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Retirement Planning > Retirement Investing

Filling The Retirement Gap

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Today, many executives are facing a “retirement gap,” which is the difference between their retirement income objective and the retirement income provided by Social Security and qualified retirement plans.

The first step in addressing this problem is to quantify the gaps extent. The next step is determining how to fill it.

One way to fill this gap is through use of a nonqualified defined contribution deferred compensation plan.

Social Security and qualified retirement plans have various restrictions and caps. As a result, highly compensated executives end up with a much smaller percentage of income from these sources than rank-and-file employees.

To illustrate just how severe the gap may be for highly compensated executives, see the chart on this page.

Even in this example where retirement income is only paid out until age 75, there is a significant gap for high-income executives. A longer time frame would result in an even larger income replacement gap. Certainly, personal savings could be used to fill the gap and a customized analysis on an individual basis should include savings and investments.

There are a number of ways to fill the gap. In the right situation, an employer sponsored defined contribution deferred compensation plan (a.k.a. “excess plan” or “401(k) look-alike plan”) is an excellent way to help executives fill the gap on a tax deferred basis.

This employer sponsored plan allows select key management or highly compensated employees, who are limited in their ability to defer adequate dollars to the companys qualified plans, an option of deferring additional income to a nonqualified plan on a pre-tax basis. The plan is also flexible enough to allow the employer to make discretionary matching and/or profit sharing contributions to select employees accounts.

Most plans today look and feel very similar to the 401(k) plan because the executive can self-direct his contributions among multiple hypothetical investment options. State-of-the-art plans offer executives and plan sponsors Internet access, daily valuation, multiple money managers and investment options.

The employees hypothetical account grows or decreases in value based on how the accounts being used to measure the benefit perform. Once the plan is in place, the employer selects whether to use an unfinanced approach, taxable investments (typically mutual funds), or a variable Corporate-Owned Life Insurance product. The best approach for a company is generally dependent on the corporations (1) tax rate, (2) cost of money, and (3) cash flow.

In most cases it comes down to financing with mutual funds or variable COLI. An analysis of mutual funds and variable COLI should be completed based on assumptions provided by the employer. Initially, mutual funds are generally assumed to be the most efficient way to finance the plan. Upon further analysis, however, it becomes clear that for a company paying tax in a high tax bracket, the tax on the realized gains on an annual basis and unrealized gains in the future can have a significant cash flow impact on the company.

COLI offers several advantages: (1) tax-deferred growth; (2) access to cash value on a tax-free basis using withdrawals to basis and then switching to loans (assuming the policy isnt a Modified Endowment contract); and, (3) tax-free death benefit paid to the corporation.

The first two advantages greatly reduce the cost of the plan while the tax-free death benefit can recover costs associated with the plan. A financial analysis of both approaches should be provided to the company so the best financing approach for the client is used. Determining which financial tool will work the best for the company comes down to whether the cost of the insurance is less than the tax costs associated with mutual funds. In many situations, COLI will be the most cost-efficient approach.

When COLI is selected, there is still work to be done. Obviously, policy features and costs should be reviewed, but a determination of whether to use a policy per person or an aggregate funding approach is a key step in determining financing for the plan.

In many cases an aggregate funding approach combined with full underwriting will be the most cost-efficient for the client. An example of aggregate funding would be to have 20 participants but to only insure 4 or 5 of them. Generally you can find healthy “preferred” executives to insure.

Many times, guaranteed issue is used with the policy per person approach. Since there isnt any medical underwriting on a guaranteed issue case, the insurer typically charges higher insurance costs to cover the risk. Most guaranteed issue programs also do not offer the top preferred underwriting classifications for insured participants.

Combining aggregate funding and full underwriting, the total cost of insurance can be reduced by 30%-40% because of fewer policy fees and lower cost of insurance.

Offering a nonqualified defined contribution deferred compensation plan is an excellent way for an employer to help highly compensated employees “fill” their retirement gap. A properly designed plan can help an employer recruit, retain and reward executives in a cost-effective manner.

, JD, CLU, is director of advanced markets, Principal Life Insurance Company, Des Moines, Iowa. He may be reached via e-mail at West.Mark@

Reproduced from National Underwriter Life & Health/Financial Services Edition, June 24, 2002. Copyright 2002 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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