A critical factor in the success of an organization is attracting and retaining the best employees and key executives. Part of this effort includes assembling a competitive compensation package, including a retirement plan.
Companies considering how to provide retirement benefits for their employees often adopt a qualified defined contribution plan, such as a 401(k). For some businesses, though, a nonqualified plan using variable universal life insurance contracts provides an alternative for owners and executives.
While 401(k) plans and other qualified plans offer significant benefits for employees, they also present challenges for business owners who want to accumulate significant retirement savings for themselves and their key executives. One major issue is that qualified plans place strict contribution limits on all employees, including executives. Often, a supplemental nonqualified deferred compensation (NQDC) program is used to offset these limits, an approach that provides advantages for many companies.
However, “pass-through” entities like S-corporations and limited liability companies (LLCs), which distribute profits and losses to individual owners who pay the taxes due on the profits or deduct the losses, don’t enjoy the same advantages. Traditional NQDC plans also delay the employer deduction until benefit dollars are paid out. Another key concern is that all deferred amounts are potentially subject to the company’s creditors.
One solution is a variable universal life insurance contract in which employer contributions are made in the form of premium payments.
Consider the following case: A construction company, set up as an S Corp. with 350 employees, established a 401(k) plan as part of a competitive benefits package for its employees. However, due to high employee turnover among hourly workers, hourly employee 401(k) plan participation was very poor.
Each year the company failed its nondiscrimination tests (ADP/ACP), leaving the firm’s owner and several higher paid key executives unable to contribute the maximum amounts to the plan. As a result of the nondiscrimination testing, the owner and several executives received 401(k) contribution checks back each year from the plan administrator.
Because the owner wanted to increase his own retirement savings opportunities and reward the key executives, he needed a retirement savings option in addition to the 401(k) plan. A traditional nonqualified deferred compensation plan was not the preferred option for tax reasons. Instead, he voluntarily limited his 401(k) contribution to his prior year’s nondiscrimination test limit.
The owner then contributed $40,000 per year to an institutional variable universal life contract. In addition, he offered the VUL plan option to his key executives. The company executives were paid a $5,000 net annual bonus that went toward their VUL plan contributions. Each executive who elected the VUL plan chose a contribution level above $5,000 to meet individual retirement funding objectives and deposited the additional amounts into the VUL plan.
With the flexibility allowed through this approach, the owner was able to establish a significant contract for himself and the key executives. This solution was considerably less expensive than the safe harbor 401(k) options the employer had considered. The VUL participants viewed their supplemental plan as similar to a Roth 401(k) plan without contribution limits.
How does it work?
Premium contributions are paid and allocated into the VUL investment options at the direction of the recipient. Typically, the investment options are similar to those available under the employer’s 401(k) plan. The performance of the investment options are reflected in the insurance contract’s cash value.
The preferred method of distribution is through tax-free withdrawals of the basis in the policy, then borrowing additional funds as needed. Loans are not taxed as long as the policy remains in force. Policies designed specifically for this market usually charge and credit a similar interest rate on loaned funds. The institutional nature of the VUL contract allows for a high immediate cash surrender value, making the accumulation period much more valuable to the participant.
As with any offering, a prospect must be educated on some potential pitfalls. Unless there is a guaranteed issue offer, VUL contracts are fully underwritten and some owners or executives could be declined for health reasons. If the employer is making contributions, termination of employment may require the executive to pay additional premiums to maintain the policy. And the policy must be maintained until a death benefit is paid to take full advantage of all the tax benefits described.
An ideal solution
All in all, this type of nonqualified benefit plan can provide an ideal solution for business owners looking for an easy, flexible way to accumulate significant savings for retirement and to recruit, retain and reward key employees.
Ron Laeyendecker, FSA, CLU, and David M. Watts, CLU, ChFC, are, respectively, senior vice president and national sales director, Executive Benefits Markets, for Great-West Retirement Services, Greenwood Village, Colo. You may e-mail them at and .