Supplemental Executive Retirement Plan (SERP)
Why Business Owners Should Consider a Supplemental Executive Retirement Plan – SERP.
The global work arena has changed, and it has become a competitive environment attracting the very best the skills matrix has to offer. It would only make sense that attracting and retaining key executives is no easy feat and in solving this problem, companies need to make their benefit packages a lot more attractive. Executives want to be recognized for their contributions and expect a package that goes beyond a pay check and the standard benefits. One way in which this can be accomplished is by offering a Supplement Executive Retirement Plan or SERP.
Whilst every employee brings a skill set and offers value, some employees are harder to replace than others. When a high-level exec such as a CEO, COO or CFO resigns or dies unexpectedly, there is a negative impact to the business.
As a seasoned Certified Financial Planner ® with extensive experience I believe the benefits of a SERP are definitely worth pursuing. Here’s how you could maximise the benefits.
What is a Supplemental Executive Retirement Plan?
For highly-compensated employees a Supplemental Executive Retirement Plan (SERP) is a type of Nonqualified Deferred Compensation Plan. The SERP provides retirement benefits over and above qualified retirement plans and Social Security. It is a cost-effective option as only those executives your business relies upon most are included, it is not required to be offered to all rank & file employees. Another benefit of a SERP is that is not subject to the rules applicable to qualified plans under which you cannot take a deduction before reaching age 59 ½ without penalty, and you are required to start taking minimum distributions once you reach age 70 ½[1]
The Supplemental Executive Retirement Plan vs A Company’s Normal Retirement Plan (Like a 401k Plan)
As mentioned, key executives prove to be highly valuable human capital for companies and they’re worth investing in. Therefore, it makes sense for a company to retain these skills by offering extra compensation. By offering a SERP, a company is offering that extra piece of compensation that incentivizes an exec to stay with the company for a long period of time. It’s a bit like an insurance policy for the company.
A highly compensated employee is one that makes at least $125,000 (in 2018 for a 2019 plan year), owns at least 5% of the company during the current or previous year, or are in the top 20% of earners in the company. The IRS has non-discrimination rules designed to keep the highest paid employees from enjoying all the benefits of a company 401(k).
Regular employees can contribute up to $19,000 in 2019 to a 401(k) plan, yet highly compensated employees could see their limits halved or more. By offering a SERP, it is an easier way to save for retirement and live at a similar standard enjoyed whilst employed.
How does a Supplemental Executive Retirement Plan work?
As a SERP is not offered to all employees, it is unlikely that it will be a pre-defined package. A typical arrangement is for the employer to provide compensation that is equal to 70% of the exec’s highest 3-year average compensation, however, the details of the plans vary widely between companies. This does not mean the SERP on its own provides the entire 70%. The company looks at the contributions to the company 401(k) plan, Social Security income and other sources to reach the 70% figure. In order to receive the full package, the employee is required to stay for a specific amount of time, usually staying with the company until retirement.
Many SERPs are informally funded with a cash value life insurance policy and since the company is the owner and pays the premiums, it has access to its cash value. As the company structures the policy to leave a substantial amount of cash value in place after paying years of benefits, the policy continues to accumulate value even once the employee is no longer part of the company. When the employee passes away, the company takes the life insurance benefit tax free, thus allowing the company to recover the cost of the SERP2. Alternatively, if the benefits are paid to the employee, the company gets a tax deduction.
Another common plan is a defined contribution plan where the employer makes intermittent contributions to an employee account, much like a pension. The money is invested on the employee’s behalf until retirement, death, or disability triggers the payment.
[1]Section 409A of the Internal Revenue Code applies to all non-qualified executive benefit plans that provide for the deferral of compensation, such as a SERP plan. Failure to comply with section 409A may subject the employee to immediate income taxation of the deferred amounts, as well as interest and a 20% excise tax on the taxable income.
Tax and the Supplemental Executive Retirement Plan
A SERP is a form of income and there’s no getting around taxes. Beneficiaries will pay ordinary income tax on the funds as they are received, but much like traditional retirement plans, if properly structured, the employee does not pay any upfront tax. This plan allows the funds to grow without taxes having a negative impact on the balance.
2When life insurance is owned by an employer on the life of an employee, section 101(j) of the Internal Revenue Code requires that certain conditions and Notice and Consent requirements be met to keep the death benefit proceeds income tax-free. Consult your legal/tax advisors for more information.
Is There A Risk To The Employee?
An important fact to remember is that a SERP is subject to the claims of the company’s creditors. Where as a 401(k) where the money is safe even if the company ceases to exist, a SERP is not safe unless asset protection planning is undertaken. Also, the SERP must have conditions that make it subject to forfeiture – in other words, it is not a guaranteed payout. If the employee leaves the company early or does not meet the performance goals, the benefits may not be received. If there is no risk of forfeiture, the IRS may label the benefit to be “funded” and immediately tax the employee.
How Does A Person Obtain A Supplemental Executive Retirement Plan?
In the early years of employment whilst climbing the corporate ladder, you won’t be considered as a high-level employee. Once you have gained experience as a high-level exec, a SERP would most likely become part of your negotiations of your compensation package, either with your current employer or a new employer.
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Benefits Of A Supplemental Executive Retirement Plan To A Business: |
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As you can probably have realized, SERP planning is highly customized and should be given considerable thought. My hope is that now you at least have a good idea of how it all works so you can take the next step to see if it makes sense for you.
Thank you for reading!
Cheers,
Derek Notman
