Is a Pension a Deferred Compensation Plan?

A pension is a form of deferred compensation, an arrangement where an employee earns income that is paid out at a future date, usually during retirement. This structure allows a portion of an employee’s total compensation to be postponed. A pension’s classification within the broader category of deferred compensation determines its protections, tax implications, and operational rules.

Defining Deferred Compensation

Deferred compensation is any arrangement where an employer and employee agree to delay paying earned income to a future year. These plans are split into two classifications: qualified and non-qualified. The classification depends on whether the plan adheres to federal requirements that dictate participation, funding, and security.

A qualified deferred compensation plan meets the requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). These regulations protect employees’ retirement savings by establishing standards for participation, vesting, and funding. Qualified plans cannot discriminate in favor of highly compensated employees and must be offered to a broad base of workers.

In contrast, a non-qualified deferred compensation (NQDC) plan is an arrangement that does not meet ERISA guidelines. NQDC plans provide supplemental retirement benefits to executives and high-income earners who may be limited by the contribution caps in qualified plans. Because they are not governed by ERISA’s protective rules, these plans carry different risks and tax consequences.

Pensions as Qualified Deferred Compensation

A pension plan is a qualified deferred compensation plan. For defined benefit pension plans, which promise a specific monthly benefit at retirement, protection is enhanced by the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal agency that insures a portion of promised pension benefits, offering a safety net if a private-sector pension plan is terminated without enough money to pay its obligations.

The employer can generally take a tax deduction for contributions made to the plan in the year they are made. For the employee, contributions and investment earnings grow on a tax-deferred basis. The employee does not pay income tax on the money until it is distributed during retirement, when payments are taxed as ordinary income.

Pension plans must adhere to nondiscrimination rules. These regulations ensure that the plan does not disproportionately benefit a company’s owners or highest-paid employees. To maintain its qualified status, the plan must cover a significant percentage of the non-highly compensated workforce.

Understanding Non-Qualified Deferred Compensation Plans

Non-qualified deferred compensation (NQDC) plans offer additional deferred income to a select group of management or highly compensated employees. These plans are not subject to the same contribution limits as qualified plans, allowing executives to defer substantial amounts of their salary or bonuses. Common examples include Supplemental Executive Retirement Plans (SERPs), deferred bonus plans, and salary reduction arrangements.

NQDC plans involve a high level of risk. Unlike a pension, where funds are held in a trust separate from the company’s assets, NQDC plans are often unfunded promises from the employer. The deferred funds remain part of the company’s general assets, making them subject to the claims of creditors in the event of bankruptcy and placing the employee in the position of an unsecured creditor.

The tax implications for NQDC plans are different. The employer does not receive a tax deduction until the compensation is paid to the employee. For the employee, distributions are governed by the rules of IRC Section 409A, which dictates the timing and form of payments. Once an election to defer compensation and the payment schedule are made, they are generally irrevocable.