Highly compensated employees often face retirement without sufficient income to maintain their pre-retirement lifestyle. Qualified plan contribution and benefit caps, coupled with current limits on Social Security benefits, mean that a highly compensated employee usually cannot reach the necessary retirement income targets with qualified plans alone. In fact, the higher the individual’s compensation level, the more severe the retirement income gap can be.
Income Needed For Retirement
A big question facing pre-retirees is how much income will be needed in retirement to preserve their family’s pre-retirement standard of living and allow for their desired retirement lifestyle.
When a person retires, spending patterns often change. Some of these changes occur gradually as people age. For example:
? Health care expenditures tend to increase at all income levels.
? Educational expenditures tend to decrease at all income levels.
? Household utilities tend to decrease at lower income levels and increase at higher income levels.
? Household operating costs tend to increase at all income levels.
? Mortgage, rent and repair expenditures tend to decrease at all income levels.
? Entertainment and leisure expenditures tend to increase at lower income levels and decrease at higher income levels.
Expenditures directly related to employment can change abruptly upon retirement. For example:
? Food expenditures tend to decrease upon retirement for lower income levels and increase for higher income levels.
? Apparel expenditures tend to decrease upon retirement at all income levels.
Income Replacement Ratios
An income replacement ratio is the percentage of pre-retirement income an individual needs in retirement to maintain a desired standard of living. By using these ratios as a benchmark, plan sponsors can measure the sufficiency of their own programs when combined with Social Security benefits and personal savings.
A comprehensive retirement income replacement ratio study should include the projected effects of:
? Federal, state and local tax rates.
? Various levels of taxation on Social Security benefits.
? Offsets in Social Security benefits by post-retirement earned income.
? Factors that cause changes in spending patterns post retirement.
The 2008 Georgia State University-Aon study2 suggests the following replacement ratios:
Qualified Plan Limitations
Income and benefit caps in Social Security and employer-sponsored qualified retirement and savings plans reversely discriminate against highly compensated individuals, limiting the percentage of retirement income from these sources.
To help close the retirement income gap, individuals need other income sources such as:
? Personal savings.
? Earned income from working beyond retirement.
?Employer-sponsored pension, deferral and savings plans (qualified and nonqualified).
Company-Sponsored Executive Plans
Supplemental executive programs may be the solution employers are seeking. Here are summaries of programs that can help employers address these challenges:
Deferred Compensation Plans
Deferred compensation plans allow executives to save for retirement and defer paying taxes on these amounts until payments are actually received. Generally elective, the executive decides how much compensation to defer and often can choose how these deferred amounts will grow.
Many plans include an employer match, with employer contributions geared to employees’ deferrals. These employer matches provide a powerful incentive to the executives to save for retirement.
Some deferred compensation plans are wholly funded by employer contributions, with deferred bonuses or other compensation credited to the employees’ accounts for distribution at a later date.
Although deferred compensation plans generally provide for distribution at retirement or other separation from service, some plans permit “in service” distributions, with executives electing to receive distributions at specific dates. When structured correctly, these distribu-tions can be timed to coincide with events such as children beginning college or the desire to purchase a second or vacation home.
Supplemental Executive Retirement Plans (“SERPS”)
SERPs provide retirement income to supplement benefits executives receive from other sources, such as qualified plans, Social Security and personal savings. SERPs are usually designed as defined benefit plans, with retirement payments calculated according to a predetermined formula. Retirement payments often are based on the executive’s compensation and years of service with the company.
Retirement payments in a defined contribution plan reflect the accu-mulated value of contributions made to the plan while the employee is actively at work. These contribu-tions often are tied to annual compensation and company performance. In a defined contribution plan an executive’s retirement benefit is based on the balance in that individual’s account when he or she retires.
Employer-Sponsored Plans with After-Tax Funds
Many executives and employers look for a savings structure that permits them to accumulate funds on an after-tax basis. Also, owner-employees of S Corps., equity partners in professional service firms, and executives in not-for-profit entities often find it impractical to defer compensation for income tax purposes beyond amounts allowed under qualified plans.
For situations such as these, an employer-sponsored savings plan may be the ideal solution. In this instance, the employer provides periodic cash bonuses that are used to pay premiums on institutionally-priced permanent life insurance coverage owned by the employee. The employee is also the insured and names the beneficiary. The bonus is taxable to the executive and deductible by the employer. Cash value growth is tax-deferred and can be accessed by policy loans tax-free at any time.
Financing Nonqualified Benefits
Companies often seek to provide informal financing for nonqualified benefit programs, such as SERPs, deferred compensation, survivor benefit and post-retirement long-term care insurance arrangements. Many of these companies choose company-owned life insurance as the financing vehicle, because COLI growth is tax-deferred and cash proceeds, when received by the company either as borrowings from the policies or as death benefits upon the death of the insured, generally are income tax-free. In addition, companies can recognize in their financial statements the increase in COLI’s cash surrender value each year.
Attracting and keeping executive talent productive is more important than ever as companies strive to succeed in today’s challenging business environment. By offering executives a comprehensive and well-structured compensation and benefits program, a company can differentiate itself in the competition for leaders who can make a difference.
Albert J. “Bud” Schiff, CLU, MSPS, AEP is the CEO of NYL Executive Benefits (NYLEX Benefits), a subsidiary of New York Life Insurance Co., New York. You may e-mail him at [email protected].