Non-qualified deferred compensation programs allow executives to defer pre-tax compensation until some future date, allowing the funds to be invested on a tax-deferred basis until they are paid out to the executive.
The opportunity for an investment to grow without immediate taxation can provide a substantial financial advantage compared to an after-tax investment alternative. This is because amounts withheld for current taxation cannot generate future investment earnings. The longer the time frame, the larger the gap becomes between the values of a pre-tax investment strategy and the after-tax alternatives. But the relative advantage depends heavily upon the tax attributes of the available alternative after-tax investment vehicles. Future investment earnings from a pre-tax deferral program are taxed at ordinary income rates when received.
In a deferral plan, the market risk associated with an investment is compounded by the credit risk of the company. Non-qualified plans are by definition unsecured promises to pay out future benefits. Even with the use of a common funding vehicle such as a rabbi trust, the executive is not protected from the insolvency of the company.
Both executives and employers considering voluntary deferred compensation arrangements have many factors to weigh during this transition period. It takes an extended time horizon for deferral plans to be advantageous to the executive, and many executives are not willing to put their dollars at risk for the long term. Companies will always find creative ways to compensate talented executives, but the cost and administrative burden of voluntary deferral plans may force companies to look toward other types of compensation and benefits to accomplish their goals.