Advanced Sales Idea
Use Non-qualified Plans Funded with Life Insurance to Help Business Owners Recruit, Retain and Reward Executives
Business owners today are faced with increased competition for talented key executives. In the past, business owners attracted, motivated, and retained their more talented executives by offering a combination of salary, incentive bonus, and qualified retirement benefits. Unfortunately, these traditional compensation strategies fail to address several important issues:
- Salary increases and bonuses have short-lived impact on long-term job satisfaction and loyalty to the business.
- Salary increases and bonuses force executives to pay taxes on income now, even though the funds may not be needed until later.
- ERISA makes it difficult to single out and reward highly-compensated executives using qualified retirement plans.
Fortunately, there are alternatives to the traditional compensation strategies. Non-qualified plans ("NQ plans") provide flexible options for businesses that want to reward and retain key executives. NQ plans include deferral plans (such as Non-qualified Deferred Compensation arrangements and 401(k) look-alike plans and supplemental plans (such as SERPs, 457 plans and severance plans).
Sales Opportunities: Businesses or Executives
The client seeking to enter into a NQ plan may either be the business owner or an executive. When the plan is marketed to an employer, the goal is generally to offer a benefit which will recruit new executives and/or retain current executives. Where the client is an executive, however, the goal is usually to help accumulate funds for retirement while deferring current income taxation.
Whether you are working with business owners or executives, the following situations offer opportunities to market and sell NQ plans:
Attracting and Retaining Talented Executives
In a rapidly changing and competitive market place, NQ plans can be an effective tool for recruiting, retaining, and rewarding valuable executives. With flexibility in design and the ability to discriminate in favor of key executives, these plans can be customized to meet the needs of the business and top management. Competitive benefit levels, deferred vesting of substantial benefits, future benefits dependent on meeting current company objectives, and similar incentives encourage top executives to remain with the company.
Income Tax Deferral
Catering to the executive's desire to avoid current taxation, the employer can establish a salary reduction or deferral plan. Incentives for performance in the form of added employer dollars, higher interest earnings, or both can be added to the basic deferral design. In this manner, a deferral plan can be converted into "golden handcuffs" as employer-provided benefits become substantial over time.
Equalizing Deferral Opportunities
Qualified retirement plans offer the best savings opportunity for retirement; contributions are not taxed to employees until withdrawn from the plan and employer contributions are tax deductible. But there is a limit to how much a participant can contribute to a qualified plan ($15,000 annually for 401(k), 403(b), and 457(b) plans). The effect of this limitation is to discriminate against highly paid executives.
A highly paid executive who participates in a qualified retirement plan fails to receive the same ratio of before-to-after retirement income as the average worker. For example, an employee making $60,000 a year can contribute up to 25% of his or her income to a qualified plan whereas an executive making $100,000 can only contribute 15% of income. NQ plans are a tool which can be used to help highly paid executives achieve the same ratio of tax-deferred retirement contributions enjoyed by average workers.
Incentive and Reward for Staying with Growing Business
Often times a new business cannot afford to pay executives what they would be paid if working for an established business. When a business expecting rapid growth and high profitability in the future is currently paying salaries that are low in comparison to industry standards, a NQ plan can be used to reward executives for sacrifices made during the start-up phase. Such rewards can even be tied to growth in the company's value using equity-based incentives (such as stock appreciation rights or a phantom stock plan).
For Outside Directors or Board Members
NQ plans for directors are becoming more common in today's business environment. Just as with executives, a NQ plan can be an effective tool to recruit, retain, and reward outside directors. Techniques which provide tax deferral may be particularly attractive to outside directors as they are often highly compensated executives of other corporations.
Funding NQ plans
NQ plans can be funded in a variety of ways, including providing no funding at all. Where a business chooses to fund its obligations under a NQ plan, it may want to consider using a product which is tailored to meeting retirement needs.
The preferred asset for funding NQ obligations may include the following features:
- Simple to purchase or establish
- Tax-deferred accumulation of funds
- Easy access to funds
- Tax-favored distributions at death or retirement
- Minimal legal or accounting costs associated with the financial product
- A death benefit which can provide cost recovery for the business
Life insurance is an efficient tool for funding NQ obligations because cash values grow tax deferred and the death benefit provided by a policy assures the business that funds will be available to pay benefits in the event of an untimely death. Death benefits provided by life insurance can also be used to provide additional benefits to the executive's family or to provide "cost recovery" for the business. And by using products specially designed for NQ plans, such as ING's Strategic Investor Variable Univeral Life, a business can fund its NQ obligation in a manner which should not adversely impact the company's balance sheet.
Compliance with IRC §409A
Keep in mind that NQ plans are subject to IRC §409A, which, among other things, places restrictions on the timing of elections and distributions from such plans. Failure to comply with §409A could have adverse consequences for both the plan and its participants.
Case Study
To see how a NQ plan might work in practice consider the following sample case study.
ABC Company has 11 employees to which it would like to provide additional benefits. Working with an insurance professional, ABC Company decides to adopt a SERP with the following assumptions:
- Benefit paid to executives who retire at age 65 or later with at least 10 years of service
- The retirement benefit will be 50% of the participant's final salary, payable for 20 years
- A pre-retirement death benefit totaling 50% of final salary will be paid to beneficiaries of participants who die while still employed by ABC Company
- Employee tax bracket is 28%
- ABC Company tax bracket is 34%
- Each funding policy will be designed for targeted cash value of $50,000 at age 100
The census for the ABC Company plan is as follows:
| Participant | Sex | Age | Underwriting | Current Salary | Final Salary | Retirement Benefit |
|---|---|---|---|---|---|---|
| Alan Adams | M | 45 | Preferred | $63,000 | $91,780 | $45,890 |
| Bob Baker | M | 56 | Non-smoker | $80,000 | $95,608 | $47,804 |
| Connie Carter | F | 45 | Non-smoker | $58,000 | $84,496 | $42,248 |
| Doug Davis | M | 46 | Preferred | $67,000 | $95,962 | $47,846 |
| Erin Edwards | F | 34 | Preferred | $55,000 | $99,624 | $49,812 |
| Fay Ford | F | 38 | Smoker | $43,000 | $71,956 | $35,978 |
| George Green | M | 43 | Smoker | $68,000 | $103,066 | $51,533 |
| Harold Hill | M | 35 | Non-smoker | $40,000 | $71,034 | $35,517 |
| Ian Iverson | M | 50 | Preferred | $69,000 | $91,044 | $45,522 |
| Jane Johnson | F | 42 | Preferred | $57,000 | $88,120 | $44,060 |
| Kim Kelly | F | 54 | Preferred | $61,000 | $74,358 | $37,179 |
Steps to Implement
- ABC Company, working with its legal counsel, establishes a supplemental executive retirement plan SERP for the 11 selected executives.
- ABC Company purchases ING's Strategic Investor Variable Universal Life insurance policies on each of the 11 participating executives.
- Each policy is designed to provide the promised retirement benefit through a combination of loans and withdrawals from the policy's cash value.
- Also, each policy is designed to provide a death benefit high enough to provide ABC Company with full cost recovery for plan expenses.
- Annual premiums required to maintain all fourteen policies is $159,273.
- Premium payments are not deductible to ABC Company.
- Upon reaching retirement at age 65, each plan participant begins to receive a retirement benefit equal to 50% of his or her final salary. The benefit will be paid out over a period of twenty years.
- These payments are taxable to the executives as ordinary income and are deductible to ABC Company.
- Upon the death of each plan participant, ABC Company receives policy death benefits which are used to recover plan costs.
What Has Been Accomplished
By implementing an informally funded SERP plan using Strategic Investor Variable Universal Life insurance from ING, ABC Company has accomplished the following:
- Provided a tax-deferred retirement benefit to selected executives
- Used "Golden Handcuffs" (benefit will not be received unless executive stays with ABC Company through age 65) to retain executive services until retirement age
- Created a source of cost recovery by informally funding with life insurance
Summary
NQ plans are flexible tools which can be used to help recruit, retain and reward talented executives and directors. NQ plans can be used to provide a tax-deferred source of retirement income or to provide incentives to reward executives for staying with a company during its start-up phase.
Life insurance is an efficient tool for funding NQ plans because it offers tax-deferred accumulation, provides tax-favored distributions, can minimize balance sheet concerns and offers a death benefit for cost recovery.
To learn more about NQ plans and life insurance products which can be used to fund them, visit ING's Advanced Marketing section on the Virtual Financial Center at ingvfc.com. And, for top-notch sales support from leading industry professionals dedicated to helping you grow your life business, call the ING National Sales Support Team at (866) ING-SELL or (866) 464-7355.
Variable insurance products are offered by prospectus only. To solicit variable insurance products you must maintain a variable insurance license, be appointed with the issuing company and be a registered representative of a broker-dealer that has a current selling agreement with the issuing company
Neither ING or its affiliated companies or representatives offer legal or tax advice. Clients should consult with their tax and legal advisors regarding their individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matter addressed in this document.
Strategic Investor Variable Universal Life, policy form #2513 (VUL) - 1/02, is issued by Security Life of Denver Insurance Company and distributed by ING America Equities, Inc. Both companies are members of the ING family of companies
Non-qualified Plans Frequently Asked Questions
- What is a non-qualified plan?
- A non-qualified ("NQ") plan is any arrangement for employee benefits, including pension or retirement benefits, that does not qualify for special tax treatment under IRC 401. Examples of NQ plans include SERPs, deferral plans, bonus plans, 401(k) look-alike plans and welfare benefit arrangements. NQ plans are typically structured as unfunded promises by an employer to pay future benefits to an employee.
- What does it mean for a plan to be "un-funded"?
- Although a business may set aside assets to help finance its obligations under a NQ plan, the arrangement must be "un-funded" to avoid current taxation on the benefits. An arrangement will be considered un-funded so long as any assets set aside to pay benefits are unsecured and are exposed to the claims of the employer's general creditors. The NQ plan participant must have no greater rights in the funding asset than those of a general unsecured creditor.
- How is ERISA applied to NQ plans?
- The Employee Retirement Income Security Act of 1984 ("ERISA") governs the funding, vesting, administration and termination of employee benefits plans in private organizations. Both qualified and non-qualified plans are subject to ERISA. Qualified plans are those plans which qualify for specialized tax treatment under IRC 401. Non-qualified plans are benefits plans which do not qualify for specialized tax treatment.
Title I of ERISA has five parts:
- Reporting and Disclosure
- Participating, Vesting and Spousal Consent
- Funding
- Fiduciary Responsibility
- Administration, Enforcement and Claims Procedures
Qualified plans are subject to all five parts of Title I. Non-qualified plans may or may not be subject to some or all of Parts one through five depending upon the type of plan.
Non-qualified plans can be divided into four categories, all of which are subject to different parts of Erisa's Title I:
- Employee pension benefit plans
- Employee welfare benefit plans
- Excess benefit plans
- Top-hat plans
An employee pension benefit plan (or "pension plan") is any plan or fund established or maintained by an employer to provide retirement income to employees. Unless a pension plan meets the requirements of a "top-hat" plan, it is subject to all five parts of Title I. Such plans have all of the burdensome aspects of qualified plans with none of the tax advantages. Consequently, most non-qualified plans are designed to be top-hat plans.
An employee welfare benefit plan (or "welfare plan") is any plan or fund established or maintained for the purpose of providing to participants or their beneficiaries, through the purchase of insurance (or otherwise) medical, surgical, and hospital care or benefits or benefits in the event of sickness, accident, disability, death or unemployment. These plans are subject to Parts one, four and five of ERISA. Among other things, the reporting requirements of Part 1 include the distribution and filing of a Summary Plan Description. Plans with fewer than one hundred 100 participants, however, are exempt from the reporting and disclosure requirements (See DOL Reg. 2520.104-20). Where welfare plans are unfunded, or funded only with insurance, Part four requires a written plan instrument and the appointment of a "named fiduciary." For funded welfare plans, Part four imposes numerous fiduciary obligations relating to plan assets.
An excess benefit plan is a plan maintained "solely" for the purpose of providing benefits for certain employees in excess of IRC 415 limitations on qualified plans. Excess benefit plans escape all requirements of Title I. It can be difficult, however, to design a plan that qualifies as an excess benefit plan. For example, if voluntary employee deferrals or incentive compensation is included in a plan, the plan would not be solely for excess benefits.
The most common type of nonqualified plan is the "top hat" plan. A top hat plan is an employee benefit plan which is unfunded and maintained for a select group of management or highly compensated employees (See DOL Reg. 2520.104-23). Top hat plans are subject only to simplified reporting procedures under Part one (i.e. no Summary Plan Descriptions need be disclosed or filed) and Part five of ERISA's Title I. Top hat plans are not subject to Parts two, three or four of ERISA.