In this issue, answers to:

• How do nonqualified retirement plans fit into the overall compensation philosophy of a tax-exempt organization?

• When is plan redesign warranted and what alternatives exist?

• How will anticipated regulatory guidelines affect the design of nonqualified retirement plans?

• What is the potential impact of a nonqualified retirement plan on a tax-exempt organization's ability to manage and retain talent?

2009 promises to be a year of big changes on multiple fronts for tax-exempt organizations, with executive compensation and benefit practices being no exception. There are several factors that are converging this year.

First, the economic crisis is putting significant pressure on compensation practices at all levels, including in the executive suite. Tax-exempt organizations are finding that they need to be sensitive to the impact of external pressures on pay. Federal, state and local tax exemptions are being scrutinized, and executive compensation can be a flash point for organizations as they are called upon to "earn" and defend their tax-exempt status. Moreover, in this challenging economy, organizations are sensitive to fairness issues that surface, as employees and members of the community face salary freezes, reductions in incentive pay, and other curtailments; plus, these organizations are facing significant adjustments to their own operating budgets and fundraising ability.

Second, the reporting of executive compensation overall, and nonqualified retirement plans in particular, is becoming more transparent for tax-exempt organizations. In 2009, for the first time, exempt organizations are required to file the new IRS Form 990, Return of Organization Exempt from Income Tax, which requires significantly enhanced disclosure of executive pay. This new form includes not only the disclosure of payments from executive nonqualified retirement plans as it has in the past, but also a description of those plans and the annual value of benefits as they are earned. These public disclosures will shine a brighter light on compensation practices generally, as well as deferred compensation in particular, and the optics of some arrangements will likely cause many organizations to revisit their plans and practices.

Third, there is the prospect of additional regulatory guidance that is anticipated under Section 457(f) of the Internal Revenue Code. That section governs nonqualified deferred compensation arrangements for tax-exempt organizations. The new rules will likely have an impact on the permissible structure of those arrangements to preserve tax deferral and will also influence organizations' decision making.

In this Perspective, we offer Mercer's point of view on what organizations should be doing in light of these issues and events. We present a checklist of 2009 actions that tax-exempt organizations and their compensation committees or boards should take to ensure that deferred compensation arrangements not only are responsible in today's environment, but also best meet the organizations' executive talent needs.

Checklist of actions

Ensure that plans align with the organization's mission, business objectives and compensation philosophy

During this period of increased scrutiny of pay practices, it is important for the organization to step back and consider how nonqualified retirement plans fit into the overall compensation strategy. Understanding the role of these programs in the context of other compensation elements, the current economic environment, the organization's current business situation and its executive talent needs is critical to gaining a full understanding on what role these plans play. In some cases, organizations may find that the focus of the plans has changed and that it would be better for the organization to discontinue the plans rather than add more complexity, disclosure and/or tax risk. Some questions to ask are:

• Are the plans intended for long-term retention?

• Does the organization wish to provide only competitive economic value without regard for retention considerations?

• Are the plans intended to deliver retirement income or equivalent current cash?

• What is the role of the plans in the context of fixed salary, variable compensation, and benefits and perquisites?

• What is the appropriate eligibility for the plans?

Validate competitiveness and compliance with Intermediate Sanctions

Given the economic environment, organizations should review their current nonqualified executive retirement and other deferred compensation plans to determine their competitiveness and their impact on total remuneration. Increasingly robust competitive data are available on these arrangements to ensure that the programs are effective to attract and retain talent. Recent trends in the delivery and value of these benefits should be considered to assess whether "all in" compensation is competitive. Plus, the IRS requires that total compensation - including executive benefits - must be reasonable for senior executives of exempt organizations, so understanding the economic impact of these arrangements on total pay over time is critical.

Consider best practices and the appearance of these plans to organization stakeholders

With more transparent disclosure required by the new Form 990, organizations would do well to think through the rationale for providing overly generous executive retirement plans, especially when many of the organization's constituents are struggling. And it will be important for the board to have a clear picture of how these plans will be viewed by outsiders, including the media, regulators and the community, when the disclosures are made public. Boards should review and understand the reporting and disclosure requirements of the new Form 990 over the life of the retirement arrangements - including annual accruals, vesting dates and payouts. The disclosure impact will vary considerably for defined benefit (DB) versus defined contribution (DC) arrangements.

Many proactive organizations are providing enhanced disclosure, including a detailed compensation philosophy, how they developed the executive compensation programs, the peers they compare themselves to, and how their risk-based pay and executive retirement plans are utilized in support of executive motivation, retention and the organization's mission. This, they believe, will increase constituents' understanding of the compensation programs and how they are used, and thereby reduce misunderstandings and the public reaction that often follows.

Evaluate executive plans in light of actions the organization is taking for its employees generally

Many employers already have or are considering freezing or reducing benefits in their qualified plans, along with making other tough decisions regarding their rewards programs. When significant employee cuts are being made in cash compensation and benefits, it is important that the executive team lead by example. Thus, deferring, reducing or eliminating accruals to a supplemental retirement plan to reduce costs indicates that the executives are taking their share of responsibilities seriously. In these times of economic strain, making this kind of statement is important, and boards are now actively engaging their leadership teams along these lines.

Review 'substantial risk of forfeiture' provisions

In terms of nonqualified retirement plans, organizations have historically used a variety of ways to satisfy the risk of forfeiture requirement under IRS Code Section 457(f). Some of these approaches, such as a risk of forfeiture contingent on continued employment, are sound. Others, such as basing forfeiture on compliance with noncompetition provisions, will not comply with these rules going forward, and we expect the new IRS guidance will confirm this point. Although it is not clear what, if any, transition relief would be provided and whether or how existing plans will be grandfathered¹, we anticipate that new guidance will be issued soon and that many existing plans will need to be modified to comply with the new rules or be terminated. Therefore, organizations should consider the appropriate role of vesting provisions and the time period over which benefits can be earned (and the risk of forfeiture lapses). As organizations consider changes to these plans for governance and transparency purposes, many will take this opportunity to address other changes needed to comply with the upcoming guidance.

1 The IRS has previously issued guidance that non-compete provisions do not satisfy the substantial risk of forfeiture requirements; thus there may be no grandfathering rule available on this point.

Source: Mercer's Executive Benefit and Perquisite Practices Survey for Tax-exempt Organizations

Consider the appropriateness of redesign alternatives

Based on a comprehensive review of the governing objectives for the programs and consideration of the appropriateness of the current design, organizations should assess whether design adjustments are appropriate. Some key areas of focus include:

• Eligibility - Are the currently eligible participants appropriate, based on the goals of the organization for the plan?

• Benefit magnitude - Based on the competitiveness and objectives of the plan, should the benefit levels be adjusted? Does the benefit remain appropriate in light of the organization's goals and the current economic environment?

• DC vs. DB plans - Is the structure of the arrangement appropriate to reasonably balance the investment risks assumed by the organization and the participant? How would the arrangements be reported on Form 990?

• Vesting - Should the vesting provisions be adjusted to meet attraction and retention requirements? How would Form 990 reporting be affected if they were adjusted?

• Payout - Should the benefits be paid out as vested, or should they be retained by the organization to support a retirement objective?

Given the combination of these many forces - the economy, demand for greater transparency, heightened scrutiny of executive pay actions and the prospect of additional IRS guidance on Section 457(f) - we expect that organizations will consider one of the following strategies:

• Continue the existing 457(f) plan and ensure the presence of a valid risk of forfeiture

• Pay additional current cash compensation in lieu of nonqualified executive retirement benefits

• Change the retirement program to an after-tax strategy, where deferrals vest periodically, taxes are withheld and paid, and the after-tax balance is accumulated until retirement

While the ultimate strategy will require customization to meet the organization's objectives, consideration of these three approaches is a good starting point.

Continue 457(f) plan with a valid risk of forfeiture

Organizations that already use a valid risk-of-forfeiture provision may choose to maintain the status quo. Requiring participants to satisfy a service requirement (for example, a five-year vesting period) serves a useful retention goal. As organizations rethink their compensation plans and philosophy, if retention is one of their objectives (it usually is), then organizations may wish to continue their practice. That said, vesting becomes less motivating the longer the vesting period. So we see many organizations with DC plans moving into more regular vesting, such as three to five years for the initial vesting and then every two years thereafter for ongoing vesting, as an additional retention tool. Organizations may, however, consider short-term adjustments to the programs in light of other actions they may be taking in their broader employee plans. For example, organizations may temporarily suspend or reduce contributions or benefit accruals to nonqualified executive retirement plans if broader employee compensation or retirement benefits are being reduced.

Pay additional current cash compensation in lieu of deferred compensation/ retirement benefits

Some organizations will decide that, rather than complying with anticipated new regulatory guidance or the complexities of Form 990 disclosure, they will simply discontinue their plans and replace the value with additional current cash compensation. Determining how much to increase cash compensation in lieu of additional retirement benefits will present some challenges. Those that choose this approach will need to develop a sound rationale and consider the market competitiveness of the organization's overall total compensation program. While administratively easy, this approach may have appearance or disclosure issues, depending on the size of the package.

Switch to an after-tax strategy

With a more restrictive substantial risk-of-forfeiture requirement, we will likely see more organizations providing retirement income that is currently taxable and then accruing the remaining after-tax amounts until retirement. There are a number of trade-offs with this approach that will need to be considered, such as the lower retention value of vested benefits (versus unvested benefits), the loss of the tax-deferral on accrued balances for the executive and the resulting increased cash compensation disclosure.

Organizations that take this approach might consider increasing the benefit to keep the executive "whole," given the effect of early taxation. Strategies to accomplish this may include increasing the benefit/contribution to make up for the lost earnings due to accelerated taxation and/or taxation at a higher rate. It is also more common to utilize funding vehicles, such as a deferred annuity, when using an after-tax strategy; however, these strategies may come at a substantial additional cost and complexity to employers. Therefore, it will be important for organizations to carefully analyze the implications of adopting such a strategy and weigh them against the value to the organization, competitive market practice, Form 990 disclosure implications and the current economic context.

Conclusion - taking a holistic view

Given the economic climate, increased government and media scrutiny of exempt organizations' pay practices, greater demand for transparency, and the pending Section 457(f) guidance, it is more important than ever for organizations to carefully consider the role of executive benefits within the context of the organization's core mission, its current challenges and its total compensation philosophy as articulated by the board. Nonqualified executive retirement and other deferred compensation plans provide meaningful benefits that can promote the stability of the executive team and sustain organizational performance. A holistic review of these programs is needed to ensure that they are a best fit for the organization and should be on the board or compensation committee agenda of every tax-exempt organization in 2009.