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In A Switch, SERPS Are Being Funded With Fixed Annuities

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In A Switch, SERPS Are Being Funded With Fixed Annuities

By Douglas I. Friedman

One result of the stock markets volatility is that clients are now choosing fixed annuities to informally fund a supplemental employee retirement plan (SERP).

In general, a SERP provides nonqualified benefits to a select group of management or highly compensated employees. (See sidebar.)

In the past, clients would usually choose variable life insurance for a SERP. Thus, the switch to annuities is, in itself, a major change. The choice of fixed annuities reflects the desire for a more conservative approach.

Even so, clients are relying upon their advisors more than ever for innovative and cutting-edge ideas in plan design. The challenge, then, for advisors in this market is to be resourceful–to provide more than just a product. They must add value. Following are some strategies for doing that.

Design considerations for the employer. A SERP can be “informally” funded with annuities. Informal funding means the employee cannot have any rights in the annuity. If the employee has rights in the annuity, the employee would pay income tax on the annuity premiums.

Since the employee has no rights in the annuity, if the employer has financial problems, the annuity is subject to claims of the employers creditors. That means the employee would be a general creditor of the employer and may not receive any benefits.

Funding a SERP with fixed annuities offers interesting design possibilities. Single premium immediate or deferred annuities may be utilized. The employer is applicant, owner and beneficiary of the contract. The payments may be received directly by the annuitant (the employee) or by the employer. Either way, the payments are considered wages from the employer.

How to utilize the annuities is where I believe the agents advice can be particularly valuable. For example, if benefits are to be paid immediately, one possibility is to recommend using a SPIA with a single lump sum payment.

If the employer does not want to make a lump sum payment, consider recommending a series of immediate annuities. Then, if the employee dies prematurely, the employer does not lose the lump sum payment. Of course, if the employee lives longer than anticipated, the employer may end up paying more in premiums through buying a SPIA each year than by making a single lump sum payment.

Another possibility would be to buy a SPIA that is designed to pay benefits for a specific term, such as the next five years. This allows the employer to spend less initially than the single lump sum approach. And, it offers more certainty about funding than purchasing another SPIA each year.

If the employees benefits are deferred, a SPDA, or a series of them, can be utilized in the same fashion as the SPIA.

The advisor can also point out another way the employer can protect against the premature death of the employee. This is to purchase life insurance in an amount equal to the premium payments. The employer would be owner, applicant and beneficiary.

Income taxes may affect the employers decision about buying annuities for this purpose. Each annuity payment made by the insurer is taxable to the employer. Part of each payment received by the employer is taxable income as interest, and part is a nontaxable return of principal. The parts are determined by an exclusion ratio under Section 72 of the Internal Revenue Code, in the same way as for an individual taxpayer. After the principal is recovered, all of the annuity payment is taxable income to the employer.

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.


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