I. Two Types of Plans
Most independent school heads plan to retire in part on the distribution from their 403(b) plan to which they have contributed over the years. However, as many as 50% of US independent school heads now have one or both of two nonqualified deferred compensation plans, which in the long run, may result in a much greater retirement asset than the classic 403(b) or 401(k) plan alone. There has been a major trend in this direction in the last 10 years. Heads need to “bone up” on these plans.
About 25 years ago, deferred compensation plans came to the attention of boards and school heads but at that time, most heads who participated in them were leaders of larger, more established, and wealthier independent schools. Today heads of even small schools may have these plans.
In our head compensation benchmarking work with thousands of independent and international schools since 1983, we have seen these plans proliferate. Currently only a very few schools offer these plans to senior management other than the head, but that is changing. Some schools have created these plans (either funded by the school or by the individual) for the CFO, advancement director, deputy/assistant/associate head and division heads. These plans can function as both recruitment and retention tools.
These deferred compensation plans are two kinds: the 457(b) and the 457(f). The “b” plan is more common, simpler and has an IRS cap (now $22,500) on the annual contribution that tends to rise by about $500 annually. There is also a “catchup” contribution for those over 50, and that limit is now $7,500. Most of these plans are in the head’s name and called “nonqualified”, meaning that it can be offered to a higher paid employee, but it does not have to be offered to others. That is opposed to “qualified plans” which must offer the same percentage contribution to all, i.e., the school cannot contribute a greater percentage of base pay to a 403(b) plan for higher paid individuals than for lesser paid individuals.
These 457(b) plans are often invested through TIAA and other similar investment funds, and in our experience, the school can set up the plan. The contribution can be from the head and/or from the school though the majority of schools pay the contributions, not the head. The money is tax deferred and upon its vesting date it is taxable as regular income.
The 457(f) plans are more complicated, and generally are the real “cash machine” by which long term heads may build a substantial retirement asset. These plans have no cap on contribution levels (as far as we know) and both the head and the school can contribute. The plans are generally “funded” (though that is not required) and are a part of a school’s endowment portfolio. The school manages and owns the plan until it is vested. The head trusts that the school manages it with an appropriate level of risk.
These plans are at “substantial risk of forfeiture” meaning that if the head leaves before the vesting date agreed upon, the accumulated asset is forfeited even if the head leaves on very good terms. A second risk is if a school is experiencing extreme financial stress, then in rare cases these funds might become the property of the creditors of the school like any other school asset. Finally, if a head is fired for “cause” (gross misconduct, illegal behavior, moral turpitude, etc.) the funds might be lost. This is one reason why the language in a head’s contract regarding “cause” must be very explicit.
These plans are almost exclusive to US based schools. However, we have seen a smaller number of international schools in Europe, Asia, and the Middle East in particular, where similar plans have been created though under different laws.
II. What Does the Future Hold for Head Compensation?
Most heads in the 35 to 55 age range may decide after five years and a vesting date, not to take out the funds but to roll them over for another five years, for example. That pushes off the date of taxation.
One Head after many years in the role at the same school, retired and had about 8 million dollars in his deferred plan. Since this information was in the public domain, the local press took a shot at the School and Head. However, the School spokesperson pointed out how many years this plan had been building, and that one third of the funds had come from the School, one third from the Head himself in deferrals, and one third from earnings. The School had managed the funds extremely well. That calmed folks down. Keep in mind that very few people who might be interested in this information really understand how these plans work.
These 457(f) plans do, in our opinion, require hiring an attorney who specializes in creating these plans. Generally, the school pays for these legal costs. Also, these plans often have a performance component, that is, part of the annual contribution to the plan is guaranteed, but the remainder may be based upon the head meeting certain metrics such as enrollment and retention numbers, fund raising goals and overall financial health. The total amount invested in the plan annually might be determined by the Board Compensation Committee near the end of the fiscal year.
Some heads might resist the idea of tying all or part of the contribution to the plan to performance. However, heads must recognize this is becoming more and more common as boards are increasingly focused on evaluation, accountability, and the long-term financial health of the school.
The concept of deferred compensation allows a school to provide “golden handcuffs” to keep a valued leader while also allowing the leader to have funds growing on a tax deferred basis over several years, resulting in substantial sums. Payouts of $100,000 to $500,00 and more are common among schools that have had these plans in place.
Littleford & Associates is not a law firm, but we do work with various attorneys who work with independent schools on the topic of head compensation. Every head should be having this conversation with their board compensation committees if the board does not take the initiative. It may be uncomfortable for some heads to raise this topic, but doing so is in their own best interest.
In addition, the Intermediate Sanctions Act, passed in 1996 by the US Congress, requires that all 501(c)3 nonprofit organizations have a compensation committee of the board that meets annually to benchmark the compensation of the CEO. A relatively recent regulatory ruling by the IRS asks that the board annually provide for the file (and maybe later on to any authority seeking it) a “Rebuttable Presumption of Reasonableness Checklist” which is a list of the protocols used for the benchmarking, including who was involved from the board in making the compensation decisions.
All these shifts in practice over time require a board and especially the chair to exercise due diligence in how it manages its one employee, the head of school.
Effective evaluation of a head of school begins with the creation of a Head Support Committee, as a standing committee of the board charged annually with benchmarking the head’s compensation, overseeing the evaluation process and renewing his or her contract. on behalf of the board.