A deferred compensation plan (“DCP” for short) is a type of plan that lets you push income into a future period to be used later. Typically, these make sense when you make more money than you need now and you need a vehicle for deferring your income into the future.
Some large companies, such as Microsoft, offer these plans to their higher-level executives as a benefit. However, the vast majority of employees out there don’t have access to a DCP through their employer. They are left to fend for themselves and ensure they have enough to live on in retirement.
Using a certain type of life insurance policy, however, we can recreate a deferred comp plan for clients. Let’s look at an example:
Stanley Biggs is a seasoned developer within the Cloud Division of a highly successful tech company. Stanley is bringing home a salary of $250K per year and is also getting stock grants totaling $150K per year net of taxes. Stanley and his wife Margaret spend roughly $15K per month to maintain their current lifestyle. Net of tax, his salary covers the majority of his living expenses but he doesn’t need the $150K in stock grants to live on at the moment. He wants to save that money for retirement.
Given he is getting new grants each year, and 100% of his income comes from his employer, he makes the smart decision to sell the stock to diversify away. But now he must decide what to do with the money.
His local bank pays him less than 1% to keep it in Savings or a CD so he is looking for other options. He could invest it in the stock market, or the bond market, but he believes both are expensive right now and they are both subject to a lot of volatility.
During the last collapse, Stan pulled all of his money out of the market a month before the market bottomed and he missed the majority of the subsequent recovery. He doesn’t trust himself anymore to deal with volatility in a smart way.
Stan’s financial advisor tells him he should use a nonqualified deferred comp plan because it allows him to put money into a plan that will pay at least a guaranteed 4% per year and he can pull that money back out of the plan down the road tax-free. Stan learns that these plans also have a death benefit associated with them, so if something happens to him, Margaret and his kids will be well taken care of. The other benefit his advisor tells him about is that these plans don’t have any volatility on the investment balance. They go up every year like clockwork. They aren’t going to have massive up years like you could experience in the stock market, but they aren’t going to have big down years either. Or any down years for that matter.
Given Stan’s track record in the market, he thinks this is a wonderful idea and begins putting his stock grant money into the plan every year.
What’s the catch? The catch is that you have to keep the money in the plan for at least 7-10 years before you can touch it, and the good economics don’t really kick in until years 15-20. But for the right person like Stan, this is a wonderful way to provide an income for yourself in the future.
If you want to learn more about deferred compensation plans, please reach out to our team.
All the best,
Your Fortis Capital Management Team