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Life Health > Life Insurance

Executive Benefit Planning: Simpler Is Better In Uncertain Times

By Alan T. Schauer

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The tsunami of rules and regulations affecting executive benefit plans began with the regulatory fallout from Enron and continues to this day. Both clients and practitioners would be right to feel uneasy in the midst of such dynamic change–and perhaps scale back or postpone executive benefit planning until such time as the tides return to more predictable patterns.

But that need not happen, because there are safe harbors that you can steer into right now without having to wait for all the uncertainty to subside.

The corporate scandals at Enron, Worldcom and others led to the wide-ranging rules contained in the Sarbanes-Oxley Act of 2002. While the act itself had direct impact on executive benefit planning, it also set into motion the continuing quest for transparency and shareholder accountability. This sweeping change has placed executives–and every aspect of their compensation–under continuous scrutiny by federal regulators, states’ attorneys general and shareholders. Even small, closely held companies are impacted by many of the changes.

Executive benefit plans using corporate-owned life insurance must now comply with a host of new controls. These include the virtual elimination of equity split-dollar arrangements, litigation over insurable interest in broad-based COLI programs and the major changes introduced by the Pension Protection Act of 2006.

The PPA even rolled out new code sections. Section 101(j) limits the scope of COLI and added new “notice and consent” requirements. Section 6039I requires employers purchasing COLI to file an annual return with the government. COLI death benefits will be received income tax-free only if all the new standards are met.

Even plans that don’t use life insurance are impacted by new rules. Code section 409A (created by the American Jobs Creation Act of 2004) eliminated some of the perceived abuses in nonqualified arrangements, and practitioners have generally appreciated the “bright lines” that created relatively clear guidelines where none existed before. Nevertheless, the increased regulatory complexity (and the stiff penalties for mistakes) has made nonqualified plans much less appealing to many clients, particularly among smaller businesses.

And there may be a few surprises yet to come. As of this writing, the Internal Revenue Service has still not issued the final 409A regulations pertaining to nonqualified plans. When the final rules are released, they are expected to further impact split-dollar arrangements. In any case, all of this uncertainly adds up to a kind of paralysis in decision-making, as companies are increasingly reluctant to implement new benefit plans for company executives for fear that they will have to undo the plans sometime in the near future.

Looking forward to 2008

In addition to the near-term uncertainties, we have the real possibility that the executive branch, like Congress before it, will transition from Republican to Democratic control in 2008. Depending on the economic agenda and fiscal realities, all tax-favored arrangements, including COLI and nonqualified plans, are likely to be viewed as potential sources of much needed revenue for funding of a new legislative agenda.

A source of consternation for our industry is the fact that all new spending proposals on the Hill must identify an offsetting revenue source (the so-called “pay-go” rules). The special tax status enjoyed by life insurance and benefit plans could appear to be an easy target, even though most beneficiaries of “executive” benefit plans are actually mid-level managers, not the top tier of highly-paid corporate officers.

Back to timeless fundamentals

As practitioners, we have a tendency to gravitate toward sophisticated plan designs with clever features and cutting edge concepts. We also tend to focus more on taxes than on benefits. In today’s environment, it may be more prudent to return to the fundamentals. By doing so, we can help business clients reward their executives while simultaneously steering around much of the uncertainty in the political maelstrom.

Rather than thinking about different plan designs from the start, look deeply at the situation from the client’s perspective. By uncovering what is at the core of the company’s mission, values and goals, it may be possible to develop a remarkably simple–yet highly effective–benefit plan, far from the “cutting edge.”

Start with basic questions: What is the basic culture of the company, and what is its compensation philosophy? What are the strategic business goals of the enterprise? Does the client want to reward executives, incentivize them or restrict their ability to leave? Plan designs that mirror the mission of the business can form a crucial component of future business success.

The KISS solution

The KISS (“Keep It Simple, Stupid”) theory suggests the simpler the plan design, the more likely it is to be successful. In the current environment of change and uncertainty, simpler designs are less likely to run afoul of legislative tinkering. They are easier to set up and administer, may cost less, and are certainly easier for the client to understand. Here are a couple of “low-tech” designs to consider:

The Section 162 bonus plan

The stalwart bonus plan is taxed as regular compensation at the front end; the executive (rather than the employer) owns the benefit. You can make bonus plans quite powerful by coupling them to the employment agreement, then funding benefits with life insurance.

In such an arrangement, the executive owns the cash-value life insurance policy, but an amendment to the employment agreement restricts the ability of the executive to access the cash value until a future benchmark has been reached. This restricted employee bonus plan (REBA) avoids the use of COLI to fund a deferred benefit. Because the executive pays the income taxes up front (usually the tax is also bonused by the employer), most rules pertaining to nonqualified plans might not apply.

The DBO plan

The death-benefit only plan may be the most overlooked simple plan design. Many executives don’t require more compensation and larger estates. They are, rather, more interested in the welfare of future generations of the family or in leaving a legacy to charities and communities.

The DBO plan is defined by an agreement between an executive and the employer, and is funded by COLI. The employer receives the death benefit income-tax free, then makes a taxable payment to the executive’s beneficiary. However, the employer will capture a tax deduction on that payment, and so the employer could gross up the payment to the beneficiary, at no net cost to the employer.

You can probably think of other tried-and-true designs, such as group carve-out, disability “combo” plans and long-term care protection. Just remember to try out the simple ideas first before you move on to the custom-designed, sophisticated and highly creative ones. Doing so may keep you and your client sailing in calmer waters for many years to come.

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