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Not frightened enough by the dwindling balance in your retirement accounts in the last year?
Here’s a nightmare for you: Imagine waking up one morning to discover that your employer is bankrupt and the money you have set aside in your deferred compensation plan belongs to the company’s creditors.
Unfortunately, this possibility is a real one for employees of companies like Chrysler. A 401(k) plan is safe from those your company owes money. But creditors can — and will — go after deferred-compensation plans, which allow high-level employees and many others earning more than $100,000 to $200,000 or so annually to contribute money, which then grows on a tax-deferred basis for use later. And if a company goes bankrupt, employees may end up with nothing.
Many people who are enrolled in these plans, common at large companies and at many smaller ones, too, have no idea that their funds are vulnerable and that the company does not even have to set aside the money in a separate account. Others may have found the warning in the fine print when signing up years ago but have long since forgotten about it. And plenty more remain in denial about their company’s true prospects and won’t get wise until it’s too late.
As brand-name companies like Lehman Brothers, Chrysler and Filene’s Basement declare bankruptcy and scores more consider it, the number of employees facing this loss is probably going to grow.
HOW THE PLANS WORK There are many kinds of deferred-compensation plans, but the most common allow employees to contribute money from their salary or bonuses to an account where their balances grow on a tax-deferred basis. You don’t pay taxes on the money you defer from your pay, and there are no taxes to pay while it grows. The taxman shows up only once you take the money out.
The big idea here is that rather than paying 28 percent or more in income taxes on that money now, you can take the money out later in the hopes of paying less income tax then. While employers don’t advertise these accounts as retirement plans per se, many people use them with the intention of leaving the money until they stop working.
Companies are allowed to invite only a select group of highly paid workers to participate. While there are no strict rules, usually only the top 5 or 10 percent of earners get in. There are no legal limits on how much you can save, though employers often impose a cap.
Once participants set aside the money, it can grow. Some employers add to the workers’ total based on the prime rate or a long-term Treasury bill rate. Or they may let people choose from a selection of mutual funds.
WHO SHOULD PARTICIPATE? Bankruptcy issues aside for a moment, deferred-compensation plans have had many attractions, at least until recently. Salespeople who had an unexpectedly big earnings year, for example, could defer income until later, when they would probably pay lower taxes.
Others might have wanted to lower their income for different reasons, including financial aid eligibility and planning for a forthcoming leave of absence. The plans are also a form of forced savings. In recent years, however, as the looming cloud of Medicare and Social Security has grown ever larger, it’s become less certain that taxes for retirees will be much lower a decade or three from now. Uncertainty around tax rates has only gotten higher since President Obama has taken office and the size of the stimulus packages has grown.
So all of a sudden, paying income taxes now, investing in mutual funds in taxable accounts and then hoping that capital gains tax rates remain low doesn’t seem like a half-bad bet.
WHAT HAPPENS IN BANKRUPTCY? Panic, basically, for those who are in a deferred-compensation plan. (Did you expect a different answer?)
“There are thousands of retired Chrysler executives running around trying to figure out what their rights are,” said David Neier, a lawyer and partner at Winston & Strawn in New York specializing in bankruptcy.
Mike Melbinger, a partner and chairman of the employee benefits and executive compensation practice for Winston in Chicago, said, “They’re not going to find an answer or a way to get their money.” All that Chrysler is saying publicly is that it will figure out how to handle its plan as its bankruptcy unfolds.
Why is Mr. Melbinger’s assessment so downbeat? Even though employees enrolled in deferred-compensation plans are in fact creditors in a bankruptcy, there are many others who, by law, stand ahead of them in line at the corporate asset trough. As a result, there often isn’t much, if anything, left for them by the time they reach the front.
One other thing to keep in mind: If you think your plan is safe because the most senior people at the company are still invested, it could be that they are in a different plan with special protections that yours lacks.
SO WHAT SHOULD YOU DO? The most natural response would be to simply take your money out of the plan. But a deferred-compensation plan is not like, say, an Individual Retirement Account, where you can withdraw at will and simply pay taxes and a penalty if need be. While the rules are complicated, contributions to a deferred-compensation plan tend to be locked up for at least two years, and you’d have to make a decision about what you’re going to do at the end of that second year at least one tax year beforehand.
You could also quit your job, if your plan allows you to withdraw your funds upon departure. It sounds a bit extreme, but if you have hundreds of thousands of dollars in the plan and are close to retirement age, it might be worth it to get out before your company declares bankruptcy, even if it does mean you’ll face a sizable tax bill.
Departing may not always be possible or practical, though. As Howard S. Beltzer, a partner at Morgan, Lewis & Bockius in New York and co-chairman of the firm’s restructuring group, pointed out, there are laws that allow creditors, under certain circumstances, to come after people who have quit and taken their deferred compensation. If those employees had reason to believe that the company was headed for bankruptcy, they might have to turn the money over to creditors.
If your company tries to reorganize in Chapter 11, all may not be lost. The company and its creditors may decide it’s better to keep the plan intact so that employees are willing to stick around and try to save the firm. Then again, this could infuriate creditors who do not want to reward the people who ran the company into the ground.
If you find yourself in a mess like this, you’ll obviously want to make the case for preserving the plan. It will be easier, however, if you’re still working. “An employee who has left is in the passenger seat of a car going over a cliff,” Mr. Neier said.
Then, there’s the nuclear option. If all else fails, sue and say that the deferred-compensation plan was never legitimate in the first place. If you can prove, for example, that your employer let too many people into the plan, you might have a shot at getting your money back.
But betting on winning a lawsuit is not a particularly good financial plan, says Robert Keach, a shareholder and co-chairman of the business reorganization and insolvency practice group at Bernstein, Shur, Sawyer & Nelson in Portland, Me. “The default position is, if the company is insolvent, you’re probably going to lose money,” he said, even though he recently negotiated a settlement in one case and hopes to do so again for former employees of the New Century Financial Corporation, a subprime lender that declared bankruptcy.
So if there’s any chance of insolvency where you work — and who can say that there isn’t at many companies right now? — it doesn’t make much sense to participate in the deferred-compensation plan.