Non-Qualified Deferred Compensation Plans: Funding Alternatives & Executive Life Insurance Strategies

November 2025
Nate Moody, CPFA

For for-profit companies seeking to supplement their key executives’ retirement or retention planning, a well-designed non-qualified deferred compensation (NQDC) plan can be a powerful tool. Unlike qualified retirement vehicles (e.g., 401(k) or pension plans), NQDC arrangements allow greater flexibility in deferral amounts, investment options, and targeted participant populations. However, because the deferred amounts remain unsecured obligations of the employer (rather than protected trust assets), how the employer chooses to fund or reserve for those obligations becomes a critical design and communication point.

This article explores two common funding (or informal funding) approaches: (1) investment in mutual funds or other taxable securities held in a “rabbi trust” or internal reserve, and (2) use of corporate-owned life insurance (COLI) as an informal funding vehicle. We then pivot to a specialized executive benefit mechanism — split-dollar life insurance — and show how it interacts with these design alternatives.

NQDC Plan Fundamentals

Before comparing funding techniques, a quick recap of the core NQDC framework is helpful:

  • A NQDC plan is an arrangement by which an employee agrees to defer receipt of compensation (salary, bonus, equity-based or other) to a future date (typically retirement, termination, or another event) and the employer agrees to pay the deferred amount (plus any designated earnings) on that date.
  • Because such plans are “non-qualified,” they do not comply with ERISA’s nondiscrimination rules or contribution/benefit limits of qualified plans; thus they are typically reserved for a select group of management or key employees.
  • From a tax perspective, the deferral is effective only if the employee does not have constructive receipt of the compensation and the deferral is a genuine promise of the employer; amounts are taxable to the employee when actually paid.
  • On the employer side, the deferred amounts remain a general-creditor claim on the company’s assets (i.e., “unfunded” unless the employer sets aside assets). That means the employer retains the risk of insolvency or other failure to meet the obligation.
  • Employers often create “informal funding” arrangements (such as a rabbi trust) to demonstrate to participants that assets are being set aside, but the assets remain subject to the employer’s general creditors (if the trust is not “irrevocable” or otherwise protected).

Thus, once a company has decided to offer a NQDC plan, a key issue becomes: how should the company invest or reserve assets in order to ensure that when the promised benefit is paid, the company has the financial capacity to pay?

Funding Alternative #1: Mutual Funds or Taxable Securities in Internal Reserve

Many companies begin by using traditional investment vehicles to informally fund their deferred compensation obligations. Typically, the employer establishes a “rabbi trust” (or other internal reserve mechanism) and invests in taxable securities such as mutual funds or index funds.

Advantages

  • Simplicity: Mutual funds are widely available, familiar, and easily managed.
  • Liquidity and transparency: The company can monitor asset values in real time.
  • Straightforward accounting: The reserve can be reflected on the balance sheet and disclosed under GAAP.
  • Lower cost: No insurance premiums or underwriting required.

Challenges

  • Market volatility risk: Assets fluctuate; if values decline, the employer must make up the shortfall.
  • Earnings mismatch: Crediting rates to participants may not match actual portfolio returns.
  • Unsecured liability: Even with a reserve, participants remain general creditors.
  • Opportunity cost: Committed assets could be deployed elsewhere.

When it makes sense

  • Smaller, early-stage plans.
  • Employers prioritizing flexibility and liquidity.
  • Firms comfortable bearing investment risk directly.

Funding Alternative #2: Corporate-Owned Life Insurance (COLI)

An increasingly common approach for larger NQDC plans is for the employer to purchase corporate-owned life insurance (COLI) on the lives of key executives. The company owns and is beneficiary of the policy; the policy’s cash value accumulates tax-deferred, and proceeds can be used to fund future benefit obligations.

Mechanics

  • The employer purchases permanent life insurance (universal or variable universal).
  • The company owns and pays premiums; the death benefit is received tax-free under IRC § 101(j) if notice and consent rules are satisfied.
  • Cash value accumulation may be accessed through loans or withdrawals to fund future benefits.

Advantages

  • Tax-efficient growth: Cash value grows tax-deferred; death benefits are generally tax-free.
  • Hedging: Death benefit offsets liability if an executive dies prematurely.
  • Long-term funding match: Policy duration aligns with benefit time horizons.
  • Participant assurance: Adds perceived security even if plan remains technically unsecured.

Challenges

  • Premium cost: Up-front insurance funding can be significant.
  • Regulatory complexity: Must satisfy § 101(j) and avoid MEC classification.
  • Policy performance risk: Crediting rates and policy expenses affect accumulation.
  • Liquidity constraints: Accessing cash values may trigger surrender charges or reduce death benefits.

When it makes sense

  • Companies seeking long-term tax-efficient asset accumulation.
  • Large plans with substantial liabilities.
  • Key-executive retention strategies.

Comparative Funding Summary: Mutual Funds vs. COLI

FeatureMutual Funds / SecuritiesCorporate-Owned Life Insurance (COLI)
Investment riskHigh (market-based)Lower (insurance-hedged)
LiquidityHighLimited (policy loans/surrenders)
Tax treatmentTaxable investment returnsTax-deferred cash growth, tax-free death benefit
Up-front costLowHigh (insurance premiums)
Administrative complexityLowHigh (compliance, underwriting)
Participant perceptionFamiliar investment choicesImproved confidence due to insurance backing

Some companies adopt a hybrid or phased model: starting with mutual fund reserves and later transitioning to or layering in COLI as the plan grows.

Executive Benefit Strategy: Split-Dollar Life Insurance

Beyond NQDC plans, companies often explore split-dollar life insurance arrangements for senior executives. These allow an employer and employee to share ownership, costs, and benefits of a life insurance policy.

Two Primary Structures

  1. Economic Benefit (Endorsement) Regime:
    • Employer owns the policy and pays premiums.
    • Employee receives a portion of the death benefit and is taxed annually on the value of the life insurance protection.
  2. Loan Regime (Collateral Assignment):
    • Employee owns the policy; employer “loans” premium payments.
    • Employer holds a collateral interest equal to premiums paid (plus interest).
    • Upon death or termination, the loan is repaid, and the remainder benefits the executive or heirs.

Benefits

  • Attractive fringe benefit for key talent.
  • Retention incentive tied to vesting or employment tenure.
  • Cash-value accumulation for long-term planning.
  • Can be integrated with broader deferred compensation or retention programs.

Technical Considerations

  • Must comply with Treasury Reg. § 1.7872–15 and avoid characterization as compensation under § 409A unless structured properly.
  • Requires proper documentation of notice, consent, ownership, and collateral interest.
  • Loans must follow applicable federal rate (AFR) rules.
  • Failure to comply with IRC § 101(j) can jeopardize tax-free death benefit treatment.

Implementation Considerations

  • Plan design coordination: Integrate funding method with § 409A timing and payout requirements.
  • Asset-liability matching: Align expected plan liabilities with funding growth assumptions.
  • Disclosure & transparency: Communicate that plans remain unsecured.
  • Accounting & compliance: Ensure proper GAAP reporting and EOLI documentation.
  • Transition planning: Evaluate when to move from mutual funds to COLI.
  • Change-in-control contingencies: Address how obligations are handled under sale or merger events.

Conclusion

For companies designing or reviewing NQDC programs, funding strategy is as critical as plan design itself. Mutual-fund reserves offer simplicity but leave exposure to market and credit risks. Corporate-owned life insurance introduces long-term stability and tax efficiency but at higher cost and complexity. Split-dollar life insurance provides an additional executive benefit vehicle that can complement or integrate with these funding methods.

Selecting the right combination depends on plan size, participant demographics, corporate cash flow, and risk tolerance. Proper coordination with tax, legal, and actuarial advisors ensures both compliance and optimization of employer and executive objectives.

Sources

  1. McLane Middleton – Life Insurance as a Funding Mechanism for Deferred Compensation Plans: Tax Traps for the Unwary.
  2. Nolan Financial – Transitioning Mutual Fund Balances to COLI.
  3. Ascensus – Maximize Nonqualified Plans with COLI: Tax-Efficient Funding for Key Talent.
  4. Morgan Stanley at Work – Corporate-Owned Life Insurance (COLI).
  5. Insurance and Estates – Corporate-Owned Life Insurance (COLI): Pros, Cons, and Use Cases.
  6. Securian Financial – Split-Dollar Life Insurance Strategies for Executive Compensation.
  7. John Hancock Retirement – Funding Non-Qualified Deferred Compensation Plans.
  8. Fidelity Viewpoints – Non-Qualified Deferred Compensation Plans (NQDCs).
  9. Guardian Life – Split-Dollar Life Insurance Overview.
  10. Prudential – Collateral Assignment Split-Dollar Arrangements.
  11. Executive Benefit Solutions – Split-Dollar Life Insurance: What to Know.
  12. Internal Revenue Code and Treasury Regulations – IRC § 409A, IRC § 101(j), IRC § 7702A, Treas. Reg. § 1.7872–15.

This material is for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or investment advice. You should consult your own tax, legal, and accounting advisors before making any decision.

Securities offered through Valmark Securities, Inc. Member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor. | 130 Springside Drive, Suite 300, Akron, OH 44333–2431 | Telephone: (800) 765‑5201 | Lebel & Harriman, LLP and Lebel & Harriman Retirement Advisors are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc.

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