Its Time To Improve Nonqualified Executive Bonus Plans

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In todays world of nonqualified executive benefit planning, there is a pre-Enron era and a post-Enron era. The corporate scandals that rocked Wall Street over the past year have had a profound impact on all aspects of working with companies and their executives on pay, incentives and benefits.

Companies want executive benefits to be simple, clean, and clear, particularly from a tax and accounting standpoint. Executives want guarantees, security and portability.

In the financial services world, this has led to a new interest in an old idea: Executive Bonus. However, these post-Enron times demand a new form and new features to this concept. It is time to take a fresh new look at executive bonus.

Why is executive bonus back in vogue? One reason is the core benefit that it addresses. While the headlines are focused on those few who used executive benefits to amass huge fortunes at shareholders expense, key employees in most firms are focused on a far more mundane issue: filling the retirement gap.

The retirement gap is the difference between what the employee has for projected retirement income and what is needed in order to retire comfortably. Traditionally, the retirement income gap for the highly compensated employee occurs when Social Security and pension benefits do not meet the employees retirement income needs.

Recently, however, a new gap has emerged: the investment gap. With the precipitous drop in not only returns, but in principal, the executive is challenged to refill the savings pool for retirement. Stock options and other incentive-based benefits may be far too unpredictable to be counted on, especially since they offer little opportunity for diversification. Likewise, with the very public collapse of brand name companies, some employees may be hesitant to allow their employers to defer current income as a way to boost retirement income.

The tragedy of 9/11 also has taught us all that our plans can be interrupted in unimaginable ways. Retirement income planning must factor in contingency planning for unemployment, health challenges, disability and even premature death.

Enter the executive bonus plan. The security of actually owning the financial contract that drives the benefit is compelling for executives. Employees control the product, they decide how it is invested, and they determine the timing of distributions. The benefit is a real and tangible incentive, not just a promise for the future.

For employers, income tax and accounting issues drive the renewed interest in the nonqualified executive bonus plan. The payments are immediately deductible for the business. It works well with pass through companies (S-Corporations, LLCs, etc.), and is not under review with the IRS. Although executive bonus does not offer the same degree of tax leverage as some of the more aggressive benefits that have been marketed recently, it does offer clear and simple tax consequences.

On the accounting side, it does not require booking an ongoing liability. Payments are treated as compensation to the employee in a clear and transparent transaction.

401(k) plans have changed the retirement paradigm. They have taught employees the value of deferring their pay in order to fund their retirement. In contrast, employers still pay the entire cost of a traditional 162 executive bonus plan. It is time to take this approach with executive bonus and rethink how contributions are structured. The idea here, as with 401(k) plans, is to increase the employees sense of ownership, while granting the employee some degree of flexibility.

A truly modern executive bonus program should give the employee an opportunity to contribute toward the solution. Highly paid employees are accustomed to deferring their money with 401(k) plans and deferred compensation plans. An executive bonus can be structured in a similar manner:

The employees own income can fund the program, and then the employer can mirror a 401(k) plan by offering to match the employees contribution;

Where appropriate, the employer may choose to add to the program with a more traditional bonus; and,

Since the executive bonus program is an after-tax solution, the employer can further help out by paying a tax bonus in the form of cash or compensation, effectively providing a pre-tax effect on employee contributions.

Modern executive benefits emphasize flexibility; executive bonus designs should allow for all of these contribution sources.

Another executive bonus topic that needs revisiting is the use of restrictions. The restrictive endorsement concept (typically called a “REBA”) is a policy endorsement that mandates employer permission in order for the employee to have access to the policy. Although REBA certainly has its value in particular instances, it should be used sparingly. If the person is an owner, a long-time employee, or a key player in the business, why tarnish the value of the executive bonus with this restriction? The whole point of this kind of plan is to give the employee a sense of ownership and control.

Furthermore, if a restriction is needed, it should have a limited lifetime that is built into the policy record. For example, if the employer insists on some handcuffs, put a three-year restriction on the policy. It has the effect of a three-year cliff vesting schedule. As a safeguard, there also needs to be a legal agreement between the employer and employee as to the terms of the restrictions.

Although the tax status of the executive bonus concept appears very solid, adding too many restrictions on access to the policy can jeopardize the deductibility of the premiums paid.

To take an extreme example, say the REBA is for 20 years (or worse yet, unlimited) and additionally there is an employment contract that severely stretches out the vesting of the plan. An argument could be made under both IRS 162 and 83 that there are too many strings attached to the benefit to have made a clear transference of the policy. The employers deduction might be challenged. The point is to use restrictions judiciously or not at all.

Historically, the life insurance industry marketed the nonqualified executive bonus plan as an effective life insurance sale. It is time, however, to expand the definition of executive bonus to include other financial products. Employers and executives should have choices in how they fund their benefit programs.

Just as the modern executive bonus program offers multiple designs, it should offer multiple financing options. Annuities and mutual funds can be useful financing options in situations where the employee is near retirement or uninsurable. In cases where the nature of the bonus is not predictable and may not be paid annually, annuities and mutual funds offer added flexibility. Each product has it its own tax elements.

The importance of all these options is to present a program, not a group of policies. To the extent possible, the new age executive bonus program must be designed, and provide administrative services, as a nonqualified benefit program, with consolidated billing and reporting for employers, and Web access for executives.

Compared with health insurance and pension plans, nonqualified benefit programs are not seen as an entitlement. There must be a tangible bottom line value to the program. It must help the employer recruit and retain, and it must help the executive fill the retirement gap.

Since these programs target growing companies, they must offer ease of use. Many of the firms that will benefit the most from executive bonus do not have large human resource departments; any service feature that reduces internal administration will be valued.

In this post-Enron environment, there is a renewed interest in providing clean and simple, but effective, benefits to key employees.

is second vice president, life and health markets at Principal Insurance Company, Des Moines, Iowa. You can e-mail him at parrish.steve@principal.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 23, 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.