Check Under the Brim of Top-Hat Retirement Plans

Beware: There's a risk you could lose your money.
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This is the second installment in a look at deferred-compensation plans for high-income employees. For the first part, click here.

Top-hat plans sound like a great deal, letting you sock away loads of cash for retirement on top of your 401(k). But new participants beware: The money isn't exactly yours.

Indeed, until you withdraw the money, it's considered an asset of your employer. That's not a problem unless your employer runs into financial trouble. But as we all know courtesy of

Enron

, even the best-pedigreed companies can collapse.

The issue is all the more pressing because increasing numbers of workers are enrolling in top-hat, or deferred-compensation plans, which allow high-income employees to set aside more retirement money than the $11,000 max allowed for 401(k) plans.

Top-hat plans "don't get the same protections that broad-based employees get in qualified 401(k) or qualified benefit plans," says Bill Coleman, senior vice president for compensation at Salary.com. And as the plans have become more popular, "they're being made available to more people who are seeing them for the first time and not realizing they're no longer in the slow lane; they're in the fast, watch-out-for-yourself lane."

The biggest difference between 401(k) plans and top-hat plans is that money held in the former is protected if an employer goes bankrupt. It's considered the property of the worker. But with top-hat plans, an employer is considered the owner of the assets, which, as a result, are subject to the claims of the company's creditors in a bankruptcy.

"More and more middle-range people are putting their future retirement income at risk because it isn't set aside in any guaranteed fund for them," says Deene Goodlaw, a pension attorney and co-chair of the global benefit practice at the law firm of Pillsbury Winthrop. "Basically, they're relying on the good credit of their employer. If the employer becomes insolvent, there will be no benefits for them unless the creditor's committee or bankruptcy court allows it."

In the past, workers at such companies as Singer Sewing Machines, Eastern Airlines, and Pan Am lost money in deferred-compensation plans when the companies either filed for bankruptcy or were taken over by regulators.

In such worst-case scenarios -- surprise, surprise -- the highest-ranking folks usually have the best shot at recouping their money. Top-rung executives at Enron were able to cash out of their deferred-compensation plans before the company folded, according to reports. But lower-level management folks couldn't withdraw from their accounts, and will presumably wait in line with the rest of the company's creditors to try to recoup their money.

How Top-Hat Plans Work

The premise behind top-hat plans is that, in order for you and your company to receive tax benefits, the money can't be formally considered yours until you leave the company. A legal doctrine known as constructive receipt says if you have the right to obtain the money, you must be taxed on it. Therefore, the money in the plans is, for legal purposes, considered your employer's.

In practice, your top-hat plan might look like a 401(k), letting you choose to invest from an array of mutual funds (or it might simply offer you a fixed rate of interest based on some benchmark, such as the company's stock price return). But even if your 401(k) and top-hat plan are invested in the same fund, they're treated differently. With a top-hat plan, you basically lend money to your company to invest on your behalf.

For example, say you chose to invest your deferred money in the Fidelity Magellan fund. "At the end of the year, your 'account,' in quotes, would look exactly as if you had invested in Magellan," explains Pamela Perun, a pension lawyer and consultant for the Urban Institute. "Your company could invest the equivalent amount in Magellan, but the interest and appreciation would not be in the employee's name. All these are fictional accounts, kind of IOU accounts."

How to Protect Yourself

In other words, if you have a top-hat plan, you hold an IOU for an account full of your money plus earnings, which may well be worth hundreds of thousands of dollars. If that's the case, you should know about plan features that offer an extra measure of security.

Some plans employ what's known as a rabbi trust (named for the rabbi who came up with the idea of using a trust to pay for his retirement benefits). A rabbi trust allows money to be set aside for the sole purpose of funding deferred-compensation plans. Though the money remains part of the employer's assets, the employer no longer has control over how benefits are paid. That control passes to a third, independent party: the trustee.

When money goes into a rabbi trust, it's no longer part of an employer's general assets and so can't be used to finance its research and development, pay receivables, or shore up corporate cash flow in any other way. For that reason, rabbi trusts may not be in an employer's best interests -- but they're certainly good for participants in a top-hat plan. With a rabbi trust, top-hat accounts are "secure from the corporation reneging on all or part of the promise

to pay, all the way up to the point of bankruptcy, at which point the trust is no longer protected," explains Coleman.

A variation is the "springing rabbi trust," which could protect your account if your employer is taken over by another company. This trust ensures that top-hat funds held in an employer's general assets be automatically transferred to a rabbi trust in case of a takeover (or some other triggering event), so the new company can't get its hands on the funds.

Aside from security features, some top-hat plans have extra perks that allow them to be used in financial planning. A plan might let you take a penalty-free loan to cover short-term needs. The interest you pay on the loan goes back into your own account.

Or, you may be able to personalize your plan so that you can defer money for only a short period of time -- say five years -- so you don't have to wait until retirement to get it.

Another feature lets you withdraw money without penalty in the case of an emergency or personal hardship. Typically, a trust committee determines the legitimacy of the requests.

Granted, depending on the amount of bargaining leverage you have with your employer, you may not necessarily be able to negotiate these perks into your plan. But knowing whether you have them could give you some peace of mind, should your company for any reason try to change the terms of your plan.

Above all, remember that with a top-hat plan there's no government watchdog out to protect your interests. Nor are there rules that spell out what your employer must tell you about the plan. "As these plans get pushed further and further down into middle management, they become more of a mass-produced product and people have to read the plans very carefully," says Perun. With top-hat plans, she says, "The burden is on the employee to be smart."