Executive Compensation with Nonqualified Deferred Compensation / Supplemental Executive Retirement Plans
As employers look to design compensation packages for their employees, there are many good options out there. However, executive compensation with nonqualified deferred compensation plans may provide the best benefits for the executive…and the employer.
Within this article, we will use the terms ‘nonqualified deferred compensation” and “supplemental executive retirement plan” interchagebly. It should be noted that a supplemental executive retirement plan (or SERP) is a deferred compensaiton plan…but not all deferred compensation plans are SERPs.
Qualified retirement plans, such as the 401(k) have been a mainstay in corporate America since its introduction into the tax code in the 1970’s.
The concept is simple. The employer will place some a small portion of the employee’s salary into the employee’s 401(k) account, where it is usually invested in mutual funds and grows tax deferred. The employee will then pay ordinary income taxes on the amounts withdrawn at retirement.
This is considered to be a pure deferred compensation, or salaryreduction arrangement, as the proceeds are considered part of the employees current compensation.
When structuring benefit plans for executives and other highly compensated employees, the normal qualified retirement plans usually don’t provide enough benefits to be attractive to these highly skilled and valued employees.
Most notably, there are contribution limits on the qualifed plans…where the IRS limits the amount that can be placed into a tax advantaged account such as the 401(k) and other qualifed plans. In addition to the lack of contribution limits, NQDC plans are attractive due to the flexibility of the plan designs and not subject to ERISA laws.
Therefore, companies will usually include a non-qualifed deferred compensation plan in addition to the qualified plan as part of the executives retirement benefits.
Differences of Characteristics
Non-Qualified Deferred Compensation (NQDC) Plan
End of calendar year
Subject to ERISA* nondiscrimination rules
Yes (with Department of Labor and IRS)
Subject to general nondiscrimination rules
Yes ( Section 401(k) plan also subject to special testing )
No (may discriminate in favor of executives)
Immediate employer deduction and employee deferral of income
Employee deferral of income; deferred employer deduction
Generally taxable as ordinary income (exception: NUA ** on employer stock)
Taxable as ordinary income (no exception for employer stock)***
** Net Unrealized Appreciation (NUA)
*** Rather than taking income, NQDC plans utilizing cash value life insurance allows for executive to take tax advantaged distributions from the policy in the form of loans payable by the death benefit to supplement retirement income.
Types of Nonqualified Plans
One of the main benefits of nonqualifed plans is the flexibility. Depending on the companies and the executive’s needs and constraints, a NQDC plan can usually be custom designed to meet those needs.
To begin the design, the first decision must be which of the two types of NQDC plan to implement.
1) Salary Reduction (pure deferred compensation) – a salary reduction NQDC plan uses a portion of the employee’s current compensation to fund the promised compensation, usually payable upon retirement. This is usually not preferred by the employee as they are reducing current income, to deferr at a later date.
2) Salary Continuation – a salary continuation plan is funded with money the employer has set aside from current earnings to benefit the executive. This is preferred by most executives as they are not sacrificing current compensation. This is may be strucutred as a type of bonus…and is the foundation for a Supplemental Executive Retirement Plan.
Tax Efficiency of Executive Deferred Compensation Plans
At the heart of designing a nonqualified deferred compensation plan is tax efficiency. If the plan is not taking full advantage of the opportunities available…it defeats the purpose of even having a deferred compensation plan.
It is especially important when designing the Supplemental Executive Retirement Plans as the higher paid individuals have higher tax liabilities.
A basic test to determine if and when executive compensation will be taxed is the Income Tax Doctrines of Deferred Compensation Plans. Once any one of the three doctrines are met, a taxable event has occured.
Income Tax Doctrines for Non-Qualified Deferred Compensation Plans
Constructive receipt happens if the executive has unrestricted access to the funds set aside by the plan. Any funds constructively received must be reported immediately as taxable income to the executive…defeating the tax advantage of deferred compensation planning.
Economic benefit defines what constitutes income. One test is whether the plan grants the executive greater rights to the employer’s property than those of other parties…such as general creditors. If the funds placed in the NQDC plan remain subject to attachment by employer’s general creditos, the economic benefit will not apply and a taxable event has not occured.
Substantial Risk of Forfeiture
If funds set aside in a NQDC plan have substantial risk of forfeiture, the executive deferred compensation plan will not be treated as constructively received. In order for tax advantages to be given to a NQDC plan, the funds have to be avaialable to general creditors in the event of insolvency or bankruptcy.
Funded vs. Unfunded Executive Compensation
The names may seem fairly straightforward…and they are. However, the choice of structuring an executive deferred compensation plan as funded or unfunded will be another determining factor of the tax consequences of the plan.
Funded Deferred Compensation
A funded deferred compensation plan is pretty much what it sounds like…funds are set aside on half of the executive, held in escrow or trust.
The executive will be taxed on the later of either:
- Date the employer contributes to the trust or escrow account
- Date there is no longer substantial risk of forfeiture.
As the income tax implications of a funded executive deferred compensation plan are inconsistent with the tax deferral goal, most nonqualified deferred compensation plans are unfunded.
Unfunded Deferred Compensation
There are two types of funding options within the funded deferred compensation model…the pure unfunded and the informally funded.
- Pure Unfunded – A pure unfunded deferred compensation plan is promise to pay future benefits. As the name implies…there are no assets set aside to make good on the promise. Considerable risk is taken on the part of the executive with this model. As such, it is not a popular plan.
- Informally Funded – The informally funded deferred compensation plan is considered “unfunded” because the assets funding the plan are still owned by the company (not the executive), and remain subject to the company’s general creditor claims. This satisfies all three income tax doctrines for Nonqualified Plans…allowing for tax deferral by IRS rules.
So now comes the question…how to fund a nonqualifed deferred compensation plan?
Nonqualified Deferred Compensation Funding Vehicles
The next stage in designing a nonqualified executive compensation plan is to determine the vehicle…that is, what will the assets be placed inside?
The two most common vehicles for NQDC / Supplemental Executive Retirement Plans are irrevocable trusts and cash value life insurance.
If a Supplemental Executive Retirement Plan is going to be funded with securities…such as a portfolio of stocks and bonds, they should be held in an irrevocable trust.
An irrevocable trust is a trust held for the benefit of someone else. In this case, it is the company setting up an irrevocable trust for the benefit of the executive.
And within the confines of structuring an executive deferred compensation plan, there are two irrevocable trust options…again…each with different tax consequences.
- Secular Trust – The Secular Trust is not exactly a deferred compensation plan, but a managed investment vehicle within an irrevocable trust for the exclusive benefit of the executive. “For the exclusive benefit of the executive” means the funds are not subject to claims from the employer’s creditors. This does not satisfy the income tax doctrine of substantial risk of forfeiture, therefore the executive is taxed immedately on the employer contribution and annually on earnings. The employer does receive an immediate tax deduction for amounts contributed to the trust. However, a Secular Trust does not meet the necessary requirements for a nonqualified deferred compensation plan.
- Rabbit Trust – The Rabbit Trust is an irrevocable trust used to fund the payment of promised future compensation to the executive. In a Rabbit Trust, the trust agreement must state the assets are subject to claims from employer creditors in the event of insolvency or bankruptcy. This will cover the Income Tax Doctrine of Substantial Risk of Forefeiture. Taxation to the executive occurs when payments are received from the trust, and the employer is entitled to an income tax deduction at that time. A Rabbit Trust can also be structured to pay benefits in the event of a merger or acquisition. The employer must pay taxes each year on trust earnings, unless assets are cash value life insurance or similar asset.
Cash Value Life Insurance for Executive Deferred Compensation
Cash value life insurance checks most of the boxes desired for NQDC plans for both the company and the executive.
- Tax Deferred Growth
- Tax Advantaged Distributions
- Professional Money Management
- Low Fees
1 ) Tax Deferred Growth
The cash value of a permanent life insurance policy grows tax deferred, whether in a Nonqualified Deferred Compensation plan or individually owned.
Cash value life insurance has always received tax advantages for two reasons:
- it has been around longer than the United States Income Tax Code, and
- the government incentives for the ownership of life insurance.
How the money will grow within the policy willl be based on risk tolerance and objectives.
If there is no tolerance for variation in returns, and the policyowner prefers a lower return so long as that return is consistent, the NQDC plan will likely pursue a whole life policy to fund the plan. This produces a more precise outcome for the executives retirement planning. So if a return around 4% annually will produce the tax advantaged distributions promised for retirement, the whole life policy strategy may be more prudent.
If there is a more comfort with variability of returns, and a desire for potentially higher returns without the losses, there is the Indexed Universal Life (IUL) strategy.
The IUL policy uses an indexing strategy for cash value growth. The cash value account tracks an index, like the S&P 500. It is important to note that money cannot invest in an index. Since the money is never in the market, it cannot lose value due to market downturns.
Some may have caps, and some may be uncapped (depending on the insurance carrier and the design objectives). If a policy design has a 13% cap, and the market index goes up 15% that year, the policy’s cash value will increase the 13%. That 13% increase now establishes the policies new floor.
So the IUL has a “zero floor”, meaning the cash value return cannot go negative.
If the index goes down 20%, the next year…the cash value growth is 0% for that year (minus cost of insurance and other fees).
2) Tax Advantaged Distributions
In a permanent life insurance policy, such as a whole life policy or an Indexed Universal Life, the cash value grows for the purpose of using it at some point.
There are two ways to take distributions from a cash value life insurance policy.
1) Withdrawal – Money is taken out of the policy…not to be returned. This method is fully taxable.
2) Loans – Money is borrowed from the policy to be paid back at some point in the future.
If the company still owns the life insurance policy (pre-retirement of executive), the company may take tax free loans from the policy to fund business investments and operations.
Many insurance carriers offer participating loans, which means the loan is actually taken from the insurance carrier, with the policy acting as collateral. The end result is that the policyowner earns interest on the money borrowed.
Supplemental Executive Retirement Plans will utilize the loan option for tax free distributions to supplement their retirement income. The loan is eventually paid back through the death benefit of the policy (this is the strategy used in the case study found below).
3) Professional Money Management
When it comes to money management no institution can match the track record of the insurance companies. In 2008 when so much of Wall Street crumbled…the insurance companies were still making good on their promises. How? Conservative management with an eye on the long term.
Did you know that approximately 96% of actively traded mutual funds do not beat the market? And that’s before fees. If you subtract out a 2% management fee (or even a 1% fee), the investor is left with under performance for excessive fees.
Insurance companies management their money on decades long time frames, which has been proven successful (most insurance companies we work with have been around for over 100 years).
The insurance carriers’ “general account” (which is used for investments for the cash value in policies) is invested mostly in commercial real estate and bonds. These low risk, consistent return investments allows the carrier to provide good consistent returns (with no risk of loss of principle).
In the indexing strategy used for the Indexed Universal Life strategies, the insurance carriers are purchasing call options to be able to participate in the gains without the losses.
For example, assume you give $100 to the insurance company. They take $95 of those dollars and invest it in the general fund. This is an amount they are confident they can grow back up to $100 by the end of the year. With the additional $5, they purchase a call (option to buy) on the underlying index. If the index increases that year, they exersice the option and the policy is credited on the gain (minus fees, costs of insurance, and any caps). If the market drops 20%, the insurance company simply does not exercise the option, and your account is back up to your original $100 from the $95 investment in the general fund.
Now, that is a simplified example…but it is enough for you to understand the concepts of how they do this.
Usually, this indexing strategy is very expensive to do. It is common in some investment banks and hedge funds. However, it is too costly for most investors to participate in that kind of call strategy. But since the policy is pooled with the rest of the insurance carrier’s policies, the costs are spread out…allowing this powerful strategy to be available to policyholders.
4) Low Fees
This surprises many people, because the common understanding is that these insurance solutions are very expensive. And the may be for some people.
How much do employers pay for the administration of their 401(k) plans? Usually it’s a substantial amount.
Supplemental Executive Retirement Plans are realtively simple to set up. Some companies may need an attorney to draft up the agreement. Then the management fees are all baked into the policy…and at very reasonable rates.
Some of the higher performing IULs may have higher fees…however it is usally still less than a the managmenet fees associated with mutual funds within a 401(k) plan.
Each policy must be tailored to the client and the clients needs…as such, fees will vary from policy to policy. That being said, they are still quite competitve to fees from the investment community…but with a better track record.
It is also important to note that commissions paid to the advisor are also part of the fees (though the insurance company simply has the commissions paid through the policy over a period of time). It is imperatvie that the advisor strucutring the policy is doing so for the benefit of the client. Fees…and especially commissions paid, hurt policy performance. That is why we structure our policies to have minimal fee strucutres to benefit cash value growth for the client.
Click the button below to download the PDF in the case study below comparing the IUL fees vs. a comparable tax deferred managed investment account.
The beauty of designing a nonqualified deferred compensation plan with cash value life insurance is the flexibility.
It can be designed to provide loan provisions to the company during the accumulation / funding phase and then transfer ownership to the executive to provide tax advantaged distributions to supplement retirement income.
The company can be the sole beneficiary for a certain period of time (providing tax free cash to cushion the economic blow from the premature death of an executive). Once ownership is transfered, it is possible to have the company remain as a partial beneficiary (allowing the company to recoup the cost of the benefit), while the executive’s family or favorite charity is the other beneficiary.
Cash value life insurance provides the greatest flexibility in one vehicle to maximize the benefits to the employee and the employer.
[CASE STUDY] How One Orange County, CA Business Designed a Supplemental Executive Retirement Plan (SERP) with Cash Value Life Insurance
The owner and CEO of a successful technology company based in Irvine, CA was looking for a tax efficient solution to enhance her compensation from company profits. She did not need additional current income, and she was already maxing out her qualified account (the 401(k)).
There was approximately $250,000 she could take as a bonus annually, but did not want the tax consequences.
In addition, she wanted her company to have a cash cushion in case she were to tragically pass. This would give the company a tax free death benefit that could be used to hire a replacement, and deal with the disruption in business for a time.
We designed a Non Qualified Deferred Compensation Plan, more specifically, a Supplemental Executive Retirement Plan utilizing an Indexed Universal Life cash value life insurance policy.
The company owns the policy on the CEO’s life, pays the $250,000 annual premium, and is the sole beneficiary of the policy.
The policy is held in an Irrevocable Rabbi Trust, with a trust agreement stating the company will own the policy and be the sole beneficiary of the life insurance policy until the day the CEO retires (which is tentatively scheduled at age 65). Once she retires, the policy ownership is transferred over to the insured (CEO), and the company maintain a 20% beneficiary status to recoup the premium costs while the remaining 80% beneficiary status may be assigned to whomever the insured desires.
By the age of 65 (assuming retirement has occured) the CEO can take tax advantaged distributions from her Supplemental Executive Retirement Plan cash value life insurance policy totally approximately $637,217 every year until she turns 100 years old!
She would have to withdraw approximately $828,000 from a qualified plan like a 401(k) to get the same post-tax retirement income.
Below we have illustrated the most likely outcome based on historical S&P performance over the last 30 years.
The company pays $250,000 annually for 11 years (tax equivalent is $384.615).
If the CEO dies during her time in the company, the company is the sole beneficiary of the policy (the death benefit in this policy was designed to be as low as possible to allow for maximum cash value growth). If she were to pass in policy year 6, the company would receive $6,812,268 tax free.
Upon retirement, the retired CEO now is the sole owner of the policy. The company retains a 20% beneficiary stake, while the remaining 80% is likely to be given to her children. If she were to pass at policy year 25, the company would receive $1,479,531 while her family would receive the additional $5,918,125 tax free.
The policy has accrued enough cash to now provide approximately $637,217 tax free, every year from age 65 to age 100.
Over the course of 11 years, the company funded the nonqualifed deferred compensation plan with $250,000 every year, which totals $2,750,000. If the company did not go with a tax efficient Supplemental Executive Retirement Plan, they would have had to contribute $4,230,769 as an after tax equivalent.
The CEO now has access to $637,217 every year, tax free for 36 years for a total possible compensation of $22,939,632.
This article has illustrated some of the basic considerations to begin planning your nonqualified deferred compensation plan.
Cash value life insurance provides the greatest tax benefits and the greatest flexbility…allowing the Supplemental Executive Retirement Plan to benefit both employer and employee.
As the needs of the company are different from others, it is important to have the ability to receive proposals from multiple insurance carriers. No carrier will be perfect for every company owned life insurance program.
That is why we at Metz Strategic Insurance Solutions are 100% independent.
We do not work for any insurance company, but can have each major carrier compete to give you and your company the best rates and benefit.
Click the button below to schedule a 15 minute introductory phone call with Conrad Metz of Metz Strategic Insurance.