In A Switch, SERPS Are Being Funded With Fixed Annuities

Since the annuity payment presumably will be paid entirely by the employer to the employee, or by the insurer to the employee on behalf of the employer, the employer should be able to deduct the full payment. So, the employer should be able to deduct a larger amount (i.e. the full payment) than it treats as income (i.e., the interest component), at least until the principal is fully recovered. After the principal is fully recovered, the income to the employer, and the deduction, should be a wash.

Another tax consideration is that if the employer is a non-natural owner, such as a corporation, the interest accruals each year are ordinary income to the employer. For an SPIA, this should not be an important consideration since the entire payment will probably be paid to the employee. For an SPDA, a non-natural employer would pay income tax on the interest accruals each year.

Design considerations for the employee. If the employee is married, the employee may want a survivor benefit paid to his or her spouse in the event the employee dies first. A joint and 1/2 or 2/3 survivor annuity is often chosen. Be sure to point out that the monthly benefit will be less than a single-life annuity payable just for the employees life. The lesser amount accounts for the cost of the survivor benefit.

For an alternative to the survivor annuity, the advisor could recommend that the employee who is about to retire take the single-life annuity and then purchase life insurance. Here, the life insurance would be funded with part of the payout from the annuity. Specifically, the premium for the life policy would be the difference between the single-life annuity benefit and the benefit that would have been paid had the employee chosen a survivor annuity.

For example, consider the situation where the single-life annuity benefit is $50,000 per year, and the joint and 2/3 benefit is $40,000 per year. The employee would elect to receive the $50,000 benefit. Then, the employee would purchase as much life insurance as could be purchased with $10,000 per year ($50,000 minus $40,000).

The employees spouse may own the life insurance contract or an irrevocable trust may own it for estate planning reasons. Either way, the life insurance death benefits should be received free of income tax, and they may then be used to provide income to the surviving spouse. Even though the life insurance premiums are paid with after-tax dollars, this approach may be more favorable to the spouse than a survivor annuity under the SERP. The reason is that the SERP survivor benefits are taxable income.

The employee may also be concerned that the benefits will not be paid when due, assuming that the employer has the funds to pay them.

For example, what if the employer has a change of management, and the new management does not want to pay the benefits? To address this concern, the plan may be designed by placing the annuity contracts in a trust established by the employer. The terms of the trust provide that the employer cannot access the annuity contracts, except to pay benefits. The trust is subject to the claims of creditors.

This so-called “rabbi trust” (named after the employee in an IRS private letter ruling) may also provide for triggers that pay benefits to the employee immediately if certain events occur, such as severe financial reverses for the employer. The trigger could, for instance, be based upon financial ratios from the employers accounting statements. The trigger must be outside of the employees control, otherwise the employee may have immediate income tax upon the payment of the annuity premiums.

Let the attorney do the legal work. Plan design issues ultimately are the responsibility of the clients tax and legal counsel. If nothing else, a suitable written agreement allows the employees heirs to see what the employee agreed to, and it supports the validity of the plan for tax purposes.

A word of caution, however. The plan design is integrally tied to how the plan is funded. By offering funding ideas, you the advisor do add value to the sale. In fact, your advice will be sought out and valued by the clients counsel, since technical knowledge of the products is essential to a successful transaction. Therefore, any failure to properly consider the characteristics of the products can lead to serious practical and sometimes legal problems.

On the other hand, be wary of the client who does not want to call in the attorney because the attorney will charge the client for the advice. If the client relies upon the agent for legal advice, the agent would be well advised to withdraw from the case. If there is a problem later on, the clients attorney can have a field day upon cross-examining an agent in these circumstances. Having seen the results of this firsthand, I can tell you this is something you will want to avoid!

In addition, be careful if the employer and the employee suggest that they use the same legal counsel. What is good for the employer may not be good for the employee, and vice versa. So, each party should consult with their own legal and tax counsels.

Douglas I. Friedman, a partner in the Friedman & Downey, P.C. law firm of Birmingham, Ala., is national counsel on estate and business planning for insurers. His e-mail is [email protected].

Reproduced from National Underwriter Edition, April 7, 2003. Copyright 2003 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.