As the U.S. economy sinks deeper into recession, cash-strapped small business are confronting tough decisions about the life insurance-funded, non-qualified executive compensation packages they’ve established to reward and retain their top talent. To ease the financial strain on their balance sheets, sources tell National Underwriter, firms may need to explore a range of options, from restructuring the plans to a suspension of funding. For many, the one option that isn’t available is to do nothing.
“Experiencing a financial crisis is like having a heart attack,” says Jerry Love, past chairman of the Texas Society of CPAs and a managing partner at Davis Kinard & Co., PC, Abilene, Tex. “When you feel the symptoms, you have to admit it and address it. You can’t just stick your head in the sand.”
Michael DiPiazza, a vice president of life marketing at AXA Equitable, New York, N.Y., agrees, adding: “This is a time when people who made all the right decisions and for all the right reasons see an uncontrollable result and so begin to question the wisdom of advice they received. In times like these, clients must be reminded about the criteria they used to select the non-qualified plan.”
These criteria, DiPiazza says, touch on fundamental questions about the purpose of the executive comp arrangement. For whom was the plan established and what are the underlying objectives? Why was the plan structured one way rather than another? What risks did the business incur on setting up the plan? Assuming all the pre-crisis criteria remain valid, how might the arrangement need to be modified to ensure its continuing viability?
The beginning of the answer in all cases, says Love, is the plan document: the contract between the employer and key executives. If the business can’t comply with the plan, then the firm needs to consider amending it to do what’s feasible in terms of funding.
For some financially stretched businesses, the only realistic option is to suspend the plan–or terminate it altogether. Bryan Beatty, a certified financial planner and principal at Eagan Berger & Weiner LLC, Vienna, Va., says companies will often cut the flow of funds to retirement plans to meet basic operating expenses–payroll, the office lease, replenishment of inventory and the upkeep of equipment–and to maintain investments needed to remain competitive.
But non-qualified arrangements won’t necessarily be the first to go. Some firms, says Beatty, may opt first to suspend qualified plans, such as a 401(k) or (for non-profits) 403(b) plan. The reason: These arrangements are potentially more costly to the business because they must be extended to all employees. Non-qualified plans, though generally more expensive on a per-employee basis, can be restricted to a select group of executives.
But if this option has been exhausted, then the business may have to look to the non-qualified plan to free up cash for the business. One option, assuming the plan is informally funded with permanent life insurance–by far the most popular vehicle for funding such plans–is to reduce premium payments to the minimum necessary to keep the policy in force. When business conditions improve, payments can be ratcheted back up to a level necessary to meet plan obligations.
Alternatively, experts say, the business can exchange the life contract for a reduced, paid-up policy, an election that especially makes sense if the original face amount is no longer deemed necessary. The business can also meet premium obligations by withdrawing against the policy’s cash value. This tactic can be sustained for many months–even years–depending on how much money is sitting in the policy.
“Adequately funding all non-qualified executive comp arrangements at the outset is always the business’s best defense against a cash-crunch,” says DiPiazza. “There’s no substitute for this.”
The firm, he adds, might also fund retirement benefits out of current cash flow, the business limiting premium payments to that amount necessary to fund only the death benefit. When the executive dies, the business, as both policy owner and beneficiary, can recoup cash-flow allocations to the retirement plan from the policy’s death benefit.
Sources caution, however, that the ability to restructure the plan will depend in part on the flexibility of the funding vehicle. Premiums for a secondary guarantee UL contract can generally be adjusted within certain parameters. The same cannot be said of whole life policies that require level premium payments over the life of the contract. And, in the case of a variable contract, reduced funding could put the policy in danger of lapsing if the cash value has already declined significantly due to a market downturn.