Commonly, phantom stock plans fall into the category of “nonqualified deferred compensation” programs. This term reflects a type of retirement plan referred to in the Employee Retirement Income Security Act of 1974 (ERISA). As a NQDC plan, a phantom stock program may be exempt from most of the formal retirement plan rules outlined in ERISA and subsequent related legislation. Consequently, the sponsoring company can select and utilize flexible vesting schedules, payout terms and grant levels without concern for government rules, minimums, annual tests and reports. However, to retain these exemptions the plan must follow the guideline for employee participation. ERISA states that a NQDC plan can only be provided for a “select group of management or highly compensated employees.” For this reason the sponsor should limit participation to those employees they feel would meet this standard. Unfortunately, one cannot look for clear direction from the IRS or Department of Labor regarding a definition of a “highly compensated group.” Companies should consult with qualified advisors if they hope to adopt an exempt plan for a broad group of employees.
It may be possible to draft the plan and avoid the ERISA rules altogether. Court cases and other rulings have suggested that plans with payout dates shorter than five years from the date of grant may not be nonqualified plans and, thus, can include a broad group of employees.
For these reasons, phantom stock plans typically are limited to officers, top managers and other highly compensated employees. Companies looking to broaden participation should consult with experienced advisors.
A phantom stock plan is intended to reward employees for long-term value creation. Sponsoring companies should determine which members of the organization are expected to be accountable for the creation of that value. Typically, company owners or directors will examine the levels of leadership in the company and discuss which employees will be essential to the fulfillment of the long-term business plan.
As a company begins to analyze the amount of economic value available to be shared under the phantom stock plan it will need to forecast what that total value may represent to the participant group. This would be done by estimating or averaging that value across the potential pool of participants. Then the company decision makers can evaluate the potential value relative to the number of participants. They may discover that the opportunity appears too low (due to too many participants) or that they have room to expand the group.
For example, assume that a company anticipates new value growth of $20 million over a period of years and that they have 10 possible participants. If the company owners are open to sharing 10% of the new value the average amount per participant would be $200,000. The company would need to assess whether this average amount would be meaningful to the ten employees. Obviously, the period of time would be highly relevant.
This website includes a calculator that can assist with this determination.
Recruiting and Retention Factors
The final factor to consider when determining eligibility is the urgency associated with presenting a total compensation package that enables the company to attract the caliber of leadership needed to grow at the desired level. Certain levels of professional talent will expect wealth accumulation opportunities. Public companies are expected to provide equity or phantom equity packages as part of their overall rewards program. Private companies often compete with public companies or other successful private firms for talent.
A quality phantom stock plan can serve as an important differentiator of value and opportunity. Thus, when considering eligibility for a plan, companies need to be sure to include those employees who are most likely to be targets of competitors.
Participation in phantom stock plans is typically limited to a relatively small group of employees. Occasionally, a company may adopt a plan for a single employee. More often, one or two levels of leadership are included. As a broad rule-of-thumb, between one and ten percent of the general employee population will usually be considered for the plan.