Fund Key Employee Retirement Perk With Life Insurance In Small Businesses
Whether a business is large or small, providing adequate retirement benefits is an important factor in attracting and holding key people. Such benefits are equally important to business owners, as well.
In fact, the LIMRA “U.S. Small Businesses in 2000″ study points to small business opportunities in the areas of individual business life and business continuation plans. The survey estimates the number of small businesses (with fewer than 100 employees) has grown to between 5.4 million and 6.4 million, two-thirds of which have fewer than five employees. It estimates 37% of small businesses carry individual business life insurance, up from 25% in 1994.
The survey says companies carry individual business life for several reasons: to provide funds for the business in case of death of an owner, partner or key employee; to fund business continuation arrangements and to provide additional life insurance benefits for key employees.
Other factors foster opportunity in the small business market. Since the enactment of ERISA in 1974, a plethora of tax legislation has limited the amount that highly compensated individuals can put away for retirement. This limits their ability to create a nest egg sufficient to provide retirement income commensurate with their income during their working years. Social Security and qualified plans make up the majority of retirement savings for most people. But the limits on qualified plan savings placed on highly compensated individuals create a retirement savings gap. This gap can be filled with a non-qualified retirement plan.
For instance, an individual age 45 earning $85,000 per year can replace 100% of retirement income through Social Security, 401(k) plan and a defined benefit plan. An individual earning $170,000 can provide 61% of income with these plans. But an individual earning $340,000 may only be able to replace 30% of income with Social Security and qualified plans. Individuals in the highest income tax brackets often find it difficult to save enough money on an after-tax basis to make up the gap between income during their working years and their desired retirement income.
A non-qualified retirement plan can close the gap between an executives pre-retirement income and his post-retirement savings.
Qualified plans have the advantage that they are not currently taxable to the employee and are tax-deductible to the employer. However, regulations and restrictions on 401(k)s, profit-sharing plans, simplified employee pension (SEP), and savings incentive match plans for employees (SIMPLE) can be burdensome. These plans must cover all employees. They limit employer and employee contributions, and they impose short waiting periods for new employees and brief vesting periods. They impose tax penalties on pre-age-59 distributions. And they provide little special treatment for key employees, executives and owners.
On the other hand, non-qualified plans currently are not taxable to employees and currently are not deductible to the employer. They have significant advantages, not the least of which is great flexibility. Non-qualified plans can cover selected employees, with different levels of benefits for each employee. Vesting can be customized and there is no complicated testing and reporting, which is of particular importance to small businesses. They permit high annual benefit maximums and there are no penalties for early retirement.
Non-qualified plans take two forms, traditional deferred compensation and supplemental executive retirement plans (SERPs). Traditional deferred compensation plans permit the employee to defer some portion of salary or bonus until some time in the future. The employer may agree to “match” a portion of the amounts the employee elects to defer. SERPs are employer-funded, providing either a defined contribution or defined future benefit for the employee with no change in the employees current salary base or bonus.
These contributions are accumulated by the employer on a tax-deferred basis, providing a greater retirement income to the executive than he could obtain if he had invested the after-tax retirement contribution himself.
It is important to note that non-qualified plans are contractual arrangements with employees. They are informally funded. Any assets that may be set aside are assets of the employer, and subject to corporate creditors. The employee receives a promise to pay from the corporation. He or she has no right to the underlying assets of the plan, if any. This may make non-qualified plans unsuitable for some small businesses, but not all.
The question then arises as to how these benefits should be informally funded. Large corporations sometimes fund non-qualified benefits out of cash flow when the executive retires. This alternative is not practical for smaller businesses.