Corporate Benefit Exchanges–A Second Bite At The Golden Apple

My topic, I believe, has the potential of producing significant new premium for all of us. We will review all the financial, economic and accounting issues surrounding benefit exchanges. Additionally, we will discuss the mechanics of the “exchange” transaction and review the potential constructive receipt issues with particular attention to why most practitioners agree no constructive receipt occurs.

As a preamble to this presentation, it is appropriate to discuss the genesis of the majority of the benefits targeted for exchange.

IRC sections 401(a)(17) and 415 limit the retirement benefit available to highly compensated executives from their corporate qualified plans. It is not uncommon to find that highly paid executives retire at only 20%-35% of their final pay while rank and file employees retire at 60%-100%.

Many employers, in a effort to treat executives at least as well as rank and file employees when it comes to retirement income as a percentage of final pay, have adopted non-qualified deferred compensation programs and Supplemental Executive Retirement Programs.

Deferred compensation plans are designed to allow executives to defer the receipt of current income to create a viable retirement benefit. These plans are often designed to allow a true 15% of total compensation without regard to the current $170,000 ceiling on recognized compensation in a qualified plan.

The SERP is generally a defined benefit approach to the same goal. It might say that the employer promises a retirement benefit of 60% of final pay offset by 100% of the benefit provided by the employer’s qualified plan.

Both of these generic plans require a liability accrual by the employer to reflect the value of the promise. There is generally a partially offsetting asset account called a deferred tax credit that recognizes the fact that payments, when made, will be tax-deductible to the employer. Public companies disclose the existence of non-qualified retirement benefit programs in their proxy statements in the section dealing with executive compensation.

A simple example might be helpful. An employer promises a benefit of $100,000 a year for 15 years at a retirement age of 65 to a 45-year-old executive. The value of the benefit promise at age 65 is equal to the present value of $100,000 per year for 15 years discounted at some interest rate. For our purposes, let’s use 6%.

This benefit promise has a value of $1,029,498. The employer is required to accrue a liability of this amount over the 20 years between now and the maturity of the benefit promise. The result is an accrual of $17,013 in year one, offset by a deferred tax credit of $6,805 for a total year one charge to earnings of $10,208.

By age 65, the annual liability accrual increases to $51,475 with an interest cost of $55,475 for a total charge of $106,835. Again, this is offset by a deferred tax credit of $42,734 for a total net charge of $64,101. The net accrued liability at age 65 is $617,699 representing the gross accumulated benefit obligation of $1,029,498 offset by the accumulated deferred tax credit of $411,799.

The executive to whom the SERP promise was made may also have participated in corporate stock option and other financially lucrative bonus programs. He or she may have become wealthy beyond their wildest dreams. The SERP promise of $100,000 per year for 15 years may no longer be a meaningful benefit for this executive. In fact, this executive’s primary goal may now be to channel assets to future generations rather than to enhance retirement income.

Let’s assume our 45-year-old executive is now 63 and looking forward to a comfortable retirement at age 65. Income and estate taxes will reduce the value of the SERP to future generations. Assuming a total income tax rate of 40% and an estate tax rate of 55%, and further assuming the executive’s desire to channel this income and the value it produces to future generations, the result is as follows:

Value of accumulated SERP Income at 10% gross age 80: $1,480,351.

Value at joint life expectancy (age 88) at 10% gross: $2,810,148.

Net value to heirs: $1,545,582.

Total gross income received in retirement was $1,500,000. It was accumulated at 10% gross and allowed to continue accumulating until the death of the second to die. If no income or estate taxes were assessed, the value of the SERP at age 88 would be $8,749,737.

The goal of the Benefit Exchange is to channel as close to that amount as is possible to the heirs.

Before an executive can consider a benefit exchange, he or she must be confident of their ability to maintain a comfortable retirement lifestyle with assets other than the assets being exchanged. The decision to exchange benefits must be irrevocable.

The execution of the exchange requires the executive, in any year prior to retirement, to designate the source of the exchange. This might be a deferred compensation account, a SERP, future salary and bonus or stock option gains.

It is important to understand that it is not necessary to exchange 100% of the value of any of these sources. For example, an executive might decide to exchange 50% of the SERP or Deferred Compensation account and take the remainder as retirement income.

Giving an executive the right to exchange one benefit, the SERP, for another could trigger constructive receipt questions. The issue of constructive receipt revolves around allowing the SERP benefit to be set aside and made available for “cashing-out” at any time to the executive. The exchange does not give the executive this right and it appears that case law does support the tax-free exchange of one non-qualified benefit for another. {Martin, 96 T.C. 814 (1991)}

Let’s now turn to a discussion of the mechanics of the benefit exchange. In our example, we have a 63-year-old executive with a 60-year-old spouse. Both are in good health and have adequate personal assets to provide them with a comfortable retirement income. They want to channel as much to future generations as possible and want to do so in the most tax efficient manner possible.

Let’s assume our executive has a SERP account with a projected value (accrued liability) of $1,029,498 at retirement. The executive agrees to irrevocably exchange the income he will receive in retirement from the SERP. In exchange he receives a survivorship life insurance contract purchased on him and his spouse under a collateral assignment split dollar arrangement.

The corporation pays 100% of the premium. The executive and his spouse create an irrevocable life insurance trust that becomes the beneficiary and owner of the life insurance contract. The trust will annually receive a gift equal to the economic benefit under U.S. table 38 or its equivalent based on the net death benefit payable under the program.

The corporate sponsor, during the premium paying years and before release of assignment, receives a death benefit equal to premium paid and carries cash value on its books equal to premium paid. From an accounting standpoint, following accounting rule 85-4, the corporation pays a premium of $173,980 in year one and books a cash value increase of $163,227 resulting in a charge to earnings of $10,753. In year two, premium paid results in cash value increase of $181,189 and a gain to earnings of $7,209.

The insurance transaction has a negligible impact on the financial statement. The release of the SERP obligation has a major current impact. Releasing the $1,029,498 accrued liability results in a gain to earnings of that amount offset by the reversal of the deferred tax credit of $411,799 for a net gain of $617,699.

Ultimately, the program is cost neutral to the corporate sponsor. However, in the early years it produces a significant earnings gain.

Annual premium is determined by taking the present value of the retirement obligation being exchanged and converting it to a premium stream over five to seven years. In our example we use a seven-year premium stream. Assuming a net 6% discount rate, the annual premium developed is $173,980. This produces a first year death benefit of $4,709,400. Of this amount, $4,535,420 is payable to the ILIT and the balance (premium paid) is payable to the corporate sponsor.

We anticipate a release of the collateral assignment in the year after premium payments are completed. At that time, a taxable event occurs and the net tax liability created is paid via policy loan.

In the year prior to release of the collateral assignment, corporate death benefit and cash value is $1,217,272 and the executive’s death benefit is $4,848,506 and cash value $302,417.

Using option B, the trust death benefit increases to $8,232,220 at age 88 of the younger insured. This results in an economic advantage to the heirs of $6,686,638, a 533% difference when compared to taking the SERP or deferred compensation payments as cash compensation.

If you have clients for whom you have established supplemental retirement plans, the benefit exchange may provide an ideal opportunity to revisit your client and generate a new sale that provides great client benefit.

Michael L. Millman is president of Michael Millman, Ltd., Fairfield, Conn. This is an abridged version of his presentation at the MDRT annual meeting in Toronto.


Reproduced from National Underwriter Edition, June 22, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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