Employers frequently use nonqualified deferred compensation (NQDC) plans, but not all plans are created equal. Some executive compensation plans warrant caution, including top hat plans. If you’re considering a top hat plan for your company, it’s time to do your research.
What Is a Top Hat Plan?
NQDC plans are agreements between employers and employees to pay compensation in the future. This allows key executives to defer tax on income until the benefits are received at a later date. A top hat plan is a type of NQDC that provides unfunded, deferred compensation benefits to select management or highly compensated employees (i.e., a top hat group). They also provide exemptions from key provisions of the Employee Retirement Income Security Act (ERISA). These exemptions include minimum participation and vesting, funding and fiduciary rules (all of which apply to both qualified benefit plans and funded NQDC plans).
It’s essential to define the top hat group before implementing these executive compensation plans, but that is easier said than done. “Select group” and “management” are not clearly defined by Congress or any other government agency. This lack of guidance has led to confusion, opposing views and, in some cases, lawsuits against employers for failure to grant certain ERISA protections to employees.
The Department of Labor (DOL) provides the only top hat plan guidance in Advisory Opinion 90-14A, which states:
Congress recognized that certain individuals, by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration any risks attendant thereto, and, therefore, would not need the substantive rights and protections of Title I.
The DOL has not issued another Advisory Opinion on this issue, leaving courts to decide how to apply that definition to specific cases. To date, there is no bright-line rule to determine if a select group qualifies for top hat status.
Courts generally consider qualitative and quantitative factors when determining if a group qualifies for top hat status.
- Qualitative factors include compensation, duties and positions of the eligible group. Top hat plans should be limited to either management or highly compensated employees. Management typically includes executives, managers and officers. However, other high-level employees could be included. Highly compensated employees would be those earning an average of two times the average of all employees (note that the IRS defines highly compensated employees differently).
- Quantitative factors include the percentage of the workforce eligible to participate. While there is not a “safe harbor” percentage, limiting top hat plan participation to 15% or less is best.
Courts have been known to consider these both together and separately. They may also review other points, such as the type of work a business conducts or the language of the plan agreement. It’s entirely at the court’s discretion.
As mentioned, top hat plans are exempt from some key ERISA provisions. However, these two ERISA requirements must be followed:
- A top hat letter – The DOL must be notified within 120 days of the plan’s inception. This one-page notification must include the company’s name, address and employee identification number. It must also list the number of top hat plans maintained and the number of participants in each plan. Finally, it must declare that the employer maintains the plan(s) primarily to provide deferred compensation for a select group of management or highly compensated employees.
- The claims procedure – Plan participants must be informed about the ERISA claims procedure that applies to the plan and it should be clearly stated in the plan document.
Plan with Caution
Given the uncertainty around the top hat group definition, we urge you to use caution when designing these executive compensation plans. Defining eligibility terms and ensuring ERISA compliance can be difficult, but the right guidance can make all the difference. Our Executive Benefit Team can answer your questions and help you build a better benefits package. Your key executives are a vital part of your company, and we are eager to help you keep them.