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ORANGE COUNTY IN BANKRUPTCY : Q & A : Risks of Deferred-Compensation Plans

Little-understood risks about deferred-compensation plans are being uncovered in the Orange County financial debacle.

County employees were told last week that they will lose 10% of the $85 million they collectively had saved for retirement in the county-sponsored plan. Instead of paying promised benefits, the county will use a portion of the workers’ savings to pay other creditors--essentially confiscating money that public employees had earned and saved.

Is that legal? Can it be done without the permission of the workers who contributed their earnings to the plan?

You bet. And that’s the biggest risk of investing in so-called 457 plans--deferred-compensation programs for public-sector and nonprofit employees. What’s more, experts say, similar risks can affect some company-sponsored deferred-compensation programs.

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What are deferred-compensation plans? And how do they work? Here are some key questions and answers.

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Q: What are deferred-compensation plans?

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A: Simply put, all are programs in which employees voluntarily put a portion of their pay into an employer-sponsored savings vehicle. Generally, the money is set aside for retirement and workers have little access to it until they retire, leave the job or face a severe financial hardship.

Deferred-compensation plans include 401(k) plans, 457 plans, 403(b) plans and both qualified and non-qualified deferred-compensation plans.

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Q: How could Orange County seize worker savings?

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A: A little-understood provision in the law that governs so-called non-qualified plans--including the 457 plans offered to government workers--says that once funds are contributed to the plan, they become the property of the employer, not the employee.

The employer is obligated to pay the employees the amount they have saved, plus any accrued investment earnings, out of the employer’s general fund. Normally, this works without a hitch, compensation consultants say. But problems arise if the employer becomes insolvent, says Jim Warner, principal at Foster Higgins & Co. in Los Angeles. “If the employer becomes insolvent, the money can be lost completely,” he says.

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Q: Do all deferred-compensation plans put your money at risk?

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A: No. Only non-qualified plans. Qualified plans, which include 401(k) plans, are governed by the Employee Retirement Income Security Act, which requires employers to put workers’ contributions in trust. Deferred-compensation is only at risk of falling victim to an employer’s financial woes in a non-qualified plan. Among these are supplemental retirement programs offered to highly compensated executives, plans offered to workers in government and nonprofit organizations and some programs offered to teachers.

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Q: What’s the benefit of contributing to a deferred-compensation plan?

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A: Your contributions come out of your pay before taxes; as far as the Internal Revenue Service is concerned, you’ve never earned that money. You don’t pay tax on either the money you’ve deferred or the investment earnings accrued in the plan until the money is withdrawn at retirement or termination. That allows your savings to grow much faster than they would in a taxable investment, and often allows you to withdraw the money when your income--and hence your tax rate--is lower.

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Q: Is there any advantage to having a non-qualified plan instead of a qualified plan?

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A: Just one. In most non-qualified plans, if you meet the restrictions, you can withdraw the money before retirement without tax penalty, says Diane L. Doubleday, principal at William M. Mercer in San Francisco. With qualified plans such as 401(k)s, you would pay a 10% federal income tax penalty on money you withdrew before age 59 1/2. With a non-qualified plan, withdrawals are considered ordinary income. There’s no additional tax penalty.

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Q: How do I know if my plan is qualified or non-qualified?

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A: It’s almost always clearly spelled out in plan documents. If not, ask your plan administrator.

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Q: Is there any way for a non-qualified plan to provide guaranteed payment of benefits, regardless of the employer’s financial hardship?

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A: Yes. A few employers buy insurance to indemnify workers’ benefits in a deferred-compensation program, Warner says. But such steps are rare. A recent survey indicated that 98% of the private-sector non-qualified plans are at risk in the event of the employer’s bankruptcy, he adds. Orange County’s plan was not insured.

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Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.

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