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.
Employees of smaller businesses have a greater feeling of comfort if they know that assets are being put away in a sinking fund to fund their retirement benefits. The sinking fund may be invested in equities or mutual funds. Any income generated will be currently taxable to the employer.
The sinking fund could also be invested in annuities. However, annuities lose the advantage of income tax deferral when owned by a corporation.
An additional problem with the sinking fund approach is that if the employee dies or becomes disabled prior to his/her anticipated retirement age, there may not be enough funds available to fully fund his/her retirement. The employer could borrow to fund retirement benefits, but small businesses generally are reluctant to borrow for this purpose, and lenders may be reluctant as well.
Another alternative is to informally fund the retirement plan with life insurance, which offers unique advantages in funding non-qualified plans. The death benefits payable to the corporation are generally income-tax-free; however, death benefits may be subject to the alternative minimum tax.
Cash values accumulate on a tax-deferred basis, and if properly managed, can be distributed income tax-free from the contract to the corporation through a combination of withdrawals and loans. Of course, withdrawals and loans will reduce policy value and death benefit and may have tax consequences.
Life insurance also can provide an efficient source of plan retirement benefit payments and a pre-retirement survivor income death benefit to the executives beneficiaries. For example, the death benefit can provide funds to pay the remainder of plan retirement benefits to the executives beneficiaries should death occur during the retirement income period.
Life insurance also can reimburse the corporation for funds paid out for contract premiums, plan retirement benefits or survivor benefits including the cost of money if desired.
Life insurance on key executives can provide additional benefits to the corporation beyond informally funding retirement plans. When a key executive dies the business will suffer a financial as well as personal and emotional loss. Death of a key executive can result in lost customer relations and lost sales, as well as loss of unique business expertise and experience. It can cause the loss of confidence in the business by vendors and creditors, resulting in the calling of business loans on which small businesses often rely. It can cause unforeseen expenses to recruit and pay a replacement at a time of reduced cash flow.
Each of these losses can be ameliorated to varying degrees by an infusion of cash to the corporation. Life insurance by its very nature is designed to deliver cash when it is most needed–in the case of small business, at the death of a key executive. No other financial vehicle can combine the benefits available to small businesses and their employees as is provided by life insurance.
While non-qualified plans can provide flexible retirement funding that qualified plans cannot, they are not for everyone. For example, non-qualified plans should not be sponsored by pass-through tax entities such as a subchapter S corporation, limited liability partnership (LLP) or limited liability company (LLC), unless the participants are non-owners. The business must be expected to continue beyond the retirement of key executives and there will be complete successor business management in place.
In addition, the business should be adequately capitalized and financially stable so that employees will feel their retirement plan is secure despite the fact that plan assets are subject to corporate creditors and the employees assume the status of unsecured general creditors.
These considerations indicate that non-qualified plans may not be suitable for the smallest of small businesses. They may be suitable, however, for those stable and financially secure businesses that wish to provide flexible retirement benefits for key executives.
D. James Callahan, JD, CLU, ChFC, CFP, is Advanced Marketing Director for Prudential Insurance Company of America, specializing in marketing solutions for estate planning and executive compensation in the closely held business markets. He can be reached via email at D.James.Callahan@prudential.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, October 15, 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.