Senior Director | CAPTRUST Marketing
Events in Washington this year have caused many companies to dust off their nonqualified deferred compensation plans or, in some cases, consider offering one for the first time. In addition to the higher individual income tax rate passed into law earlier this year as part of the American Taxpayer Relief Act, high earners are also subject to the 3.8 percent Medicare contribution tax on net investment income and higher taxes on capital gains and dividends. However, beyond the obvious near-term benefit of tax savings, renewed focus on deferred compensation plans is a welcome development for many key executives for another reason — these plans may help bridge the “executive retirement gap.”
Although they may not be aware of this issue, key executives and other high earners are likely to have a difficult time maintaining their lifestyles in retirement solely based upon payments from Social Security and withdrawals from defined contribution plans. Even contributing the maximum annual amount to a qualified plan will not allow workers earning more than $150,000 a year to accumulate sufficient wealth to replace the 70–80 percent of pre-retirement income recommended. In fact, the higher the individual’s income level, the more severe the retirement income gap can be.
This executive retirement gap is a result of:
Caps on employee contributions. Employees may defer a maximum of $17,500 into a defined contribution plan, such as a 401(k) and 403(b) plan, in 2014. Those turning age 50 and older can take advantage of a catch-up provision allowing them to set aside an additional $5,500, capping the total at $23,000 a year for deferrals.1 Deferrals for higher-paid employees may also be limited as a result of top-heavy or nondiscrimination issues in a plan.
Compensation limits. The maximum annual compensation level eligible for qualified retirement plan contributions and benefits in 2014 is $260,000, meaning compensation above this level is ineligible for employer-matching contributions.2
De facto maximum on Social Security benefits. There is no explicit dollar cap on Social Security benefits. However, the program’s progressive benefit formula, combined with the earnings amount on which workers pay taxes ($117,000 in 2014) and accrue credit toward future benefits, means that the program replaces a greater share of pre-retirement income for lower-paid workers than higher-paid ones.3
Figure One illustrates the impact of these limits: a 45-year-old executive earning $150,000 a year, deferring the $17,500 annual maximum into her 401(k), receiving a 4 percent employer match, and taking advantage of her catch-up contribution opportunity starting at age 50, will be able to replace approximately 27 percent of her income at age 65 with 401(k) plan withdrawals (assuming a 7 percent investment rate of return). Based upon its current formula, Social Security should provide an additional 19 percent, totaling 46 percent income replacement. If she delays retirement until age 67, those numbers rise to 31 percent replacement from her 401(k) and 24 percent replacement from Social Security for a total of 55 percent. Supplemented with additional personal after-tax savings, a 70–80 percent replacement rate is within reach.
For a more highly compensated executive earning $300,000 a year, twice the previous example, the total replacement rate drops to 29 percent and 33 percent at ages 65 and 67, respectively, leaving a significant retirement income gap. Deferring retirement a few years until age 70 has a modest impact, raising the replacement rate to 45 percent. Regardless, a significant gap remains to be funded, presumably from a combination of other company-sponsored savings programs, such as nonqualified deferred compensation, stock purchase, or stock option plans, and personal after-tax savings.
Executives and other high earners—like all American workers—are increasingly relying on defined contribution plans as their retirement cornerstone. However, they may be surprised to learn that maxing out their qualified retirement plan savings opportunities, even on top of Social Security, will not provide sufficient income in retirement to maintain their lifestyles. Defined contribution limits and Social Security benefit formulae dictate that, as income levels rise from $150,000 to $300,000 and beyond, these programs replace a smaller proportion of pre-retirement pay. Some may believe that their current level of savings is enough; others may simply be unaware of how much they need. According to the Employee Benefit Research Institute, less than half (47 percent) of workers have completed a retirement needs calculation to determine how much money they will need in retirement and how much they will need to save to meet that goal.4 While education designed to sensitize highly compensated employees to the executive retirement gap could help, plan sponsors may also want to consider providing or promoting their additional savings opportunities, such as a nonqualified plan, to help bridge the gap. We welcome the opportunity to discuss starting or optimizing a nonqualified deferred compensation plan strategy for your company.
1 Internal Revenue Service. “IRS Announces 2014 Pension Plan Limitations; Taxpayers May Contribute up to $17,500 to Their 401(k) Plans in 2014.” Internal Revenue Service. October 31, 2013. http://www.irs.gov/uac/IRS-Announces-2014-Pension-Plan-Limitations;-Taxpayers-May-Contribute-up-to-$17,500-to-their-401(k)-plans-in-2014. Accessed December 2013
3 Ruffing, Kathy, and Paul N. Van de Water. “Social Security Benefits Are Modest: Policymakers Have Only Limited Room to Reduce Benefits Without Causing Hardship.” Center on Budget and Policy Priorities. January 11, 2011. http://www.cbpp.org/cms/?fa=view&id=3368. Accessed December 2013
4 Employee Benefit Research Institute. “2013 Retirement Confidence Survey.” Employee Benefit Research Institute. 2013. http://www.ebri.org/files/Final-FS.RCS-13.FS_3.Saving.FINAL.pdf. Accessed December 2013