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Supplemental Executive Retirement Plans

Producer Guide

For agent/registered representative use only. Not for public distribution.

For agent/registered representative use only. Not for public distribution.2 3For agent/registered representative use only. Not for public distribution.

In today’s labor market, it is important to recruit and retain top executive talent to ensure the growth and long-term success of a business. One way employers can do this is to offer a benefit that addresses a key concern of management and highly compensated executives – retirement planning.

Employers turn to nonqualified deferred compensation plans as an executive benefit because of the dollar limitations that the Internal Revenue Code (I.R.C.) places on qualified plans. The Code limits the deferral amounts, and total plan contributions and also defines maximum allowable compensation.

In effect, the limits on contributions have made qualified plans “reverse discriminatory.” These plans fail to provide the same ratio of before-to-after retirement income for executives as they would for the average worker. Personal savings, Social Security and qualified plans may meet the retirement needs of many workers but more than likely will not be sufficient for today’s highly compensated executives. Therefore, highly paid executives are actively seeking a means to replace lost retirement income.

Supplemental Exec utive Retirement Plans (SERPs) provide an attractive opportunity for rewarding valuable executives who need additional retirement income. Employer-funded SERPs are designed to reward executives who remain in the company’s employment, devoting time and attention to building the profitability of the business. Not only do SERPs provide needed benefits to select executives, but they also allow the employer to maintain control. In this way, the employer, by imposing restrictions that can reduce or even cause the loss of benefits for the executive (golden handcuffs), is able to design a cost-effective method of rewarding and retaining valued executives.

Supplemental Executive Retirement Plans

For agent/registered representative use only. Not for public distribution.2 3For agent/registered representative use only. Not for public distribution.

In general, a SERP is a nonqualified plan financed by employer dollars that provides key executives with additional retirement income. The executive has no option to receive any employer contributions as current compensation. Nor does the executive defer any of his or her own funds toward the retirement obligation.

Because a SERP is financed with employer dollars, the plan is generally designed to favor the employer. The executive’s right to any benefits under the plan are normally restricted through the use of vesting schedules or documentation requiring a set period of service or employment until retirement—these restrictions are often known as “golden handcuffs.”

SERP benefits are typically calculated using a defined benefit approach formula. That is, the employer promises to pay to the executive a set amount at regular intervals for the remainder of the executive’s life or a designated number of years. This target amount is often determined by calculating the executive’s total retirement need and then reducing this projected amount by other sources of retirement income, such as Social Security benefits or other qualified plan benefits. These projections are usually based on the executive’s normal retirement age. If the SERP benefit begins earlier or later, the amount is adjusted accordingly.

A SERP is often informally funded with life insurance. The employer finances the benefit liability by purchasing life insurance policies on participating executives.

Supplemental Executive Retirement Plans with Life Insurance

Here’s how a SERP works:

1. The employer and the executive enter into a contractual agreement where the employer agrees to provide pre-and/or post-retirement benefits.

2. The employer purchases a life insurance policy on the executive’s life. The policy serves as an informal funding vehicle for the benefit liability.1

Employer Life Insurance Policy

SERP Agreement

Executive

2

1

Employer Life Insurance Policy

3

Executive

4Employer Life Insurance Policy

6

Executive’s Heirs or Estate

5

While executive is employed When executive retiresIf the executive dies prior to retirement

3. The employer pays the promised retirement benefit.

The payment is deductible by the employer (assuming compensation is reasonable).

The retirement benefit is taxable compensation to the executive.

4. With proper design, the benefits can be paid using income tax-free withdrawals from the informal funding vehicle, the life insurance policy.2 Income tax-free distributions are achieved by withdrawing to the cost basis (premiums paid) then using policy loans. Loans and withdrawals may generate an income tax liability, reduce available cash value and reduce the death benefit or cause the policy to lapse. This assumes the policy qualifies as life insurance and is not a modified endowment contract.3 Alternately, the company can pay the liability from current earnings and recover the cost of the plan upon receipt of the death benefit.

5. The policy pays an income tax-free death benefit to the employer.4

6. The employer pays any benefit owed to the executive’s heirs. This payment is deductible by the employer and is taxed as ordinary income to the heirs.5

1 As an informal funding vehicle, this policy remains available to the employer’s general creditors. A plan participant must have no rights in this policy if the promised benefits are to avoid current taxation.

2 Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered).

3 If the policy lapses or is surrendered, the IRS will tax distributions received over the life of the policy and at termination that are in excess of total premiums paid.4 Death benefits from life insurance will be received income tax free if the policy purchase complies with the requirements of IRC Section 101( j), including the written

notice and consent provisions for the insured. May be subject to corporate alternative minimum tax (AMT).5 Compensation which was earned by the decedent but not included in his or her taxable income for the year of death is income in respect of a decedent (IRD).

1

For agent/registered representative use only. Not for public distribution.

5For agent/registered representative use only. Not for public distribution.

To Counter the “Reverse Discrimination” of Qualified Benefits I.R.C. §415(b) and 401(a)(17) act to limit benefits paid to highly compensated executives from qualified plans. Employers adopt SERPs to replace benefits lost to executives because of this reverse discrimination effect.

To Recruit New ExecutivesA properly designed SERP can be a deciding factor for an executive contemplating a career move. Most qualified benefit plans pay retirement income tied to the number of years of service an executive completes with an employer. Many mid-level executives are faced with a unique challenge. Often they have not accrued enough years of service with their current employer to have earned a vested benefit and will lose needed retirement money if they leave. By making up for these lost years of service, a SERP can provide the encouragement the executive needs to join the new employer.

To Reward Valuable Executives A SERP can be used to reward key executives for outstanding service to the employer. A nonqualified SERP allows the employer to pick and choose those executives the employer feels should be rewarded with additional retirement benefits.

As Part of an Early Retirement Program A SERP can be a useful tool when it’s time for an employer to make room for a new generation of management or when faced with the reality of downsizing due to change in the market. A SERP provides additional retirement benefits that help executives to realize they are financially secure and ready for retirement, while allowing the employer to reach out to up-and-coming talent.

To Act as Golden Handcuffs A successful executive will always be the target of other companies wishing to benefit from his or her abilities. If an executive risks losing a substantial amount of retirement benefits by leaving the company, he or she might rethink a career move. Therefore, a SERP designed with a vesting schedule can be a very successful retention tool.

Uses of SERPs

For agent/registered representative use only. Not for public distribution.6

6 The cash values of the corporate-owned policy grow income tax deferred and are general assets of the employer.

7 Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered).

8 Death benefits from life insurance will be received income tax free if the policy purchase complies with the requirements of IRC Section 101(j), including the written notice and consent provisions for the insured. May be subject to corporate alternative minimum tax (AMT).

9 Provided the policy is not a modified endowment contract (MEC).

Both the employer and the executive receive a number of benefits from this type of nonqualified plan.

For the EmployerA supplemental retirement plan informally funded with life insurance: Enhances the business’ ability to attract and retain talented executives. Can be implemented with a qualified plan in place or used on its own. Offers an alternative to the stringent I.R.C. requirements applicable to

qualified plans. Requires minimal ERISA compliance when properly structured. Allows more discretion to choose which executives may participate. Provides design flexibility. Allows the plan sponsor to access the cash values of the corporate-

owned policy through loans and withdrawals when needed.6 Loans and withdrawals may generate an income tax liability, reduce available cash value and reduce the death benefit or cause the policy to lapse.7

Allows for the corporate-owned policy to be designed to provide cost recovery through the income tax-free death benefit.8

For the Executive Benefits lost through qualified plan limitations are replaced with

no out-of-pocket expense to the executive. Retirement funds accumulate on an income tax-deferred basis. Early distributions are not subject to the 10 percent early

withdrawal penalty.9

The employer’s choice of life insurance as an informal funding vehicle assures the executive that steps are being taken to accumulate the funds needed to pay the future benefit.

Potential Advantages of a SERP


The terms of the SERP plan are outlined in a legal agreement between the employer and the executive. Such agreements generally include the following:

A description of the benefits to be paid under the plan and a clear statement of what events will trigger benefit payment and in what form (lump sum, installments, reduced amount, etc.).

Vesting schedules, where used. Employer and employee rights under the agreement. Termination provisions and a statement of each parties’ rights upon such

an event. An outline of the normal claims procedure. A designated plan fiduciary.

In addition to the plan document, a resolution issued by the Board of Directors authorizing the implementation of the plan is typically required when a corporate entity is establishing a SERP.

Documenting the SERP

Whichever approach is used, it is important to remember that nonqualified plans are generally pension plans for ERISA purposes. Unless carefully constructed to be exempt from ERISA, these plans will be subject to the compliance requirements of Title I. Adherence to these requirements is burdensome, time consuming and costly. In addition, a nonqualified plan, if required to meet the minimum funding, vesting and fiduciary trust requirements found in Title I, will be considered funded for IRS purposes. As a funded plan, executives lose the advantage of income tax deferral unless their right to receive benefits is not transferable and is subject to a substantial risk of forfeiture.

Absent an exemption from ERISA compliance, most employers would tend to shy away from maintaining a SERP. Fortunately, ERISA provides two exemptions for SERPs designed as top-hat plans or excess benefit plans.

Top-Hat Plan

Unfunded top-hat plans, designed to provide benefits to a “select group of management or highly compensated employees” are excluded from most of the Title I ERISA requirements for nonqualified plans. Properly structured, top-hat plans are exempt from Parts 2, 3 and 4 of Title I of ERISA. In addition, the plan administrator can meet the requirements of Part I through a simplified reporting procedure.

Select GroupThe definition of a “select group” is not clear. The Department of Labor (DOL) has taken a restrictive view limiting it to executives who appear not to need the protection afforded by ERISA. This implies that these executives have some degree of control over, or input into, the business entity’s decision-making process that the average employee lacks.

The courts have taken their own path regarding the interpretation of this phrase and tend to examine the facts, circumstances and purposes of each benefit arrangement to determine whether a plan constitutes a top-hat plan under ERISA. Despite numerous cases, no clear fact pattern has emerged as a safe harbor.

Highly Compensated EmployeesAgain, the DOL’s position on the interpretation of this term is unclear.

It is not safe to assume that the definition of a highly compensated employee found in I.R.C. §414(q) can be used to define the members of a top-hat group for ERISA purposes. This definition of highly compensated—salaries in excess of $115,000 (in 2014)—is intended as a directive for qualified plans. This arbitrary number does not take into account the relative pay level or the management responsibilities of so-called highly compensated as compared to other employees. In addition, the preamble to the regulations of this section states the Treasury Department and DOL agree the definition of a highly compensated employee under the Code does not determine highly compensated status under Title I of ERISA.


The SERP plan generally specifies the eligibility requirements for an executive to participate in the plan. The most common requirements are salary, position and years of service. Often, participants are selected at the sole discretion of the Board of Directors.

Eligible Participants and ERISA Rules

It is to the employer’s advantage to develop a justification for those executives included in the top-hat plan. Listed below are some common approaches: Selected Individuals

Participants selected by the employer are both management and highly compensated individuals.

Selected Office Holders Participants hold high level offices within the organization.

Selected Highly Compensated Individuals Participants are earning in excess of a certain compensation level. The established dollar level should be sufficiently high in relation to the general work force to satisfy top-hat criteria. In view of all the uncertainties, it is important that ERISA counsel be consulted before implementing a top-hat plan, especially when the plan covers a relatively large, more inclusive group of management.

Excess Benefit PlanAn excess benefit plan is a nonqualified plan designed to restore those retirement benefits lost by a company’s key executives due to the application of the I.R.C. §415 limits on contributions and benefits under qualified plans.

Under ERISA §4(b)(5), an unfunded excess benefit plan is exempt from all requirements of ERISA Title I.

ERISA §3(36) defines an excess benefit plan as: “A plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by I.R.C. §415….”

The DOL has not provided any guidance with respect to the meaning of the term “solely.” To protect the status of an excess benefit plan, the purpose of such a plan should be clearly stated to provide benefits in excess of the I.R.C. §415 limits. If the plan provides other benefits or takes into account other limitations under the code, it may cease to be an excess benefit plan for ERISA purposes. If the plan fails to qualify as an excess benefit plan, it may be re-classified as a top-hat plan. However, even when the plan meets the top-hat criteria, problems can arise if the plan has not satisfied the applicable ERISA reporting and disclosure requirements.


Compensation may be defined in a number of ways. Depending on the goals of the employer and the executive, compensation can be defined broadly or narrowly.

Compensation Defined

Includes all wages, salaries, overtime, bonuses, commissions and other amounts received for personal services rendered in the course of employment.

A SERP can be designed as either a defined benefit or a defined contribution plan.

Defined Contribution Plan Under a defined contribution approach, the employer contributes a dollar amount each year to the executive’s account. This amount may be a flat dollar amount or a percent of compensation. These contributions grow with interest or investment income. At retirement, the income stream available to the executive is determined by the amount in the account. When a defined contribution approach is chosen, it is more than likely that a deferral plan will be implemented in conjunction with the supplemental plan.

Defined Benefit PlanUnder a defined benefit approach, the employer promises to pay the executive a specified amount of retirement income upon normal retirement.

The benefit formula dictates how the specified amount is to be determined. There are two main types of benefit formulas used with a defined benefit approach: Unit Benefit Formula

A specific amount of benefit is credited for each year of service. This annual amount is expressed as a percentage of compensation or as a specified dollar amount. Often the annual benefit amount varies by the number of years of service. For example, the annual benefit may be 2 percent of pay per year for the first 5 years and then increase to 4 percent per year of service thereafter.

Flat Benefit Formula The plan provides for a specified benefit amount to be paid to the executive if a minimum number of years of service has been earned.

Formulas for Benefit Calculations


Broad

Limits what is considered compensation. For example, includes only base wages or base wages plus bonuses.

Narrow


If the executive does not have the required minimum years of service, the benefit is reduced proportionately. The benefit amount may be a percentage of compensation or a set dollar amount. For example, a plan may provide for a $50,000 lump sum benefit at retirement if the executive has 20 years of service, with the benefit reduced to $25,000 for 10 years of service.

Unlike qualified plans, nonqualified benefits may be “backloaded.” Here, the employer sets the benefit formula so that a disproportionate percentage of the total benefit is earned in the later years of service.

When the basic function of a SERP is to provide additional retirement income which, when combined with any other retirement benefits, brings an executive’s total retirement package to a predetermined target amount, a defined benefit plan may be a good fit.

Coordination with the Qualified PlanMost employers take the approach that, regardless of the source, they want to provide a total targeted amount as a retirement benefit to their executives. Since the executive generally receives retirement income from Social Security and from any qualified plans sponsored by the employer, the SERP is often used to make up any shortfall between the desired target amount and the projected benefits received.

Under this approach, known as the “offset method,” the SERP benefit formula is calculated to deliver the total targeted amount less any amounts provided by Social Security or other qualified plans.

Coordination with the Compensation DefinitionOnce the determination has been made as to what will be included in compensation for benefit determination, then the benefit formula generally specifies a time period or point in time to be used for the actual calculation.Common approaches are as follows: Final Average

Generally, this approach defines compensation as the average pay in the executive’s final years of service, typically the last 5 years of service.

Career Average The average pay during the executive’s total years of employment is used to calculate the benefits due.

Final Pay The benefit formula uses the executive’s pay immediately prior to retirement as the basis for benefit determination.

Cost of Living Adjustment (COLA)

When a SERP incorporates a COLA provision, the retirement benefit is adjusted annually to keep pace with inflation. COLA provisions are most often used in defined benefit plans. The inflation factor is generally determined by the increase in the Consumer Price Index (CPI) during the previous 12-month period. The COLA increase can be capped at a set percentage. An additional provision could be added stating that any benefit increase that is capped will accrue to the executive in subsequent years when actual inflation is less than the cap.

Vesting represents the nonforfeitable interest of participants in the accrued benefits. The employer may create “golden handcuffs” by subjecting accrued benefits to some type of vesting schedule. If the executive leaves the company before a specified time period, he or she loses all or a portion of the right to the accrued benefits.

Vesting Schedules

Depending on the employer’s goals, “golden handcuffs” can be structured narrowly to favor the employer or generously to reward the executive. Two common vesting schedules, borrowed from the qualified plan rules, are: Five-year Cliff Vesting (Favors Employer)

The executive becomes 100 percent vested after he or she is credited with five years of service. Prior to the fifth year, the vesting percentage is zero.

Five-year Graded Vesting (Favors Executive) The executive becomes 100 percent vested after he or she is credited with five years of service. Gradual vesting percentages apply prior to the fifth year.

The percentages are as follows:

After 1 year of service: 20 percent vested

After 2 years of service: 40 percent vested




Unlike qualified plans, unfunded SERP plans are not subject to the prescribed vesting standards of ERISA or the IRS. Plan designers have unlimited freedom to incorporate vesting schedules reflecting the employer’s specific needs for benefits and limitations.


The SERP document’s definition of the term “retirement benefits” determines when and how much the executive will receive. Generally, there are two applications of this term:

Retirement Benefits

Normal Retirement Normal retirement age for a SERP plan is generally linked to the employer’s qualified plan definition of normal retirement age. At this point in time, the executive can receive benefits as determined under the SERP formula without any adjustment of the amount received.

Generally, if the executive retires before normal retirement age, the benefit amount is reduced. The plan document will specify the reduction factor to be used each year—generally a percentage reduction of benefits earned. Where the plan document allows, the employer may waive the reduction when it is necessary to encourage executives to retire—for example, during a period of downsizing induced by a poor economy.

Typically, early retirement is defined to be age 55 with at least 10 years of service. Or, it may be defined as that point in time when the executive’s age added to years of service equals 65.


If an executive retires prior to the early retirement age stated in the plan document, he or she may be treated as having terminated service and the benefit payment will be determined under the termination provision of the plan.

Deferred or Late Retirement Benefit Generally, a deferred retirement benefit is treated just like a normal retirement benefit. Additional years of service and higher pay subsequent to the normal retirement date are taken into account in determining the benefit amount. That is, the benefit is adjusted upward.

Other benefits determined by the SERP documents are: Termination Benefit

The termination benefit is paid to the executive if he or she leaves the company prior to becoming eligible for the early retirement benefit. This benefit is usually determined as a percentage of the accrued benefit. The percentage applied to the accrued benefit usually increases with years of service and is reflected in the vesting schedule.

Termination may be defined narrowly as voluntary resignation only, or more broadly, to include discharge by the employer. When the two definitions are separated, the latter is called a severance benefit and is often treated differently from a voluntary resignation.

Disability Benefit The focus of a SERP is retirement income. Since most executives are covered by disability income insurance policies, many SERPs do not provide disability benefits. Furthermore, many SERPs will not penalize an executive during short disability periods but provide for continued accrual of service during this period. Some plans treat permanent disability differently, providing for specified payments when the executive is severely disabled and not expected to return to active work status.

Death Benefit Prior to Retirement SERP plans are designed to provide retirement income; it is not mandatory that a SERP include any pre-retirement death benefit. However, many SERPs do provide benefits to the executive’s heirs should he or she die prior to retirement.

The death benefit may be a stated dollar amount or a multiple of salary. Or, it may be the present value of the executive’s accrued benefit at the time of his or her death. Alternatively, the plan may pay the accrued benefit without any reduction for early payment but limit the number of years that the specified payment will be received.


The defined benefit promised under the SERP may be paid out in different forms. Often the form of the payout depends on the triggering event—disability, normal retirement, early retirement, etc. Typically, employers mirror the normal retirement payout after the format used by the qualified plan. Under this approach, the benefit stream would be based on the participant’s life, or where the executive is married, a joint and survivor annuity.

Tax Consequences to the Executive A key goal in designing and implementing a SERP is to avoid current taxation to the executive. The objective is to defer the income tax liability until distributions are actually received. This objective is defeated if the doctrine of constructive receipt or economic benefit applies to the arrangement. Two simple but effective rules can help achieve this tax deferral.

These rules are a short synopsis of the two tax doctrines that the participant must avoid to achieve tax deferral on the sums in his or her account: constructive receipt and economic benefit. Constructive Receipt

The constructive receipt doctrine is used to currently tax cash basis taxpayers on income that is made available to them even if they have not actually received it. If the executive’s right to the deferred compensation is forfeitable, there is no constructive receipt. Even where the executive’s rights are non-forfeitable (vested), there will be no constructive receipt provided that (1) the deferral contract is entered into before the services are performed, and (2) the employer’s promise to pay is not secured in any way. For the employer’s promise to be unsecured, the plan must be considered unfunded. That is, the plan assets must be general assets subject to the claims of the employer’s creditors.

Economic Benefit While constructive receipt deals more with the receipt of income, the economic benefit doctrine involves the receipt of property rights under I.R.C. §83. The economic benefit doctrine will likely apply if the employer’s liability to pay the deferred compensation is funded and the executive acquires an interest in the funding vehicle. I.R.C. §83 excludes unsecured and unfunded promises to pay from the definition of property, providing another escape hatch for nonqualified deferral plans. If the nonqualified plan is funded, then it is important that a “substantial risk of forfeiture” be included in the plan design or the executive will be subject to immediate income taxation on the deferred amounts.

Pay-Out Method

An executive will not realize income under a nonqualified plan, even though he or she is partially or totally vested, if the employer’s promise to pay future compensation is unsecured and unfunded.

Vested but Unfunded

An executive will not realize income—even if the nonqualified plan is funded— if the executive’s right to receive the future payment is not transferable and is subject to a substantial risk of forfeiture.

Funded but Not Vested


When is the Benefit Taxable? When the retirement benefits are actually paid to the executive or he or she is in constructive receipt with no substantial risk of forfeiture, then income taxation will occur. Retirement benefits are a form of compensation and will be taxed as ordinary income whether received by the executive or heirs.

Income Tax Consequences of the Plan—For the Employer The employer is not permitted a current tax deduction for contributions to the SERP. Just as the executive’s inclusion in income is deferred until receipt of the benefits, the employer’s deduction is deferred until these amounts are included in the executive’s income. This is true even if the executive’s rights under the plan are vested. When the benefit payments are included in the executive’s income, generally during the retirement years, then the employer may deduct the payments, provided they meet the criteria for reasonable compensation.


Completely Unfunded No funds are set aside by the employer. This type of approach favors the employer because cash is not tied up in an investment but remains available for ongoing business needs. The downside is that this “pay-as-you-go” approach offers the executive little assurance that the employer will be able to make the promised payments. In addition, future managers are left paying the obligation for former executives who may have never contributed to their current profits.

Informally Funded Confusion exists about the meaning of the term, “informally funded.” In nonqualified planning, it generally refers to the situation when the employer sets aside assets as a targeted source from which to pay its promise. The plan will be considered unfunded for both ERISA and IRS purposes if these assets remain available to the employer’s general creditors.

Informal Funding of SERP with Life Insurance While the executive’s promised retirement benefits cannot be formally funded, assets can be set aside to provide liquidity when it is needed. The advantage of using corporate-owned life insurance is that cash values grow tax deferred. By monitoring the policy’s performance, the employer can help ensure that when a benefit obligation comes due, the cash value in the policy will match the obligation. Then, by accessing policy cash value through a combination of loans and withdrawals, benefits can be financed. Alternately, the employer may pay the benefits from current working capital and recover the cost later from death benefit proceeds. Life insurance can be suited to informally fund SERP benefits because: – When the plan includes a death benefit, life insurance is the only vehicle

able to match the death benefit obligation from the plan’s inception.

– An income tax-free benefit10 is eventually realized by the company in amounts that can help provide cost recovery to the employer, help the employer’s investment and any AMT.

In addition: – When the plan promises income, the cash value build-up is available to

the employer to finance promised retirement income.11

– When the plan provides for disability benefits, premium waiver riders can be added to the policy.

– The cash values accumulate income tax-deferred and may be subject to minimum guarantees.12

– Policy performance may produce an attractive internal rate of return (IRR)exceeding the company’s cost of funds.

Corporate owned life insurance is the funding vehicle of choice when the employer is in a high tax bracket and benefits will not be paid in the near future. With sufficient funding, the policy cash value accumulates due to the income tax-deferred growth.

The accrued benefits represent a future liability for the employer. The employer needs to make certain there will be adequate working capital available to pay the benefit obligations as they come due. A prudent employer anticipates this need and may informally fund this obligation. Since the nature of the “funding” is directly tied to tax deferral for the executive, it is important to understand the different options available to the employer and the effect of each.

Informally ‘Funding’ Plan Obligations

10 Death benefits from life insurance will be received income tax free if the policy purchase complies with the requirements of IRC Section 101(j), including the written notice and consent provisions for the insured. May be subject to corporate alternative minimum tax (AMT).

11 If the policy lapses or is surrendered, the IRS will tax distributions received over the life of the policy and at termination that exceed total premiums paid. Policy loans and withdrawals reduce available cash value, reduce the death benefit or may cause the policy to lapse.

12 Variable insurance products are subject to investment risk, are not guaranteed and will fluctuate in value. In addition, there is no guarantee that any variable investment option will meet its stated objective.


The Recovery AmountThere are a number of different approaches used to determine the amount of life insurance needed as an asset reserve for a nonqualified plan. Generally, the employer seeks one of three levels of recovery:

1. Recovery of the after-tax costs of the benefit payment at the executive’s death—the obligation only.

2. Recovery of the after-tax costs of the benefit payments and the net premiums paid on the life insurance contracts—the obligation and the cost of the funding vehicle.

3. Recovery of the after-tax costs of the benefit payments, the net premiums paid on the life insurance contracts and the cost of money—the obligation, the cost of the funding vehicle and the cost of lost investment opportunities.

No matter which recovery method is used, it is important to remember the actual cash for the benefit payments may or may not come from withdrawals or loans against the cash value of the policy.

Death Benefit FundingThe employer may choose to use the corporate treasury to pay current benefits, leaving the policy intact until the death of the plan executive. This approach is especially useful for the older executive whose employer establishes a plan just prior to the executive’s retirement or where the employer is unwilling to assume the higher premium cost of a current benefit funding plan.

Current Benefit FundingIn the current benefit funding scenario, death benefits are still used to reimburse the employer’s net costs. However, the benefit payments come from withdrawals or loans from the policy.

Of course, many variations of these techniques are possible. Flexibility in funding is one of the most attractive features of a nonqualified plan.

The employer is the owner and beneficiary of the policies. The executive has no interest in any life insurance policy on his or her life. Death benefit proceeds are paid income tax free to the employer and may be used to recover theemployer’s costs incurred in connection with the plan.

How Corporate Owned Life Insurance Works

For the ExecutiveLife insurance used to informally fund benefits under a nonqualified plan, when properly designed, should not change the general rule that unsecured, non-transferable benefits are currently not taxed to the participant. This is because there is no constructive receipt.

For the Employer When life insurance is used as the informal funding vehicle, the premiums paid on the life insurance contracts will not be deductible by the employer because the employer is directly (or indirectly) the beneficiary of the policies.

Under a death benefit funding scenario, death benefit proceeds are paid income tax free to the employer so long as the purchase of the policy complies with the requirements of I.R.C. Section 101( j), including notice and consent requirements for the insured. However, death benefit proceeds from corporate-owned life insurance policies may be subject to corporate alternative minimum tax (AMT).

If a current benefit funding scenario is used, where benefit payments come from withdrawals and loans, it is important to remember that policy surrender or lapse will result in taxation where the total amount received exceeds the employer’s basis in the policy. In addition, taxable income may be recognized by the employer in connection with a withdrawal from contract values if the change results in reduction of the death benefit within 15 years of the issue date (the recapture ceiling).

Variable Universal Life Insurance While other forms of life insurance can be used with nonqualified plans, variable life insurance is a popular informal funding vehicle for SERP plans. Using variable life policies allows the employer to avoid the current taxation that occurs with mutual funds, and still have the ability to invest in variable investment options. The variable investment options placed within the variable product allow for potential tax-deferred cash value growth.

Like every insurance product, a variable policy includes mortality charges, commissions, administrative costs and probably surrender charges if the policy is canceled during a specific period of time. The employer is responsible for minimizing these costs and effectively using the death benefit.

One solution is to choose a variable universal life insurance product. These can be designed to maximize the portion of the premium payments that go directly into the variable investment options and minimize administrative and possible surrender charges. Also, by tying the use of vesting schedules for the employer’s matching funds to the set time period when surrender charges occur, it is possible to design a plan so that the employer will not incur additional cash outlay for a distribution to an executive. For those employers who are concerned with the ability of the insurance company to pay claims, variable universal life insurance may lend an additional security aspect because cash value is invested in separate accounts that are not part of the general account assets of the insurer. Therefore, the funds are not subject to the claims of the insurer’s creditors. Please note that investments and variable insurance products are not guaranteed and are subject to investment risk including the possible loss of principal.


Income Tax Consequences... Life Insurance as an Informal Funding Vehicle

The participants in the plan are only general unsecured creditors of their employer. However, executives are always seeking more assurance that their benefits will be there when needed. Rabbi trusts are often used in SERP arrangements to provide greater assurance to participants of the employer’s ability to pay promised benefits.

A rabbi trust is an irrevocable grantor trust established to accumulate money and other assets to finance the obligation. The executive gains additional security because the assets in the trust are protected from employer invasion and takeovers. However, in the event of the employer’s bankruptcy or insolvency, such a trust will not protect the participants. The funds in a rabbi trust remain at risk to the employer’s creditors, so that the executive may continue to defer taxation on benefit amounts in the trust.

Securing the Liability


All SERP plans, whether informally funded with life insurance or not, must be recorded in the employer’s financial records using specific accounting rules known as Generally Accepted Accounting Principles (GAAP). The benefit liability and the insurance asset are treated separately under standards set forth by the Financial Accounting Standards Board (FASB). The benefit obligation is recognized as a liability under SFAS No. 106—Employers’ Accounting for Post-retirement Benefits Other Than Pension. Technical Bulletin 85-4 (Accounting for Purchases of Life Insurance) details the accounting treatment of corporate-owned life insurance. In addition, SFAS 109 (Accounting for Income Taxes) addresses the accounting treatment of deferred taxes for both corporate-owned life insurance investments (if any) and the deferred compensation liability.

Accounting Principals


Federal Income Tax Withholding An employer is required to withhold income tax when compensation is either actually or constructively paid. In a properly designed SERP, income tax withholding will normally occur when benefits are paid to the participant.

Social Security Tax and Federal Unemployment Tax On January 29, 1999, the IRS issued final regulations (T.D. 8814) under I.R.C §§3121(v)(2) and 3306(r)(2) on when amounts deferred under nonqualified plans will be considered wages for FICA/FUTA purposes. These regulations are applicable on and after January 1, 2000, and generally follow the rules of the proposed regulations issued in 1994.

Under the “Special Timing Rule” found in these regulations, any amount deferred under a nonqualified plan will be subject to FICA/FUTA on the later of (a) when the services are performed or (b) the date on which there is no substantial risk of forfeiture (as defined by I.R.C. §83 regulations). The manner in which the “amount deferred” is determined depends upon whether the nonqualified plan is an account balance plan (generally a defined contribution plan) or a non-account balance plan.

Generally, a SERP is a non-account balance plan. Here, the amount deferred for the accounting period equals the present value of the additional future payments to which the executive has obtained a legally binding right during that period. The regulations give employers the flexibility to use any reasonable actuarial assumptions and methods to calculate the present value of the benefits. Generally, benefits will be subject to FICA/FUTA taxes when they are vested.

Payroll Taxes


Any amount payable to a beneficiary under a SERP Plan can be included in the executive’s estate. Payments by the employer to the executive’s beneficiaries are “income in respect of a decedent” (IRD) and are taxed as they would have been to the executive. The compensation is treated as ordinary income. The beneficiary should be entitled to a miscellaneous deduction for any estate taxes paid due to the SERP.

Federal Estate Taxes

Unfunded Top-Hat Plans When the top-hat exemption is met, the plan will be exempt from most ERISA provisions. However, the plan administrator must, within 120 days from inception of the plan, file a short written notice with the Secretary of Labor. Failure to meet this deadline means the plan is probably obligated to comply fully with all the reporting and disclosure requirements of Title I, Part 1, of ERISA. In addition, the plan must provide for a plan administrator and identify a claims procedure.

Unfunded top-hat plans do not require any type of annual filings, such as Form 5500 series filings, with the IRS.

Unfunded Excess Benefit Plans An unfunded excess benefit plan is exempt from all requirements of ERISA Title I. Unfunded excess benefit plans do not require any type of annual filings with the IRS.

Annual Filing Requirements


Security and Exchange Commission (SEC) Registration

Registration with the SEC will not be required if the SERP is an involuntary non-contributory plan maintained by the employer. Participation in this type of a plan is not considered a security.

Third-Party Administrators (TPAs)

Similar to the qualified plan market, independent benefit administrators are fast becoming an important component of the nonqualified benefit world. They free the producer to do what he or she does best—sell.

The services provided by TPAs may be as limited as basic bookkeeping or broad enough to encompass all aspects of plan implementation, administration and maintenance. The choice of a TPA will depend on the services needed. Some TPAs work on a fee-for-service basis while others will do fee and commission splits. Some TPAs will actively participate in the sale if desired, and others provide administration support only.

Depending on the TPA selected, a variety of services in the four basic areas of plan implementation and maintenance are available. These services include but are not limited to: prospecting and presentations; design and documentation; proposals and illustrations; and administration.

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