By Doug Hall
As American business enters the 21st century, old methods are being replaced with the new — technologies, approaches and ideas about attracting, rewarding and motivating high-quality employees.
Nowhere is this more evident than in key employee and business owner compensation, and specifically in deferred compensation planning.
A deferred compensation plan (DC plan) is what its name implies — it allows an individual to defer a portion of current income, and the taxes due on it, 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 to participants and, benefits may be taxable to participants when they have the right to receive them — not necessarily when they are actually paid.
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 and the selected participants’ goals.
Let’s 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, allowing them to postpone paying taxes on it 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 above their regular salary, but defers payment until a later date. These 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 it should be a defined contribution plan, where the amount contributed each year on behalf of participants is established 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 underlying funding vehicle(s). Under a defined benefit plan, the amount payable at retirement is guaranteed, but annual contributions may vary — making it difficult for an employer to work plan contributions into its annual budget.
Contributions to certain DC plans can be made by both the employer and covered participants. In such cases, participant contributions are generally matched by the employer in much the same way as a traditional 401(k).
These kinds of DC plans are often referred to as 401(k) overlay or 401(k) mirror plans, and can be used in conjunction with, or in place of, a traditional 401(k) plan. When used in conjunction with a 401(k), it 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 lower- paid counterparts.
Once the determination has been made as to which type of DC plan is best, the big question becomes how to fund it.
There are numerous funding alternatives. Some employers choose simply to pay the agreed upon benefits out of company cash flow and hope that it will be adequate when benefits come due. Others use securities such as stocks, bonds and other investment options to finance their plan.
Unfortunately, unforeseeable market fluctuations can leave these types of plans underfunded when benefit payments are scheduled to begin. Another disadvantage is that investment gains are taxable when realized, which can burden an employer’s bottom line.
To address that, many employers turn to company-owned life insurance (COLI) to fund their DC plans. Under COLI, the employer buys a cash value life insurance policy on each participant, and is the owner, premium payer and beneficiary on each policy. Salary deferrals and/or company contributions are used to pay the policy premiums. 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.
If a participant dies prior to retirement, the plan can provide for a death benefit to be paid to a beneficiary, essentially self-completing the plan. And policy riders can be added to provide disability benefits if disability is a benefit trigger.
Using life insurance as a funding vehicle can also allow an employer to recover the plan cost — in part or in full — through the receipt of death proceeds, and contractually guaranteed cash values can ensure that the funds required to pay benefits will be there when 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 issuer’s claims-paying ability.
How do deferred compensation plans work?
There are four steps to establishing a DC plan. First choose the employees who will be included in the plan, the benefits which will be paid out and the triggers (termination of employment, retirement, disability, death, etc.) that will initiate benefits payment. Step two is deciding where the salary deferrals will come from — will they be taken from current salary or paid in addition to current salary, but deferred until a later date. Step three is the funding vehicle selection — 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.
DC plan benefit payments become a tax deduction to the employer and are taxed as ordinary income to the participant or 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 to attract, motivate and retain high-quality employees — a DC plan may be what you need to meet personal, business, retirement and tax-reduction goals.
Doug Hall is a partner at 1847Financial in Conshohocken.