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.