Deferred comp plans, or what to an ERISA lawyer is a top hat plan, have become widespread in recent years, used for a variety of purposes, from executive recruitment and retention to simply rewarding important executives at smaller employers who may lack other resources for doing so. But a story from the other day about executives losing the funding – and with it almost certainly the payout – of their deferred compensation agreements as part of the collapse of Steward Health Care is a good time to remind executives that they should not simply smile and say thank you when gifted with a deferred compensation agreement, but should instead carefully and directly look the gift horse in the mouth. Now note that I certainly didn’t say they should reject the benefit – it’s a good one and something far beyond what most people can look forward to receiving in retirement. But executives awarded that benefit need to be aware that it comes with certain risks attached to it, and they should account for those risks in their retirement and other long range financial planning.

As an introduction to this piece, I am writing it in light of this story, which details that senior executives at Steward Health Care have had the rabbi trust, containing millions of dollars originally purposed to fund the deferred compensation payments that were contractually due them, instead attributed to the bankruptcy estate available to payment of all creditors. It is clear from the comments on LinkedIn and elsewhere to this story that many executives, including I suspect some who have been awarded deferred compensation, believe that the funding set aside for deferred compensation payouts is similar to the funds held in 401(k) accounts, and thus inviolable. In the context of deferred compensation plans under ERISA, that is simply not the case, and the risks of not receiving payout over time is something that executives should be aware of.

Now, I don’t happen to think that those risks are high, across the universe of such awards to executives. For the past quarter century or so, I have been representing both companies and executives in litigation and in non-litigation matters involving top hat plans and I freely admit to a selection bias problem. In other words, I typically only see deferred compensation plans when there is a problem (although I sometimes see them prospectively, when executives want an opinion or guidance before participating), and thus most of the top hat cases I handle are ones where one or more of the risks inherent in them has come into fruition. I feel quite confident in saying, though, that most plans don’t end up manifesting one or more of the potential problems that run alongside such plans and sometimes cause them to end up on my desk.

The issue, though, is that executives should not assume, without any foundation or analysis, that their plan will be one of the majority where problems won’t come to exist or that the risks in such plans are only for someone else at some other company. Instead, they should evaluate the likelihood of eventual full payout of the funds promised them under such a plan in the same way they evaluate any other long-term investment, including thinking through their tolerance for, and ability if needed to hedge in their financial planning against, a possible negative outcome.

In my practice, I have come to believe that there are three categories of risk in deferred compensation plans to which executives are exposed, to lesser or greater degrees dependent on the specifics of the companies that employ them and the industries in which they work. The first is what I like to call operational risk, which is essentially exactly what it sounds like: the risk of operating mistakes in administering the top hat plan itself. Sometimes this can consist of legitimate, good faith disagreement over the meaning of the terms of the top hat plan itself, such as in this recent decision out of the Eighth Circuit. Oftentimes, they consist of what I sometimes refer to as the “no good deed goes unpunished” principle for top hat plans. These often involve smaller employers who add a deferred compensation benefit as a retirement package for a very small number of senior executives, but lack the internal expertise to manage the plan nor the relationship with a vendor competent to do so, leading to operational mistakes that end up costing the executive gifted with the retirement package a significant amount of money at the end of the day, typically because of distribution, election or recordkeeping errors.

The second I like to refer to as managerial risk, in that these tend to place a retired executive’s deferred compensation payout at risk because of a deliberate decision by subsequent management to do so, such as a decision to revise the plan or to reinterpret its terms so as to reduce the financial burden of the plan on current management’s books, at the expense of the departed executive. You can see an example of this in one of my cases here, in which the company sought to amend the deferred compensation plan after retirement of the executive affected by the change for the purpose of reducing the payout. Another favorite example of mine from my own practice involved what I continue to this day to be convinced was score settling between former colleagues, with the one remaining a senior executive interpreting the plan as precluding a substantial payout to a retired executive as payback for a past, and long simmering, dispute between them over a long ago transaction.

The third is the risk you see in the Steward Health Care matter, which I would tend to call solvency risk, and is exactly what the name implies: the risk that the company, which generously promised the deferred compensation to the executives during good times, will go out of business in the bad times, taking the money needed to pay out the deferred compensation with it. You don’t actually see this happen that often, but for a number of reasons I think this is likely an increasing risk for executives, and one they should take seriously. Luckily, based on my experience, many of the senior executives granted deferred compensation benefits are well-suited to both access the necessary information to evaluate this risk and to make the evaluation. It is important, in figuring in how much to rely on their deferred compensation payouts for their retirement income, that they do so.