Better Benefits
Reasons to Reevaluate Your Rabbi Trust
Reasons to Reevaluate Your Rabbi Trust
The Internal Revenue Code and ERISA require that nonqualified deferred compensation plans be unfunded and unsecured. A well-designed rabbi trust, however, helps offset many concerns about plan security.[1]
Employers offer nonqualified deferred compensation plans (NQDC) to help highly compensated employees voluntarily save on a pre-tax basis for retirement or short-term goals, such as saving for a child’s college education. Various surveys show that over 90 percent of public companies offer an NQDC plan to help attract, retain and reward key talent. From the plan sponsor’s perspective, NQDC plans help drive company objectives when performance-based incentives are tied to the plan.[2]
A rabbi trust is a specific type of grantor trust that provides added protection to the assets set aside for participants in a nonqualified deferred compensation plan.
Qualified plans, including 401(k) plans (which are off balance sheet), offer plan participants protection in the event of company insolvency. Nonqualified benefit plans are not permitted to include this same guarantee provided to qualified plans because the participants’ balances are truly a liability of the company. Using a rabbi trust can help plan sponsors better protect nonqualified plan participants in the event of a company’s change of control, change of heart or change in its financial condition.
How Rabbi Trusts Work
A plan sponsor sets aside assets in a rabbi trust, which is often referred to as “informally funding” the plan. The rabbi trust allows assets that are informally set aside for this objective to be invested by a third party—the trustee—without causing the NQDC plan to be categorized as funded.
The grantor of the trust, which is the plan sponsor, retains ownership and tax liability for the assets within the trust until the assets are distributed to the plan participants. Participants are liable for tax on income received from plan distributions.
Transactions, such as the receipt of interest or dividends on trust investments or capital gains on the sale of rabbi trust assets, are taxable to the company as the plan sponsor and grantor of the trust. Assets may be invested through tax-advantaged strategies such as Trust Owned Life Insurance / Corporate Owned Life Insurance, (TOLI / COLI) which effectively eliminates taxation of the assets permanently if properly managed.
Assuming the Trust is irrevocable, once funds are placed in the trust, they may not revert to the employer until all benefit obligations are fully discharged unless exceptions have been negotiated. For example, an overfunded trust might be allowed to return excess funds to the sponsor if stated in the trust document.
Designing the Rabbi Trust
All rabbi trusts must comply with IRS Revenue Procedure 92-64, but a well-drafted rabbi trust goes beyond this document. Rabbi trust agreements should align with a company’s post-change in control needs and, at the same time, provide protection to the plan participants.
Specific features for consideration include:
- Mandatory Funding upon a Change in Control. Full funding of a trust equal to the plan liabilities should also be a trust agreement requirement. Full funding should be mandated to occur 30 days before the change in control. Additionally, trust funding at 110 percent of plan liabilities is common to provide for trust administrative and legal expenses, should any arise.
- Post Change in Control Trust Administration and Benefit Entitlement Decisions. Decisions concerning the administration of the trust, benefit entitlements, and investments should be made by an individual or group not affiliated with the acquiring company, such as a committee responsible for overseeing the plan and trust before the change in control. The trustee must not be influenced by the company making the acquisition, and this change in control function should be included in the trust agreement.
- Termination of the Trust. The trust agreement should not permit post-change in control termination of the trust without a majority or two-thirds of participants' written approval.
In the event of company bankruptcy or insolvency, the trustee determines how the assets are deployed and will respond as directed to the legal authority overseeing the bankruptcy or insolvency issues.
While the best rabbi trust agreement will never completely secure a nonqualified plan account in the event of an employer’s insolvency, a well-designed trust agreement can provide significant protection in the event of a change of heart, change in financial condition or change in control.
Reviewing the Rabbi Trust
Companies need to be confident their rabbi trust agreements meet their company’s change in control requirements while affording protection to plan participants. Although your organization may have a rabbi trust agreement, the terms of the trust may not contain all the appropriate features to protect plan participants optimally.
If you have any questions about when or why a rabbi trust is important, how plans differ, or how much risk exposure executives at your company may have with their current plan, please contact the Executive Benefits team at OneDigital.
To learn about other executive benefits strategies, read: How the 2025 Retirement Plan Limits Impact Highly Compensated Employees, How Changes to Dodd-Frank Clawback Policies May Affect Your NQDC Plan and Split Dollar Life Insurance as a Deferred Comp Tool for Not-for-Profit Organizations.
Sources:
[1] The Employee Retirement Income Security Act of 1974 (ERISA). More information: https://www.dol.gov/general/topic/health-plans/erisa
[2] 2022 Newport / PLANSPONSOR Executive Benefits Survey
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein. The examples shown are for illustrative purposes only. The material in this report may contain financial illustrations, which may reflect hypothetical dividends, interest, rates of return, and/or expense and mortality assumptions, none of which are guaranteed.
Adam Monson is affiliated with Valmark Securities, Inc. Securities offered through Valmark Securities, Inc., member FINRA, SIPC. 130 Springside Drive, Suite 300, Akron, OH 44333. 800-765-5201. Investment Advisory Services are offered through OneDigital Investment Advisors LLC., a SEC Registered Investment Advisor. OneDigital is a separate entity from Valmark Securities, Inc.
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