Deferred Pay at Risk: The Hidden Dangers of Rabbi Trusts

News that Steward Health Care executives may lose millions in unqualified retirement savings due to the company’s use of a “rabbi trust” has sent a jolt through the ranks of corporate leadership. Steward’s deferred compensation plan—intended to provide financial security for its top employees—has instead become a cautionary tale of how quickly that security can vanish when a company becomes insolvent.

While rabbi trusts are a common feature of executive compensation, their structure carries a critical vulnerability: in a bankruptcy, the funds held in trust are not protected and may be used to satisfy the employer’s debts. Many executives assume that a trust equates to safety, but in the case of a rabbi trust, that assumption can be dangerously misplaced.

This article explains what a rabbi trust is, why it poses a risk in times of financial distress, and what options—albeit limited—executives and other plan participants may have if trouble arises. Whether you’re currently participating in a non-qualified deferred compensation plan or advising those who are, now is the time to fully understand the legal and financial implications of relying on a rabbi trust.

What Are Rabbi Trusts?

Named after the first arrangement of its kind reviewed by the IRS involving a synagogue and its rabbi, rabbi trusts are a common tool used by companies to provide non-qualified deferred compensation, particularly to executives and highly compensated employees. These arrangements allow participants to defer income tax on compensation that will be paid at a future date—often upon retirement or separation from service. The employer sets aside assets in a trust that is managed by a third-party trustee, and the trust agreement governs when and how the funds are to be distributed.

Crucially, rabbi trusts are structured to preserve the tax-deferred nature of the compensation. This is achieved by making the trust assets subject to the claims of the employer’s general creditors in the event of insolvency. In effect, participants have an unsecured promise to receive future payment. While this satisfies tax rules under the doctrine of “constructive receipt,” it also means that if the employer files for bankruptcy, participants’ deferred compensation can be lost.

The Bankruptcy Risk

The vulnerability of rabbi trusts becomes painfully clear during a bankruptcy. Because the assets are not shielded from creditors, the trust funds can be pooled with other corporate assets to satisfy debts. For employees counting on deferred compensation as part of their retirement planning, this risk can lead to the complete loss of substantial savings.

Participants in such plans are treated as unsecured creditors in bankruptcy proceedings. They rank behind secured creditors and certain priority claims, and may receive only a fraction—if anything—of what they are owed. This is not merely a hypothetical concern; as recent events show, the financial collapse of a sponsoring employer can convert tax-deferred income into an unrecoverable asset.

Why Not Convert a Rabbi Trust to a Qualified Plan?

It may seem like the logical solution is to convert deferred compensation held in a rabbi trust into a qualified plan such as a 401(k), which is protected from creditors under the Employee Retirement Income Security Act of 1974 (ERISA). However, there are significant legal and tax obstacles that make such a conversion unworkable in most circumstances.

Qualified plans are governed by strict requirements regarding contribution limits, coverage, and non-discrimination. Non-qualified deferred compensation plans, including those funded by rabbi trusts, are not subject to those same limitations and are typically used to supplement benefits for a select group of executives. Attempting to transfer funds from a rabbi trust to a qualified plan would likely trigger immediate income taxation and violate various provisions of the Internal Revenue Code, including Section 409A.

Moreover, because qualified plans must be broadly available to employees and meet rigorous contribution and testing standards, large deferred balances in a rabbi trust often cannot be accommodated within the framework of a qualified plan.

Possible, Though Limited, Mitigation Strategies

Although there is no seamless or tax-neutral way to move funds from a rabbi trust to a protected plan, some limited strategies may offer alternatives:

1. Accelerated Distribution Before Insolvency: If financial trouble is anticipated, the employer may be able to pay out deferred compensation early, subject to tax at the time of payment. This must comply with Section 409A rules and may also risk being considered a preferential transfer in a later bankruptcy.
2. Prospective Plan Adjustments: Employers might prospectively reduce or freeze contributions to the rabbi trust and instead enhance contributions to qualified plans within legal limits. This does not protect existing balances but may reduce future exposure.
3. Plan Termination: Under narrow circumstances, non-qualified plans can be terminated and paid out within a fixed period (often 12 months), which results in taxation but could reduce the risk of total forfeiture if done before insolvency is imminent. These terminations must comply with detailed Section 409A requirements.

Each of these options carries legal, tax, and timing considerations that must be carefully evaluated.

Conclusion

For executives and other participants in non-qualified deferred compensation plans funded through rabbi trusts, the tax benefits come with serious credit risk. The employer’s financial health is a critical factor—one that is often overlooked until it is too late.

While there are some strategies that can mitigate risk, none can fully insulate participants from the consequences of bankruptcy once it occurs. As the Steward Health Care situation highlights, understanding the limitations of rabbi trusts is essential for sound financial and retirement planning. Employees and employers alike should regularly reassess the structure of these plans and consider whether the tax deferral is worth the potential downside risk.

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