Executive Benefits are gaining attention due a perfect storm of factors impacting employers. This includes:
Challenges in attracting qualified and high-performing talent;
Likelihood of an increase in both corporate and personal tax rates;
Relatively low contribution rate for qualified plans which are subject to discrimination testing; and
Difficulty in retaining talent.
A supplemental executive retirement plan (“SERP”) is a highly effective non-qualified executive benefit strategy to provide additional compensation for a handful of key employees, motivate performance and to encourage them to stay with the company.
How a SERP Works
An employer makes a written, contractual promise to a participating executive in the form of either a defined future benefit or a defined contribution. For example, in the instance of a defined future benefit, the employer could promise an income of a set amount for a set period of years after retirement. The promise could also be a percentage of the executive’s final salary for a set period of years after retirement. A formula could be a part of the promise, “Retirement benefit equals 75% of the average of the executive’s final three years of salary for ten years after retirement.”
In a defined contribution promise, the employer might credit a specific dollar amount to the executive’s SERP account each year. For example, the employer might credit $50,000 a year and either state an interest rate or tie the growth of the account to the growth of the company or mirror indices like the S&P.
SERP plans often provide for the payment of the accrued benefit amount to the executive’s family in the event of the executive’s pre-retirement death or disability. Also, the employer may choose to place a vesting schedule on the plan, which can act as a ‘golden handcuff’ to encourage the executive to remain with the company for a specific time.
Upon the occurrence of a triggering event such as the executive’s death, retirement, disability or plan termination, the SERP benefit will be paid to the employee. The benefit will be paid out either in a lump sum or in a series of installments, depending upon the written terms of the arrangement.
When the executive receives benefit payment, they are then responsible for ordinary income taxes and the employer subsequently takes a corresponding income tax deduction.
A SERP is considered an ‘unfunded’ promise to pay an executive and formally tying a funding source to the benefit would cause the benefit to be immediately taxable. Therefore, the employer must make arrangements to informally fund the contractual promises made to executives in their SERP agreements.
Most employers choose to purchase cash value life insurance policies on the lives of its key executives to help the company pay for future benefit payments and to recover the costs of the plan. When informally funded with life insurance:
The policy is an asset of the business, which is the policy owner, premium payor and the beneficiary.
The employee pays no costs associated with the policy but must consent to the insurance policy on his or her life.
Life insurance has multiple tax advantages that make it useful to the employer to informally fund a SERP plan, such as:
Policy cash values which grow tax-deferred;
Policy cash values which can be accessed income tax-free; and,
A death benefit that is received income tax-free.
Although employers may consider other informal funding techniques such as self-funding, a sinking fund with marketable securities or mutual funds or annuities, life insurance is most often used for its tax advantages and cost recovery.
Because a SERP is a non-qualified plan, the employer cannot segregate assets protected from the company’s creditors without subjecting the plan to ERISA. If the employer were to file for bankruptcy and be unable to pay the SERP benefit, the executive would be considered a general creditor of the employer and would not receive preferential treatment in recovering the benefit.
Internal Revenue Code Section 409A applies to all non-qualified executive benefit plans that provide for the deferral of compensation, including a SERP plan. The SERP plan document must comply with the rules detailed in §409A. Failure to comply with §409A may subject a participant’s income to immediate income taxation, as well as interest and a 20% excise tax on the taxable income.
SERP Benefits of Employers
Flexibility. Employer can select which employees will participate in the plan and determine the benefit for each employee.
Golden handcuffs. Employer can impose a vesting schedule, creating ‘golden handcuffs’ and giving the executive an incentive to remain with the company.
Cost recovery. When informally funded with life insurance, the death benefit is generally received income tax-free and can provide plan cost recovery.
Tax deduction. Employer receives a tax deduction at the time the retirement benefit is paid.
SERP Benefits for Executives
Supplemental, employer-funded retirement income. A SERP can be used to supplement qualified plan savings with additional retirement income for highly compensated executives.
Pre-retirement death benefit. Executive may also receive pre-retirement death payment benefit for his or her family.
Protection. The additional annual retirement income and/or survivor benefit will help to ensure that the employee’s family is protected.
Tax-deferral. If properly structured, the employee will not have to pay income taxes on this benefit until received.
A SERP plan can be a powerful strategy for an employer to reward a key executive’s performance and loyalty to the company, especially in cases with qualified plan income and contribution limits can hinder the executive’s’ ability to fully save for retirement. Cash value life insurance continues to be the most tax-efficient asset used to informally fund a SERP plan as well as to provide a manner for an employer to recover all plan costs.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.