As the new administration in Washington eyes raising taxes, including corporate taxes, large and mid-sized companies are increasingly becoming focused on incorporating the use of life insurance to provide competitive and secure benefits more efficiently. Corporate owned life insurance (“COLI”) has been used by companies for over half of a century to informally fund benefit promises made to employees because of its significant tax advantages.
A common application of COLI is to help employers meet obligations arising from non-qualified compensation programs. When a company makes a promise of future compensation to key employees, this promise creates a liability which can grow substantially over time. For example, a company might offer 100 executives the ability to defer a part of their income until their retirement and then offer to match a portion or all of that deferral. This contractual obligation immediately becomes a company liability and a matching asset to tap to be able to make these future payments is needed.
As these compensation arrangements are non-qualified and, by definition, there must a substantial risk of forfeiture, an employer must be careful not to formally tie the funding asset to the promise. Therefore, the asset or assets selected to later be used for the liquidity to make deferred compensation payments are said to “informally fund” the compensation plan.
While companies might set aside cash, securities or hard assets, the most tax-efficient informal funding mechanism is cash value life insurance. Since the cash value of the policies equals or nearly equals the cash paid as premiums, there is no immediate change to the company’s balance sheet. While other assets produce taxable income as their value grows, the cash value of COLI grows tax-deferred, creating a higher rate of return compared to other informal funding options.
A company is able to use COLI to obtain liquidity for its deferred compensation promises in two ways. First, the cash value may be withdrawn to the basis of the policy and, after that, loaned from the policy tax-free. Assets other than life insurance would not have this tax advantage and a higher asset value would be needed from, for instance, a mutual fund to obtain the same, after-tax amount.
The second way a company uses COLI to obtain liquidity is by collecting the income tax-free death benefit at the death of the insured employee. This is a major competitive advantage over other potential assets, particularly where the employer has promised a lump sum death payment to the employee’s family which either matches the employee’s deferred compensation promise or some additional sum.
The question of insurability is often raised when life insurance is considered. Employers have an insurable interest in their employees but what about if an employee is uninsurable due to health issues? Many life insurance companies will offer simplified or guaranteed issued policies where they look at a group of insureds and can make a fairly accurate assumption of health with little or no medical information and incorporate it into the policy pricing.
Large companies with thousands of participants in their deferred compensation programs are able to actuarially target when cash will be needed from policies as well as when covered employees will likely pass away and this can allow even greater efficiency in how COLI is purchased and positioned.
Perhaps one of the greatest benefits unique to COLI is the ability of the employer to cover all of the costs of the deferred compensation program, including the time-value of money. By increasing the amount of death benefit on a policy, a company can recover not only all of the payments made to the participants, but also target an amount to recover equal to the value of not having the cash used for policy premiums for the years until a death occurs. While increasing the death benefit means a higher premium, companies that can afford to do so eventually can eliminate the cost of their executive benefit program.
There are a number of risks associated with COLI. The IRS has rules about which employees can be covered and how documentation should be handled. A company owning COLI must stay on top of policy performance to make certain their liabilities are appropriately matched. A common mistake is for COLI to be left to run on its own, only to discover that changes made to interest rates or insurance costs have impacted policy performance. Companies can find themselves with an unexpected gap between their informal funding asset and their promise.
If you are considering utilizing COLI, our team at Life Insurance Strategies Group can help you with your evaluation. We are fee-based life insurance consultants and we do not sell products. This allows us to offer unbiased and independent advice to help HNW individuals and institutions make decisions about complex life insurance transactions.
Read our companion Tier One Interview with Bill MacDonald 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.