In view of expanded Internal Revenue Service restrictions on executive compensation plans, and still more action pending in Congress, advisors have good reason to question whether the current vehicle of choice for funding these plans–corporate-owned life insurance–will remain so. The consensus opinion among insurance professionals contacted by National Underwriter is ‘yes’ and for a familiar reason–unmatched tax benefits.
“When businesses create an unfunded liability to provide for executive retirement benefits, that’s when COLI comes into play,” says Albert “Bud” Schiff, CEO of Nylex Benefits, a wholly owned subsidiary of New York Life based in Stamford, Conn. “For many firms, COLI is a superior solution to the alternatives: funding an executive benefits package with taxable investments, such as mutual funds, or deferring the issue to the next generation of managers.”
Cameron Sutton, an executive vice president at Aon Consulting, Atlanta, Ga., agrees, adding: “COLI is like a mutual fund with an insurance wrapper around it. As such, businesses enjoy tax-deferred growth of the inside buildup of the policy’s cash value, tax-free withdrawals and loans, and income tax-free death benefits to beneficiaries.”
The tax advantages offered through corporate-owned life insurance are no small consideration for small business owners who are looking to attract and retain qualified executive talent. Sources contacted by National Underwriter say the impact of executive compensation planning on company financial measures–cash flow, P&L and the balance sheet–increasingly guides decision-making among corporate CFOs and boards.
Observers say the current regulatory environment also is fueling interest in COLI. They point, for example, to new Financial Accounting and Standards Board (FASB) rules, which have taken the luster off stock options by requiring companies to expense them on their financial statements. Also to consider is the Sarbanes-Oxley Act of 2002, which has heightened publicly held companies’ fiduciary responsibilities with respect to executive comp planning. That, observers say, has forced corporate management to take a more active role in the comp planning and to stick to packages that are sure to pass muster with government regulators.
Among these are COLI-funded nonqualified deferred compensation plans and supplemental executive retirement plans or SERPs. Sources say new rules of IRC Section 409A, an outgrowth of the American Jobs Creation Act of 2004, have increased acceptance of these vehicles by clarifying how such plans may be structured.
The IRC provisions, which took effect in January 2005, specify events when execs can take distributions on deferred comp (e.g., no sooner than six months after separation of service, death, disability or an unforeseeable financial emergency). And, certain exceptions notwithstanding, the code also prohibits an acceleration of the specified time or fixed schedule for paying benefits, as when employing “haircut distributions.”
Businesses that now legitimately operate beyond 409A’s scope would either have to amend compensation packages by year-end 2006 to bring them into compliance or terminate them. These may include, for example, plans that reimburse executives for post-retirement medical expenses.
“With codification of 409A, there’s a higher comfort level with nonqualified plans among business owners,” says Michele Van Leer, a vice president and general manager at Sun Life Financial, Wellesley Hills, Mass. “COLI-funded packages have gained a greater degree of legitimacy.”
Legislation pending in Congress, he adds, should ease concerns among large enterprises about COLI–a not insignificant point in the wake of much-publicized cases involving Wal-Mart, among other firms, that purchased insurance on employees’ lives without their knowledge.
A pension reform bill now before the House-Senate Conference Committee contains a provision codifying into federal law current “best practices” on corporate-owned life insurance. The COLI provision would limit coverage to directors and “highly compensated employees” (i.e., individuals earning at least $90,000 annually or in the top 35% by compensation); require employers to obtain employees’ informed consent before enrolling them in a COLI plan; and require employers to report information about their COLI plans to the IRS.
Yet another legal component underpinning COLI-funded plans, says John Gephart, a second vice president of advanced sales at Cincinnati, Ohio-based Union Central Life, is the “top hat” exception to the Employee Retirement Income Security Act. The ERISA exception grants employers the flexibility to develop executive compensation programs for key employees and executives.
Says Gephart: “[409A], coupled with the ERISA top hat exception, represents a fantastic sales and marketing opportunity for planners to motivate clients to review existing nonqualified plans and bring them into compliance by Dec. 31.”
Many executive compensation packages are ripe for an overhaul–and not only because of 409A. Sutton says many plans are inappropriate because the death benefit or premiums charged are too high; because the plans are funded with the wrong insurance product; or because investments are allocated inappropriately. Through its “COLI audits,” he adds, Aon has been able to improve product performance by “50 to 200 basis points” over the life of the plans.
New and revamped plans increasingly are being tied to performance. Popular among Schiff’s clients, for example, are “unit credit plans.” For each year of service, executives under these plans earn a unit of credit, expressed as a percentage. If, for example, an executive has served for 20 years, he or she would receive in retirement benefits equaling 20% of the average of the highest five consecutive years of cash compensation, which usually includes base pay, plus a performance-based bonus.
Corporate leveraging of nonqualified deferred comp plans remains high. According to a 2005 survey on executive compensation planning by Los Angeles-based Clark Consulting, 91% of respondents offer a nonqualified deferred compensation plan. That’s a slight dip from the 94% and 93% levels achieved in 2004 and 2003, respectively, but higher than the 86% rate observed from 2000 through 2002.
Corporate-owned life insurance and trust-owned life insurance remain by far the most popular funding vehicles for nonqualified deferred comp plans. Seven out of 10 respondents flagged COLI and TOLI as their vehicle of choice in 2005, up from 61% in 2004. The next most commonly used funding vehicles were mutual funds (28%) and company stock (17%). Similarly, 74% of SERPs are funded informally with COLI–a far higher percentage than is the case for alternative vehicles.
Sales of COLI-funded plans this year have been brisk for advisors. Schiff says his company is on pace to exceed revenue in 2005 by 20%, and COLI-related commissions last year surpassed that of 2004 by 35%. Executives at other firms–ING U.S. Financial Services, Aon Consulting and Sun Life–also report year-over-year gains, though they decline to provide actual dollar figures.
To be sure, not all small and midsize businesses are buying into COLI-funded deferred comp and SERP plans. In fact, according to LIMRA International, Windsor, Conn., IRC Section 162 executive bonus plans (life insurance policies that are owned by executives) remain the most widely adopted of executive benefits among small and medium-size businesses with from 10 to 1,000 employees. Of 800 firms polled in a 2004 study (the most recent year for which statistics are available), 66% said they offer executive bonus plans.
Advisors point out that while COLI-funded nonqualified deferred comp and SERP packages make sense for C corps, LLCs, S corps and other pass-through entities do not enjoy the plans’ tax-favored treatment, including the corporate tax deduction on premium contributions. Also, says Jim Atkins, a principal at Strategic Financial Advisors, Bethesda, Md., 162 bonus plans are easier to set up and, in 409A’s wake, more advantageous.
“We’re seeing more executive bonus arrangements than deferred comp plans because of the 409A changes,” says Atkins. “The plan flexibilities that existed before were somewhat removed or capped [by 409A]. We found that some of those flexibilities were key considerations for clients.”
Gephart, however, does not see the added legwork mandated by 409A as a negative.
“I don’t believe that new formalities of 409A substantially inhibit business owners,” he says. “Yes, certain exotic techniques are no longer available to corporations. The key point is that planners now need to cross their t’s and dot their i’s.”