Deferred Compensation

This is a compensation scheme in which a percentage of the income of an employee is paid out at a deferred date after the income was earned. Examples include retirement plans, employee stock options and pensions. It is at times referred to as NQDC, QDC, DC or golden handcuffs. The primary and most significant benefit of the scheme is the tax deferral to the actual date(s) when the employee finally receives the delayed income.

Although "Deferred Compensation" has been used to describe any arrangement in which an employee receives his income at a later date after earning, the more widespread usage of the terms is in reference to "non-qualified" delayed compensation. It also refers to a specific section of the tax code which is providing a special type of benefit to executives in the corporate world as well as other corporate employees who are highly compensated.

Types of Deferred Compensation

Essentially, a deferred compensation plan amounts to a retirement plan provided by the employer, designed to allow employees to put aside some portion of their hard earned money from each of their paychecks towards their retirement package. This is a plan that can help in bridging the gap between what the employee has in his/her Social Security and pension, and how much the employee will need in retirement.

There are generally two broad DC categories: qualified (QDC) and non-qualified (NQDC). The two greatly differ in their legal handling or treatment, and also from the perspective of an employer in terms of the purpose they are designed to serve or meet. Often however, "Deferred compensation" is used in reference to non-qualified plans, although technically the term covers both.

1. Qualifying (QDC)

Qualified DCs are pension plans which are strictly governed by the US Employee Retirement Income Security Act and include 457, 401(k) and 403(b) plans. Any company that is using a plan must extend the same to all the employees, but not to its independent contractors. QDC is designed solely for the benefit of the plan recipients, which implies that creditors will not have access to the funds in case the company fails in meeting its debts obligations. Contributions made to these plans are legally capped by the law as stipulated under the ERISA provisions.

2. Non-qualifying (NQDC)

Also known as Golden Handcuffs and 409(a) plans, Non-Qualified Deferred Compensation plans offer employers with a method of attracting and retaining particularly valuable employees. This is because they really don't have to be provided to all the employees and they come with no caps on amounts of contributions. Additionally, independent contractors also qualify for Non-Qualified DC plans. For several companies, NQDCs offer an excellent method of hiring expensive talent without necessary having to immediately pay for their full compensation, which means that they can put off funding these financial obligations for some time.

Non-Qualified DC plans are contractual agreements between the employer and the employees; therefore, although they come with limited possibilities legally, they are more flexible when compared to the QDCs. An NQDC, for example, might come with a non-complete clause.

How does it Work?

The contributions you make go to a specific account having your own name. The account value will depend on your contributions and the DC plan's investment performance over the years.

There are essentially 3 steps towards taking part in a DC deferred plan:

  1. Enroll - This is easy as your contributions get deducted automatically from each of your paychecks and then deposited into your DC account.
  2. Invest - Choose funds from the investment options list available within your DC plan.
  3. Receive your retirement income - The majority of employees in the public sector retire earlier compared to their counterparts working within the private sector. Before you even start the payments, carefully review the Retirement Checklist to ensure that you're ready for the transition from regular saving to spending.

Benefits of Participating in a DC Plan

Taking part in the DC plans is not mandatory. The decision on the amount you want to contribute is yours and is deducted directly from your paycheck and then submitted into the DC account. In the United States, these plans are available to all employees of the state and to public agencies employees such as commissions, boards, municipalities, and school districts if they have opted to offer it.

Deferred compensation help in terms of putting you in charge of where, when, and how much you want to invest. Additional reasons for participating include:

  1. Start anytime: Your DC plan is going to work well for you whether you're just starting to invest or are approaching retirement.
  2. Every little saving helps: Even little bits of investments done over time can really add up to something substantial - it's therefore just as important to get underway with the plan. In addition, when you continue bumping up your contributions regularly, the overall impact may not appear to be too painful on your paycheck. Consider for example, channeling bonuses and raises into your deferred comp.
  3. Plan is ideal for you: Different from other types of retirement plans, a deferred compensation 457(b) plan takes into consideration that you might retire earlier than employees working in the private sector. In general, you will not have to be anxious concerning paying penalties typically charged for early retirement or when you begin receiving income from the DC plan before attaining age 59½.
    1. What are the Investment Options?

      As a DC plan participant, you'll get access to a broad variety of investment options. Your options were pre-selected by your DC plan and help towards meeting your retirement planning requirements. Always remember that any investment involves some element of market risk, which includes potential loss of your principal.

      The kinds of investment choices that are available to you generally fall into 5 main asset classes:

      1. Target date funds
      2. Risk-based funds
      3. Bonds funds
      4. Stock funds
      5. Short-term investments


      From the perspective of the employee, Deferred Compensation plans provide the possibility of a lower tax burden and a fine method of saving for retirement. As QDC plans have contribution limits, executives who are highly compensated can only invest tiny percentages of their income in the qualified plans. However, NQDC plans don't come with this disadvantage. There is on the other hand, a risk in case the company goes bust as creditors will come and seize NQDC plans funds because they don't possess the same kind of legal protections that QDCs plans have.

      This somehow makes the NQDCs a rather risky option for those employees whose income distributions begin many years later or whose companies might be in a financially weak position. Therefore, before you enroll in any DC plan, it's imperative that you understand in detail how each fits into your general financial and retirement plan.