Deferred Compensation refers to payment to an employee that allows the employee to defer income to the future. Usually set up for tax purposes, many large employers have such programs as a benefit to their senior executives and highly paid employees.
Most plans for deferred income are administrated by a third party financial firm, much like a 401K plan. Employees participating in the programs can defer part or all of their income to the plan, which typically invests in mutual funds and other diversified investment instruments.
Technically speaking, many plans for regular employees are types of deferred compensation, such as pensions, retirement plans, and stock options. The individual can receive such benefits at a time when their income has ostensibly declined. However, most HR professionals use the term to refer to specialized programs in which the employee can elect to distribute part of their pay to a specialized deferred plan.
For example, an executive may make $450,000 per year. That high level of income puts them into a very high tax bracket. They may really only need $125,000 to pay their regular expenses. Using this form of compensation program, the executive might keep $125,000 per year, and elect to defer the remaining $325,000 to the plan.
Using this strategy, the employee puts themselves in a lower tax bracket, and can elect to realize that additional income during a year in which they are unemployed or have a lower compensation. Additionally, the dollars invested grow with interest or appreciation of the stock or bond fund, and the capital gain of the investment is realized only when the funds are withdrawn.
Corporations use deferred compensation plans as part of retention and talent attraction strategy. Especially when dealing with large executive compensation packages, the effect of a future payment can be substantial. Companies will typically develop a compensation model which includes the totality of compensation over time – using these financial plans can be a good way for corporations to show added benefit to highly compensated executives.