When corporate executives retire these days, chances are they will have had a hand in funding their leisure years using a salary reduction or other deferred compensation arrangement. That’s because a dwindling percentage of U.S. businesses are offering them the gold standard of retirement packages: the 100% employer-funded supplemental executive retirement plan.
“Just as we’ve observed a shift from defined benefit plans to cash balance plans, we’ve also seen the responsibility for retirement saving and deferral move from the employer to the employee,” says Ward Russell, president of the Todd Organization, Greensboro, N.C. “The demand for defined contribution, deferred compensation plans is now outpacing that of SERPs.”
Adds Andrew Dalgliesh, a chief financial officer for employer solutions at Principal Financial Group, Des Moines, Iowa: “Although our SERP business is growing, our deferred compensation business is growing faster because of the pressure to reduce costs to the business.”
A new study from the Todd Organization–”America’s Most Admired Companies: 2006 Executive Benefits Report”–bolsters these conclusions. Of 276 publicly held U.S. corporations surveyed in the report, 86% avail executives of voluntary deferred compensation plans. Additionally, 65% of the companies offer at least one company contribution, while another 48% provide 401(k) match restoration plans.
The percentages of companies offering defined benefit or account balance supplemental executive retirement plans are significantly lower. Defined benefit packages that use an annual accrual-based or target benefit formula–the most popular plans within the SERP world–have been adopted by just 47% and 16%, respectively, of the companies polled. SERPs using a fixed amount formula (for example, salary continuation plans) posted only a 4% adoption rate.
Why are SERPs, which in decades past nabbed the lion’s share of the non-qualified plan market, garnering a progressively smaller percentage of executive compensation packages? Experts interviewed by National Underwriter point to the shift generally among employers from defined benefit to defined contribution plans (both qualified and non-qualified) because of DB’s higher costs.
“With, say, a salary continuation plan, the onus is completely on the employer to fund the plan,” says Janice Forgays, a senior vice president at SunLife Financial, Wellesley Hills, Mass. “Regardless of how well the company’s business does, the company is committed to paying a sum certain at a time certain and for a period certain. And that may be a difficult burden to meet.”
The burden can be especially high, sources say, for start-up companies or businesses in volatile or seasonal industries that have difficulty meeting long-term financial obligations. Where SERPs continue to gain wide traction, these sources add, are in mature, stable companies that can count on consistent cash flow.
Absent that consistency, flexibility needs to be built into the plan. Hence the appeal of non-qualified plans that do not tie the business to a fixed dollar payout. Usually, observers say, this takes the form of a deferred compensation plan to which the company contributes but makes no guarantee as to the ultimate benefit.
Andrew Shapiro, a director of advance sales at Nationwide Financial, Columbus, Ohio, says most of Nationwide’s small business clients (broadly defined as firms with 250 or fewer employees) leverage a deferred comp package that mirrors a qualified 401(k) plan, thus pegging a defined contribution to a percentage of the executive’s compensation.
To be sure, SERPs continue to enjoy robust demand among small businesses. Dalgliesh notes that companies that still offer qualified pensions for all employees tend to supplement these plans with non-qualified SERPs for senior executives. Or, as is increasingly common among cash-strapped firms, they’re terminating or freezing qualified DB plans but maintaining non-qualified DB plans for top management.
Also common, says Dalgliesh, are companies that establish two-tiers of non-qualified executive compensation. In a 250-employee firm, for example, 30 managers and executives might be eligible for a voluntary deferred compensation package, 15 of whom may elect to participate. And of the 30, perhaps 2 or 3 top execs, such as the CEO and CFO, will also receive a SERP.
“We see this layering pretty frequently,” says Dalgliesh. “A good majority of deferred comp plans have a companion SERP plan.”
Among very small businesses, however, the SERP plan often stands alone.
“At businesses that don’t have a class of non-owner executives, there is really is no reason to implement a deferred comp plan,” says Peter Weinbaum, a vice president of advanced business and estate planning at National Life Group, Montpelier, Vt. Owners find they can do very different things for themselves, such as [Section 162] bonus plans.”
Not all SERPs are of the DB variety. A still small but growing percentage of companies are shifting to account balance SERPs (just as they are to 401(k)-style deferred comp) to reduce future payouts and, thereby, boost earnings. These non-DB packages include most prominently cash balance plans, wherein executives are given an account that grows by an annual credit, say, 3% of the executives’ pay each year, plus interest. When they leave the job, they can roll the amount into an IRA or cash out.
In the Todd survey, 11% of the companies subscribe to an account balance plan. Just 2% of respondents use a formula-based or other discretionary contribution.
“With an account balance SERP, dollars go into the plan, and whatever the account grows to is the amount distributed, so there is no promised benefit,” says J. Saunders Wiggens, a financial planner at The Actuarial Consulting Group, Richmond, Va. “The flexibility that many of our clients desire favors the account balance SERP.”
Irrespective of plan type, a growing number of businesses of all sizes are tying payouts to a tenure-based vesting schedule (the proverbial “golden handcuffs”) and/or performance, wherein the executive or company must meet certain benchmarks before benefits are distributed. Most companies, as documented by studies from Clark Consulting and others, are also funding their non-qualified plans with life insurance because of the vehicle’s tax advantages (i.e., tax-deferred growth of policy cash values and income tax-free distribution of death benefits).
The type of policy will vary by plan. Within the deferred comp space, variable universal life policies are common. But among SERP plans (especially DB SERPs), UL policies (and, to a smaller extent, whole life policies) predominate. These policies, Shapiro observes, are not subject like VUL contracts to the gyrations of the stock market, thus making plan funding requirements more predictable.
To be sure, life insurance is not always the favored funding mechanism. Mutual funds and other investment vehicles may be utilized depending on the type of business, tax situation, insurability and time horizon to retirement for key employees covered under the plan, experts say. Dalgliesh observes that a life insurance policy may make little sense for the business owner who is in poor health and stands to pay sky-high premiums; nor for the executive who is only 4 years from retirement and will derive little tax leverage from the policy.
Also to consider is the number of plan participants. Wiggens says life insurance becomes more compelling as the number of executives to be covered grows. Dollars flowing into an insurance-funded plan rise in tandem, yielding ever greater tax leverage for the business. But for very small firms, Wiggens finds that exchange-traded funds can also be tax-efficient because of the vehicles’ low internal expense ratios.
“A lot of producers come to the table with a predetermined notion of what they want to sell as opposed to doing an in-depth job of deciphering what is best for the client,” says Shapiro. “Often, the agent never asks whether the company anticipates a change in its tax bracket, which can change dramatically from year to year.”
Ditto as regards the tax laws and regulations to which the business is subject. Sources say the Pension Protection Act of 2006 has lent greater flexibility to plan and product design (as, for example, in the development of life products with long term care riders). And advisors generally laud IRC section 409A, an outgrowth of the American Jobs Creation Act of 2004, which sources say has provided greater “clarity” to rules governing non-qualified plans.
Not everyone agrees.
“Section 409A has been a real killer in the small business market,” says Weinbaum. “People don’t want more complications and more regulations, like a 20% penalty tax if you don’t do the plan right. We’re seeing a lot less [non-qualified] business–maybe 60% to 70% less–than we did before 409A.
“One of the top 5 priorities of the Small Business Council of America, of which I serve as a board member, is to get Congress to create an exception to 409A for privately held business,” he adds. “The clients of the organization’s leaders are finding [409A] to be a huge problem.”
IRC hurdles aside, advisors face other potential challenges. Among them: winning over key decision-makers or achieving consensus among executives who may be at odds over plan design. They also need to ensure that plans, once implemented, are properly administered (usually by a qualified third-party administrator) and kept up-to-date through regular (often annual) reviews.
Producers also need be mindful of ancillary business opportunities–buy-sell agreements, health plans and personal financial planning services for key executives–to be had after working on a SERP plan.
Says Shapiro: “I can’t tell you how many producers enroll executives in non-qualified plans and never think of them again as clients. When they do that, they’re leaving money on the table.”