In the aftermath of the Sarbanes-Oxley Act, new split-dollar insurance rules, changes to stock-option plan accounting, and 409A legislation limiting nonqualified deferred compensation plans, what executive benefit solutions are still available?
Plenty. You just have to look a bit harder.
Not long ago, the primary rule was that non-qualified plans had to be limited to a select group of executives. But in the last 20 years, creativity in plan design increased as competition grew. Pushing the limits ultimately led to today’s more regulated environment.
But the “good old days” weren’t so good. Now, for the first time, clear rules specify what can be done in the executive benefits marketplace. We’d much rather play between the lines knowing what the rules are. In more than 2 years, we have not had a debate with a tax or ERISA attorney regarding how to interpret a certain plan’s design based on related tax law.
After waiting for new rules, clients who have been sitting on the fence are moving forward, and the demand is greater than ever. So what is the market buying? Buyers want a return to basics, keeping the plan simple and well documented.
Traditional supplemental executive retirement plans continue to be used because they are the most effective approach for pure retention of a key executive. SERPs are always company-provided and subject to creditors for the purpose of enhancing retirement benefits. One trend is the movement away from an offset-driven SERP (which may use qualified plans and Social Security when determining the benefit) towards a net SERP approach, in which the SERP amount or benefit is fixed.
With fewer variables determining the benefit, a SERP becomes easier to understand, appreciate, predict and administer. SERP benefits are also increasingly being tied to performance. Performance-based SERP use is growing greatest with public companies that are concerned with proxy disclosures.
Buyers have historically turned to SERPs to make up for the shortfalls in qualified pension plans caused by governmental caps on recognizable compensation and contribution limits. SERPs are an unfunded liability of the company, and the executive is generally an unsecured creditor.
Traditionally, SERPs have been informally funded with cash, equities or life insurance cash values to ensure that the necessary cash flow is available at time of payout. They have also been combined with life insurance to recover the cost of providing the benefit.
In addition to SERPs, 3 other plans provide retirement or death benefits: (1) non-qualified deferred compensation plans; (2) IRC section 162 executive bonus plans; and (3) split-dollar life insurance plans.
Deferred compensation plans
Deferred compensation has always been a popular benefit, and it will continue to be so. In light of 409A restrictions, companies are reviewing and updating their plans. Like a traditional SERP, deferred compensation is subject to creditors, but it operates more like a 401(k) because it can be funded through executive salary deferrals, as well as company-paid or company-matching contributions. Because the money remains under the control of company creditors, deferred compensation allows an individual to defer on a pre-tax basis in amounts greater than what a qualified 401(k) plan permits.
New 409A regulations deal extensively with how a deferred compensation plan needs to be set up to be in compliance. For example, executives who want to defer $50,000 must do so before they earn it. At the time of deferral, they must also decide when they want the income back and when they will pay taxes on it. For new plans, the initial deferral must be for a minimum of 3 years. Payout dates can never be accelerated. And if executives want to delay the date, they must do so 12 months prior to when the deferred compensation is to be paid; they must defer the compensation for a minimum of 5 more years.
Deferred compensation presents an opportunity for both plan providers and practitioners. The mid-market for deferred-compensation has significant growth potential, as final 409A regulations have been issued and plan administrators and providers have now developed turnkey packages within the guidelines while keeping the benefit plan cost-effective. Nevertheless, because of the penalties incurred if the plan is not in compliance with 409A, anyone considering this benefit must find a strong back office.
Section 162 bonus plans
Section 162 bonus plans have also been making a comeback at many private companies. Not subject to creditors, the plans can be as simple as after-tax bonuses to the executive, but with the addition of restrictive access features, they can also be quite effective as a reward-and-retention device. These restricted executive bonus arrangements or REBAs allow a company to give executives a taxable bonus, provided the company decides where to invest the bonus and when the executive will be able to access it.
In a 162 bonus plan, cash values gradually build within a life insurance policy. A company puts a vesting schedule on access to the policy cash values. There is no limit to the vesting schedule, but ultimately the policy must be released to the executive.
Such a bonus plan is not vulnerable to the employer’s creditors and because of the tax-advantages and benefits that life insurance affords, a 162 can compare favorably to other after-tax investments. Several providers offer leveraged bonus plans in which the carrier provides a loan equal to the lost income from taxes, similar to a margin account in a taxable portfolio. Bonus plans have also become an effective alternative for organizations that carry post-retirement death-benefit plans and wish to avoid the resulting benefit liability that the new EITF/FASB regulations (06-04 & 06-10) require them to book.
Split-dollar insurance plans
Split-dollar insurance plans may have changed significantly under the regulations, but they continue to be very effective in certain situations. All types and sizes of organizations still use economic-benefit split dollar (or corporate-owned) life insurance to informally fund an executive-benefit plan or SERP, while purchasing a death benefit on a key executive. This death benefit would be split between the executive’s beneficiaries and the company.
Split-dollar plans can be set up under one of two options. The first is endorsement split-dollar, which is a company-owned life insurance policy. The other option is loan regime split dollar, which the executives own. The latter generally provides both death benefits and retirement benefits to the executive.
Non-profit organizations continue to use the loan-regime version as an alternative to IRC Section 457 plans. One potential pitfall for loan-regime split dollar concerns the use of the appropriate applicable federal rate (AFR), which determines the executive’s taxable income each year. Some employers have agreed to provide a gross-up for the annual taxable income to the executive, thus making the plan more attractive.
As the saying goes, “Since I don’t have a good memory, I don’t want to do anything today that requires me to remember exactly what I did years from now.” This applies to designing executive benefit plans. Be sure the plan is understandable, appreciated and well documented. Establish a master calendar of what the future will provide. Meet with the client regularly to review what is in place, making periodic adjustments along the way. This will ensure that there are no surprises at the time of the executive’s retirement.
Companies will always need to recruit, retain and reward top talent. Nonqualified executive retirement plans play a key role in this, and with clear rules finally in place, smart companies are moving ahead to install plans that will give them a competitive advantage in the talent sweepstakes.
D. John Gagnon and John Waters CLU, ChFC, are partners of Longfellow Executive Benefits, Boston, Mass. They can be reached at and respectively. Longfellow Executive Benefits is a division of Longfellow Benefits, an insurance brokerage and consulting firm.