable to the employee.
Substantial risks of forefeiture can be tailored to existing employment contracts, but must be real, not illusory. There are two ways to structure the “substantial risk of forfeiture” element, post termination and pretermination. Examples of post termination restrictions include consulting services or non-solicitation requirements and bona-fide restrictive covenants. Such restrictions usually last for two (2) years. However, as the employee gets closer to retirement, the IRS is less likely to agree that any post termination restriction rises to the level of a substantial risk of forfeiture.
A pre-termination restriction occurs prior to leaving employment. For example, with contracts that provide for a three (3) year rolling term, a pre-termination requirement could be that the employee continue in the employment for the remaining term of the employment agreement. If the employee leaves prior to the end of the term, he would forfeit the deferred compensation benefit. The IRS generally requires two (2) years of employment services in order for the deferred compensation agreement to satisfy the substantial risk of forfeiture requirement. There is, however, a lot of flexibility in determining benefit design.
This type of longevity award program must be tailored to meet the requirements of IRC § 457(f) and ERISA. It is often referred to as a “top hat” program, as it is not a qualified plan, and is generally available only to those in senior management.
By developing a 457(f) plan and granting these benefits, the public employer has an additional tool to retain key personnel. The employee, on the other hand, receives benefits which reward loyalty to the employer, and recognize his or her leadership and management skill.
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