Determining the Benefit Amount
The employer determines the contribution amount or formula to be paid, as well as when it will be paid and under what circumstances. For example, an employer might offer to make 20 annual payments to a Highly Compensated Employee (HCE) in retirement equal to 33% of their final average salary before they retire, provided the HCE remains employed with the company until retirement. Or the company may set aside a specific dollar amount or percentage of salary annually that accumulates with interest and is then paid out at retirement in a lump sum or over a period of years.
A common starting point here is to complete an income replacement study which will help determine any retirement savings gaps for executives & HCEs.
Decide How the Benefit Will Be Funded
Finding the right funding mechanism for a Supplemental Executive Retirement Plan (SERP) is key component of ensuring its cost effectiveness. Like most Non-qualified Deferred Comp (NQDC) plans, SERPs are not governed by the Employment Retirement Income Security Act of 1974 (ERISA)1. As a result, companies do not necessarily have to fund their obligations entirely in advance. However, for most companies, prefunding makes the most sense from a tax and accounting perspective.
Under general accounting principles, organizations need to account for NQDC benefits such as SERPs as a liability on their balance sheet. Typically, organizations fund these future obligations through investments or through a company-owned life insurance (COLI) policy.
Using an investment portfolio to fund a SERP can work to a company’s advantage if the portfolio’s growth is sufficient to cover the compensation that has been promised. Ensuring that growth requires careful administration of the funds and may work well for shorter time durations. Over the longer term, however, the tax consequences of maintaining such a portfolio can also eat into the returns, making it a less cost-effective option in some situations.
The employer enters into a SERP agreement with HCE.
The employer invests in mutual funds or purchases a life insurance policy on the life of the HCE and pays the premiums.
The employer owns the policy and is named policy beneficiary.
- At the triggering event, the HCE receives the agreed benefit. The payment is generally tax-deductible to the employer and taxable to the HCE.
- If the HCE dies and a survivor benefit is part of the agreement, the HCE’s beneficiaries receive the specified benefits and pay the income tax on them.
- If a COLI policy is used, the employer receives the policy death benefit, income tax free.
In many cases, especially longer-duration commitments, a COLI policy is the most tax-efficient and flexible way for an organization to fund a SERP. When the employer establishes the benefit, it purchases a life insurance policy on the HCE and names the employer as the beneficiary. Companies can then include the cash surrender value as an asset on their balance sheet. Unlike growth in a mutual fund held in a taxable account, the growth of the insurance policy’s cash value does not trigger taxes.
When the HCE dies, the employer generally receives the death benefit tax-free, and can use those funds to recoup some or all the distributions made to the HCE. Employers can also take tax-free loans and partial withdrawals against the cash value of the policy to pay ongoing benefit obligations.