Tier One: The Promise & the Path: An Introduction to Non-Qualified Deferred Compensation
“Deferred compensation has nothing to do with life insurance,” is how I begin when asked to explain the concept. This disarming statement usually draws looks of skepticism from my audience who are generally prepared to zone out in the same way as if I were asked to describe split-dollar, premium financing or private placement. There is a look of relief until I continue with, “….but funding a deferred compensation plan in the most tax-efficient and effective way has everything to do with life insurance!”
More than twenty years ago, I began speaking about non-qualified deferred compensation (“NQDC”) at life insurance producer conferences all over the country. Early on, I found that by breaking the topic into two parts, the promise and the path, what otherwise might be a complex topic is much easier to grasp. The promise is the compensation arrangement made between the employer and the employee and the path is the use of life insurance to make good on the promise.
Forget about life insurance for the time being and consider a business where the employer wants the ability to reward, retain and/or retire their executives or other highly compensated employees. The business might have one executive or hundreds but the challenges for the employer when it comes to incentivizing and rewarding these employees are similar. Qualified plan contribution amounts are limited and may only play a small part in the overall savings needs for some employees.
NQDC supplements existing qualified plans and provides an extra benefit to key and highly compensated employees while providing the employer with the ability to control behavior and maintain loyalty.
At its core, NQDC is nothing more than a written promise between an employer and an employee where the employee agrees to be paid in the future for service he or she performs during the term of the plan. The promise usually takes one of two forms:
Traditional NQDC where the employee agrees to defer a portion of their own compensation until some point in the future; or,
Supplemental Executive Retirement Plan (“SERP”) where the employer pledges its own money to provide a future benefit with or without the executive making his or her own deferral of compensation.
Generally, the company promises to pay deferred compensation at retirement or, if the employee is still employed at the company, at death or in the instance of a disability. The employer might assign a fixed growth rate to amounts deferred or mirror the performance of an investment indices such as the S&P 500 or even the rate of the growth of the value of the employer.
By making the promise, the employer establishes a liability for itself and, while that liability can go unfunded, it would be difficult to attract participants without adequate funding. Funding can take various forms, including the establishment of a sinking fund, the purchase of securities or funds, or the investment into a hard asset. All of these options have tax consequences which make them less efficient than life insurance.
By choosing life insurance as the informal funding mechanism for NQDC, the employer is able to take tax-free policy loans in the future to make good on promised payments. From an accounting perspective, a policy loan, since its tax-free, need only be in the amount of the payment due to the employee after the employer takes a tax deduction for the compensation payment. In order to obtain the same amount from any other informal funding source, a higher sum would be required so that taxation on gains could first be paid.
For a company considering the use of life insurance to informally fund its NQDC plan, it is a basic math problem. Is the savings from having to obtain less value from the policy in order to make a compensation payment less than the insurance costs associated with the policy? In most instances, the savings are incredibly meaningful. However, this savings isn’t the only benefit which comes from using life insurance.
Since the life insurance contract is owned by the employer, at the future death of the covered employee, the employer can recover some or all of the costs of offering and administrating the plan, including the time value of money, from the policy’s income tax-free death benefit. Also, in the event of the untimely death of the employee while still employed or in the payout phase of the plan, the employer can use the death benefit proceeds to make a lump sum compensation payment to the deceased’s heirs.
There are additional nuances and intricacies to offering a NQDC plan or a SERP and to using life insurance as well as a number of pros and cons to keep in mind.
Employees are not taxed on deferred compensation at the time of deferral which can lower their amount of gross income.
Unlike with qualified plans, employers may discriminate as to who is eligible to participate
Employers who own life insurance policies to informally fund deferred compensation arrangements receive the benefits of tax-free cash value accumulation, the ability to take cash-free loans and the right to receive income tax-free death proceeds.
There is much greater flexibility over qualified plans, including the employer choosing the terms of coverage, forfeiture triggers and other restrictions.
The U.S. Treasury requires there to be a “substantial risk of forfeiture” such that the employees are unsecured creditors (standing last in line to other creditors) to their promised benefits in the case of bankruptcy or other solvency challenges.
The current tax deduction an employer would otherwise take on compensation is forgone until the compensation is paid in the future.
Not every employee may be insurable so pooling coverage from other policies or other informal funding options may need to be explored.
Read our companion Tier One Interview with Justin Man by clicking here.
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.