Digging into COLI Funding Options for NQDC Plans: Pros and Pitfalls to Avoid

by Prof. Robert Bloink and Prof. William H. Byrnes

Nonqualified deferred compensation plans (NQDC plans) provide a powerful option for employers who are looking to attract and retain valuable employees—allowing those employees access to an additional source of tax-deferred retirement dollars. NQDC plans are not subject to the contribution limits applicable to traditional qualified plans, expanding the saving potential for high earning taxpayers. On the flip side, NQDC plans don’t meet ERISA requirements—so that they aren’t funded through establishment of dedicated accounts for participants, and they aren’t protected from the employer’s creditors in bankruptcy. In the end, the lack of ERISA protections means that funding the plan must be accomplished differently—and many clients may wish to explore the corporate owned life insurance (COLI) option as a tax-preferred funding alternative to other typical approaches.

NQDC Plans: Background

NQDC plans, at the most basic level, defer an employee’s otherwise available compensation so that it’s payable in a future year. NQDC funds are typically available when the individual retires, becomes disabled or dies (in which case, the funds are payable to survivors).

NQDC benefits are taxable as ordinary income when received, but excluded from current-year taxation, providing valuable tax-deferred savings. A common goal is to receive the NQDC payments in a year when the participant has dropped into a lower tax bracket. NQDC plans can allow only employee contributions, only employer contributions or both employee and employer contributions.

NQDC plans must technically be unfunded in order to avoid application of ERISA and the burdens that come along with ERISA compliance. Employees, therefore, aren’t protected if the employer goes bankrupt or simply cannot pay the promised benefit in the future. Thus, in order for the plan to accomplish its purpose of attracting and retaining top talent, employers turn to informal funding arrangements that don’t trigger ERISA yet assure employees that the future benefit will be paid.

Funding an NQDC Plan with COLI: The Basics

Corporate owned life insurance can be an attractive informal funding mechanism that reduces some of the risk associated with an employer’s future obligation to pay under an NQDC plan—yet assures the employee that their promised benefit will be paid.

With COLI, the employer takes out a cash value life insurance policy on a key employee-NQDC participant, naming themselves as the primary beneficiary. The premium payments are not deductible, but the employer receives access to the cash value buildup within the policy over time on a tax-deferred basis. The eventual death benefit paid is received tax-free.

Access to the policy’s cash value provides flexibility should the employer require use of the funds during the accumulation period. However, the cash value is not taxable during that accumulation period (while premiums are being paid), so the employer does not have to worry about paying income taxes on the accumulated funds within the policy. Allowing the gains to remain within the policy also means the employer benefits from compound returns on the accumulated earnings.

To receive the policy proceeds tax-free, the employer must satisfy certain IRC requirements. Namely, under IRC Section 101(j)(4), the insured (1) was an employee at some point within 12 months of death, or, at the time the policy was issued, was a director or highly compensated employee, (2) received notice of the COLI policy before it was issued, including notice of the maximum amount for which the employee could be insured, (3) gave written consent to being insured under a policy where coverage may continue after leaving employment, and (4) gave written consent to designating the employer as policy beneficiary.

Addressing the Downside

Employers may shy away from the informal COLI mechanism to avoid the burden of investigating and evaluating various insurance providers. To ensure the COLI funding is credible from an employee perspective, it’s important to choose an insurance carrier with long-term financial strength and a solid reputation.

To avoid intrusive medical testing and physicals, the employer may consider an insurance company that offers guaranteed issue policies. With a guaranteed issue policy, the employee won’t be required to submit to testing before the employer can obtain the policy.

To reduce administrative burden, employers may be interested in working with a COLI provider, or advisory firm that handles the vetting of the insurance company and has detailed knowledge of the issues surrounding servicing of a COLI program.

Conclusion

Employers who are interested in offering a NQDC incentive program should understand the benefits of informally funding the program to provide security for employees. Because cash value life insurance funding is most valuable over a long-term period (so that the cash value reserves within the policy have a chance to grow), employer-clients should also be advised that the greatest value can be realized by early adoption.