SERPs address a common pain point for key employees—and their employers
In an increasingly virtual world, top talent can be hard to attract and even harder to retain.
Attractive benefits packages offer one way for employers to keep highly compensated employees and key executives (HCEs) around without getting into a bidding war with the competition. However, finding a mix of benefits that is both economical for the company and compels HCEs to stay is often a major challenge.
Specialized retirement benefit offerings provide a unique opportunity to thread this needle. In effect, traditional retirement benefits built solely around qualified retirement plans like Profit Sharing and 401(k) plans create an inequitable situation for HCEs: Annual contribution limits make it impossible to build enough tax-deferred savings to reproduce their annual income in retirement. Employers who help close this gap can offer a meaningful solution to a challenge that is often top-of-mind for their HCEs.
With the right benefit structure, employers can fund these benefits cost effectively and offer them in a way that produces a strong incentive for the HCE to remain with the business until retirement.
Closing the retirement savings gap for HCEs
When it comes to providing retirement plans, businesses have several options beyond traditional qualified plans. Nonqualified deferred compensation (NQDC) plans are particularly useful as a way of providing HCEs additional opportunities to increase their potential retirement income even if they max out their contributions to qualified plans. These plans come in two broad categories:
- Deferred Compensation Savings Plans, which allow HCEs to defer a portion of their salary until retirement, more or less resemble a 401(k) from an HCE’s point of view.
- Supplemental Executive Retirement Plans (SERPs), which pay HCEs a specified amount of deferred compensation at a pre-defined occurrence or age.
A SERP allows employers to replace retirement income for one or more of their HCEs in a flexible manner.
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 an 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.
SERPs offer benefits to employers and HCEs
For HCEs, a SERP offers several key benefits:
- SERPs provide a defined, relatively predictable additional income stream during retirement.
- HCEs will only be taxed on that income when they receive it. SERPs do not produce tax consequences for HCEs while they are employed, and, like qualified retirement distributions, may offer tax advantages if HCEs are in a lower tax bracket during retirement.
- The presence of this income stream in early retirement gives HCEs the flexibility to leave savings in their qualified accounts longer, taking advantage of additional potential for compounding before minimum required distributions begin at age 72.
- Because employers oversee all aspects of funding and distributing SERPs, these benefits do not require any HCE contributions or oversight.
Employers benefit from these arrangements because:
- SERPs can be set up flexibly to minimize their impact on the balance sheet and maximize tax efficiency.
- Although a SERP represents a future obligation, employers are not required to fund them prior to distributing the compensation to the HCE.
- By structuring SERPs to vest over time, employers can maximize incentives for HCEs to remain with the company, improving retention of top talent.
- Businesses can offer retirement benefits as an alternative to incentives such as equity compensation, which may not always be a good fit for a closely held business.
- Plans are straightforward to design, implement, and communicate.
- SERPs’ administrative costs are typically less than those of a typical elective deferred compensation plan.
The power of flexibility
The advantages of a SERP come from its simplicity and flexibility. The plan amounts to an agreement that the employer will make a series of payments, either at retirement or at some other predefined point in time. The amount of the benefit usually depends on the participant’s age, compensation, or length of service. For example, the benefit could be based on replacing a specific percentage of an HCE’s final compensation, or by contributing a certain amount of money each year on the HCE’s behalf.
Businesses can control vesting eligibility, so that HCEs receive more benefits the longer they stay. For example, an employer could offer to pay an HCE $1 million at retirement, but only vest 10% per year when the HCE is between the ages of 55 and 65.
This high level of customization gives organizations the flexibility to ensure the plan addresses a particular individual’s needs, while also protecting the organization’s interests. In other words, SERPs are a differentiated benefit that employers can offer at a relatively low risk compared to other types of incentives.
Funding options are also flexible
Finding the right funding mechanism for a SERP is a key component of ensuring its cost effectiveness. Like most 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.
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.
Additional value for closely held businesses
The ability to reward valuable HCEs without diluting a business’ equity can be especially important for family-owned businesses.
When a family business executes a succession plan, older generations typically don’t mind giving up their equity to the younger generation. However, the company may not want to provide equity to HCEs who are non-family members, putting the business at risk of losing some of its most important people. Using a SERP allows an organization to offer a strong retirement package while retaining the equity necessary to execute a family succession plan. The plan can even be designed to mimic the growth of equity.
SERPs can also provide a useful way to buy out the equity of an older family member who may prefer to continue working many years longer than younger family members would prefer. With a SERP, the organization can plan ahead to have enough funding to buy back the retiring family member’s equity. Meanwhile, the SERP distributions would go towards paying the family member enough cash to maintain their standard of living—all without disrupting transfer of ownership.
Funding a SERP with a COLI policy also creates the option for small businesses to offer a death benefit that will provide for an HCE’s family if the HCE dies prematurely. In situations where owners have close personal relationships with their HCEs, the ability to pass the death benefit along to an individual’s family can be a meaningful way to emphasize how much the organization’s leaders care.
Administrative details are important
Although SERPs are relatively simple to design, structure, and maintain, it’s critical that businesses not treat them in a “set it and forget it” fashion. The agreement provisions should be reviewed regularly to ensure compliance with U.S. Code Section 409A and generally accepted accounting principles (GAAP). When funding a SERP through a COLI policy, it’s important to monitor the cash surrender value of the life insurance policy. If the value drops below a certain threshold, it can reduce the funds available to withdraw to cover distributions.
For these reasons and more, it’s important to work with a highly skilled benefits consultant who understands defined benefits from a consultative, compliance, and technical perspective.
Meaningful, cost-effective benefits can attract and retain top talent
Offering a retirement benefit like a SERP can be a key differentiator for organizations seeking to attract and retain highly compensated talent. Addressing the common challenge of closing the retirement funding gap offers a meaningful benefit. The option to provide a premature death benefit can make this alternative even more significant.
On the employer side, the flexibility to offer a SERP on a vesting schedule provides more leverage for attracting and retaining HCEs late in their careers. And the flexibility to fund these benefits efficiently, without adversely affecting the organization’s balance sheet or diluting equity, can make them a highly cost-effective choice for organizations large and small.
