This article first appeared in Vol. 16, No. 3 of Enterprising Women Magazine (www.enterprisingwomen.com) and is being reprinted with permission from the publisher. All rights reserved.
As American business enters the 21st century, old methods of doing business are quickly being replaced with the new – new technologies, new approaches, and new ideas about attracting, rewarding, and motivating high quality employees. Nowhere is this more evident than in the matter of key employee and business owner compensation, and specifically in the area of Deferred Compensation Planning.
A Deferred Compensation Plan (DC Plan) is exactly what its name implies – it's a plan that allows an individual to defer a portion of his or her current income, and the taxes due on that income, until a future point in time – usually retirement.
Because it is a non-qualified plan, employers may select whomever they want to participate from their executive or management team. There are no contribution limits and no significant filing or reporting requirements. On the negative side, contributions are not tax deductible until benefits are paid out to participants and, under the doctrine of constructive receipt, benefits may be taxable to participants when they have the right to receive them – not necessarily when they are actually paid. (Establishing a vesting schedule can help address this issue)
DC Plans come in many shapes and sizes. They can be Defined Contribution or Defined Benefit; Salary Reduction or Salary Continuation Plans; and they can be structured to provide disability and life insurance benefits. Choosing the right plan arrangement depends upon a company's specific goals (e.g. retaining key employees) and upon the goals of the selected participants (e.g. supplemental retirement income, current tax reduction).
To help you get a better understanding of the variety and flexibility of the DC Plans, let's briefly consider each of the above structures:
Salary Reduction or Salary Continuation?
DC Plans generally fall into one of two categories – “Salary Reduction” or “Salary Continuation.” Under a Salary Reduction Plan, participants agree to defer a portion of their current salary (or bonus) to a future point in time – usually retirement – allowing them to postpone paying taxes on that income until they are likely to be in a lower tax bracket.
Under a Salary Continuation Plan, the employer agrees to provide participants with additional compensation over and above their regular salary, but it defers payment of that additional compensation until a later date – in most cases retirement. Salary Continuation Plans are often called Supplemental Executive Retirement Plans (SERPs).
Defined Contribution or Defined Benefit?
When an employer chooses a salary continuation plan, another consideration is whether the plan should be a Defined Contribution Plan, where the amount contributed each year on behalf of participants is established (“defined”) under the plan agreement, or a Defined Benefit Plan, which specifies the amount each participant will collect at retirement. Under a Defined Contribution Plan, retirement benefits could vary depending upon the performance of the plan's underlying funding vehicle(s). Under a Defined Benefit Plan, the amount payable at retirement is guaranteed under the agreement, but annual contributions may vary – making it difficult for an employer to work plan contributions into its annual budget. Again, this potential variation is governed largely by how the plan is funded.
Contributions to certain DC Plans can be made by both the employer and the covered participants. In such cases, contributions by participants are generally “matched” by the employer in much the same way as a traditional 401(k) Plan. These kinds of DC Plans are often referred to as 401(k) Overlay or 401(k) Mirror Plans, and they can be used in conjunction with, or in place of, a traditional 401(k) Plan. When used in conjunction with a 401(k), these types of plans can help “equalize” retirement benefits for highly compensated key employees who, because of government regulated funding limitations, would otherwise receive a lower percentage of wages at retirement than their lower paid counterparts.
Once the determination has been made as to which type of DC Plan will best meet the needs and objectives of the employer and participants – defined contribution, defined benefit, salary reduction, or salary continuation – the big question becomes how to fund it.
As one might expect, there are numerous funding alternatives. Some employers choose simply to pay the agreed upon benefits out of company cash flow and hope that their cash flow will be adequate when benefits come due. (Of course, whether such an un-funded plan would be enough to motivate and retain a much-needed key employee is certainly open to debate!) Other employers use securities such as stocks, bonds, and other investment options to finance their plan. Unfortunately, unforeseeable market fluctuations can leave these types of plans seriously underfunded just when benefit payments are scheduled to begin. Another disadvantage to this method is that investment gains are taxable when realized, which can further burden an employer's bottom line.
To address these issues, many employers turn to Company Owned Life Insurance (COLI) to fund their DC Plans. Under a COLI arrangement, the employer purchases a cash value life insurance policy on each participant, and is the owner, premium payer, and beneficiary of each of the policies. Salary deferrals (contributions) and/or company contributions are used to pay the premiums on the policies. Policy cash values grow income tax-deferred and, at retirement, can be accessed via loans or withdrawals to pay plan benefits. Withdrawals and outstanding loans will reduce the policy's cash value and death benefit. However, if a participant dies prior to retirement, the plan can provide for a death benefit to be paid to his or her beneficiary, essentially self-completing the plan. As well, policy riders can be added to provide disability benefits should the plan include disability as one of the benefit triggers. It is this flexibility that makes COLI such a popular funding method.
But the benefits of funding a DC Plan with COLI don't end there. Using life insurance as a funding vehicle can allow an employer to recover the cost of the plan – either in part or in full – through the receipt of death proceeds, and contractually guaranteed cash values can ensure that the funds required to pay plan benefits will be there when they are needed. Under a COLI arrangement, the employer can change who is insured under the COLI contracts; it can pay benefits from either policy death benefits or policy cash values; premium, interest, and expense guarantees allow the employer to develop a long-term financing plan; and buying as a “group” often allows for favorable underwriting considerations. This can be especially helpful if an owner or key employee has health or medical issues that might otherwise make purchasing life insurance costly or difficult. All guarantees are based upon the claims-paying ability of the issuer.
How do Deferred Compensation Plans work?
There are essentially four steps to establishing a DC Plan. The first step is choosing the employees (participants) who will be included in the plan, the benefits which will be paid out under the plan (retirement income, disability income, death benefits, etc.), and the “triggers” (termination of employment, retirement, disability, death, etc.) which will initiate the payment of benefits. Step two is deciding where the salary deferrals will come from – will they be taken from current salary (Salary Reduction) or paid in addition to current salary, but deferred until a later date (Salary Continuation)? Step three is the selection of a funding vehicle – and if life insurance, the purchase of a cash value life insurance policy on each participant. Step four is the payment of benefits following a “trigger” event – usually retirement, disability, or death.
DC Plan benefit payments become a tax deduction to the employer and are taxed as ordinary income to the participant (or his or her beneficiary). If properly structured, at the participant's death, a portion of the life insurance proceeds can be used to reimburse the employer for premiums and/or benefits paid. It's that simple.
Could a DC Plan be right for you?
If you're looking for ways to reduce current income taxes and supplement future retirement income – or if you're looking for a way to attract, motivate, and retain high quality employees – then a Deferred Compensation Plan may be just what you need to meet your personal, business, retirement, and tax reduction goals. Ask your financial advisor for more information.
This information should not be construed as tax advice applicable to each individual. Please consult a qualified tax advisor regarding your individual circumstances.
Content prepared by Penn Mutual.
©2011 The Penn Mutual Life Insurance Company, Philadelphia, PA 19172