"SERPs" up: retirement benefits for senior executives; why supplemental plans for top management are an increasing important part of compensation packages.

The principal purpose of a supplemental executive retirement plan (SERP) is to ensure adequate post-retirement income for selected senior executives. Under these plans, they receive benefits beyond those provided by the employer's qualified retirement plan. SERPs are becoming increasingly popular--a recent survey of the Fortune 100 industrial companies showed 93% currently maintain SERPs.

WHY A SERP?

SERPs are beneficial to executives and employers for many reasons. For the executive, the principal benefits are the supplemental retirement income and survivor compensation in the event of the executive's premature death.

The benefits usually are carefully defined and easily understood by the executive. Typically, SERPs do not require that performance goals be achieved but do require continued employment to a specified age for eligibility. As opposed to many other forms of compensation, the executive is able to defer tax on the earned benefits until they are paid, usually after retirement.

A substantial disadvantage to the executives covered by a SERP is that the employer's obligation to pay the promised benefit is unsecured. Although certain techniques discussed below may provide limited security for the executive, the participant must rely on the employer's financial stability.

This reliance is a disadvantage often overlooked by executives. Today's turbulent economic and legal climates have left major corporations unable to meet their legal obligations, including those owned to their employees. One prominent example is LTV Corporation, which has been in bankruptcy since 1986 and was the subject of a U.S. Supreme Court decision. The Court ordered LTV to reassume responsibility for its pension plan, thereby relieving the Pension Beenfit Guaranty Corporation, but left it up to the bankruptcy court to set priorities for the company's obligations.

Still, SERPs remain attractive to employers since they can provide benefits to a select group of executives without jeopardizing the preferred tax status of retirmenet benefits under qualified plans. What's more, the employer needn't provide the same benefits to a broad group of employees. If the company had to provide these benefits to a large group of employees, often it would not provide the benefit at all.

A employer can use a SERP to

* Facilitate early retirement for executives whose services are no longer desired.

* Attract senior executives who otherwise would receive an inadequate pension due to short service.

* Enhance the executive compensation package to motivate toplevel executives.

* Protect selected executives against involuntary termination.

* Create "golden handcuffs" by proportionately increasing benefits for additional years of service, thus providing a financial incentive for valued executives to remain with the company.

WHY NOW?

Changes in tax law have increased the popularity of nonqualified deferred compensation. Tax reform legislation has reduced the amount of benefits an executive can receive from qualified plans and increased the expense of providing a particular level of benefits to executives.

In annual reports to Congress, the Office of Management and Budget consistently lists qualified employee benefit plans as the single greatest "tax expenditure" in the federal system. In an era of proclaimed fiscal responsibility and a mounting deficit, Congress is likely to continue to reduce benefits and tax advantages associated with qualified retirement plans, particularly those for highly paid executives. Accordingly, employers will continue to search for programs that supplement or replace qualified employee benefit plans for these executives.

SERPs vs. EXCESS BENEFIT PLANS

Employers can use two principal types of nonqualified deferred compensation arrangements to bypass the qualified plan rules: the excess benefit plan and the SERP.

An excess benefit plan must be limited to providing employees with benefits in excess of the maximum qualified retirement plan benefit and contribution limitations, the so-called section 415 limits. While there is no limit on the type or number of employees that can be covered under an excess benefit plan, as a practical matter such plans usually are limited to highly paid executives since they are the ones whose benefits under a qualified plan would exceed the section 415 limits.

A SERP is more flexible and comprehensive. Unlike the excess benefit plan, SERPs are not limited to replacing benefits and contributions restricted by the section 415 limits. In their broadest form, SERPs simply are nonqualified deferred compensation plans providing retirement benefits.

In practice, these plans provide specialized retirement planning for the covered executives. For example, an employer can use them to provide additional retirement benefits for management of a particular division or to replace benefits that an executive may have lost in midcareer after resigning from a previous job.

AVOIDING QUALIFIED

PLAN RULES

A properly structured SERP is not subject to the rules in the Internal Revenue Code governing qualified plans. For example, with a SERP an employer can

* Provide benefits based on compensation in excess of the limit imposed by the code. For 1990, the $200,000 cap on the amount of compensation that can be taken into account under a qualified plan was raised to $209,200 to reflect cost-of-living increases (see exhibit 1 on page 97).

* Provide for employee-elective pretax deferrals in excess of the limit--$7,979 as adjusted for 1990--allowed under cash-or-deferred arrangements such as section 401(k) plans.

* Provide for contributions in excess of those allowed by the nondiscrimination rules for employee-elective deferrals and employer-matching contributions.

* Provide benefits based on a broader definition of income (for example, deferred compensation and bonuses) than the employer's qualified plan.

* Avoid the 10% added tax for certain qualified-plan distributions to employees younger than 59 1/2 years of age.

* Avoid the 15% excise tax on annual distributions over $150,000.

SETTING UP A SERP

To avoid many of the burdensome requirements of the Employee Retirement Income Security Act of 1974 (ERISA), a SERP must qualify as a "top-hat" plan--that is, a plan that is unfunded and maintained by the employer primarily to provide deferred compensation to a select group of management or highly compensated employees. If a SERP does not qualify as an unfunded top-hat plan, it will be subject to all ERISA requirements. Under ERISA, among other things the SERP would have to be funded; its assets would have to be held by a trustee in an irrevocable trust; and, in addition, coverage, fiduciary responsibility and prohibited transaction rules would apply. (See exhibit 2 on page 97 for a comparison of the requirements for qualified plans versus SERPs.)

Unfortunately, the Labor Department has never issued regulations defining a "select group of management or highly compensated employees" or, when a plan exists, "primarily for the purpose of providing deferred compensation." Defining these terms is often particularly difficult. The Labor Department long ago stopped ruling on whether or not employees are highly compensated because this decision involves a question of fact rather than law. In addition, the Labor Department has indicated publicly that it will rescind its old advisory opinions describing a top-hat plan because they no longer reflect the department's position. A regulation project on this issue was opened in 1989, but it appears unlikely that anything will be issued in the near future.

The top-hat exemption. When setting up a SERP, the employer should take into account the present uncertainty regarding the top-hat plan exemption. If a plan covers only the employer's key executives, it should qualify as a top-hat plan. If coverage extends to a few rank-and-file employees, the plan still may qualify, although this is uncertain. Each plan must be viewed case by case.

In view of this uncertainty, it may be advisable to establish separate SERPs covering questionable employees. This way, a SERP for more highly paid or senior executives will not be adversely affected if the plan covering questionable employees does not qualify for top-hat status.

"FUNDING" AN UNFUNDED PLAN

Even if a plan mainly benefits a select group of management or highly compensated employees, it must be unfunded to qualify as a top-hat plan. Frequently, the employer's ultimate obligation under a SERP is met on a pay-as-you-go basis, directly and solely from the employer's general assets. Without question, a pay-as-you-go plan will be respected as an unfunded plan.

However, SERPs supported by informal funding arrangements are increasingly common. For Labor Department purposes, an unfunded plan generally denotes one that provides benefits from the employer's general assets--even if set aside in a segregated account--so long as the employee does not have a beneficial ownership interest in those assets. In 1985 the Labor Department informed the Internal Revenue Service that for top-hat plans it would accord "significant weight" to certain IRS rulings stating a plan is "unfunded" for income tax purposes. The IRS has reviewed numerous arrangements in which employers walk a fine line between keeping the arrangement technically "unfunded" while providing as much security as possible to the employees.

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Rabbi trusts. The most popular "funding" mechanism at the moment is the so-called rabbi trust (so named because the first such trust was established by a synagogue to supplement its rabbi's retirement income). A rabbi trust is a grantor trust established by an employer to hold deferred compensation or supplemental retirement assets. Although usually irrevocable, some trusts are revocable. In either event, the trust's assets remain subject to the claims of the employer's creditors.

The primary purpose of the trust is to protect the executive's benefits against the employer's refusal to pay benefits when due. This is a particular concern if ownership of the business changes. A greater degree of protection is afforded the executive in the case of an irrevocable rabbi trust because the assets are limited to two uses:

* Payment under the deferred compensation agreement.

* Payment to creditors in the case of the employer's insolvency.

The IRS has issued numerous private letter rulings regarding this type of arrangement. Generally, the employee does not have income for federal income tax purposes until the benefits actually are paid. The employer receives a deduction for federal income tax purposes when the employee is required to recognize the income. The income of the trust during its term is taxed to the employer.

Other "funding" techniques. Many employers have chosen to "fund" such plans by purchasing assets such as corporate-owned whole life insurance. The combination of a tax-deferred build-up of cash values, the tax-free receipt of death proceeds and (although severely limited by the Tax Reform Act of 1986) the deductibility of policy loan

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interest have made such insurance a popular funding vehicle. The policies are owned by the employer, which is the designated beneficiary, and the contract remains part of the employer's general assets, which are subject to the claims of the employer's creditors.

Other popular arrangements used to provide security to employees include

* Third-party guarantees of a related company, whereby a party related to the employer agrees to pay the employee should the employer default on payment obligations for any reason.

* Escrow arrangements, in which an escrow account to satisfy the employer's obligations is established at a bank. Any escrowed assets must remain general assets of the employer and are subject to claims of the employer's creditors.

Exhibit 3 on page 99 compares various "funding" arrangements for "unfunded" SERPs.

SERPs AND LABOR

DEPARTMENT RULES

If a SERP meets the above-discussed requirements, it is exempted from ERISA provisions on participation, vesting, funding and fiduciary responsibility. However, the SERP must comply with the ERISA reporting and disclosure requirements. These requirements, easily met, call for a single filing with the Labor Department of an information statement within 120 days after the plan is adopted, stating the number of employees covered; on the statement, the employer also agrees to provide plan documents to the Labor Department on request. Failure to file the documents can subject the plan to full reporting and disclosure requirements under ERISA.

Although unfunded, the SERP remains subject to ERISA enforcement provisions. Accordingly, a plan participant may bring suit under ERISA to enforce the terms of the retirement plan.

SERPs AND IRS RULES

SERP benefits are taxed to the executive as ordinary income when they are actually or constructively received--that is, when benefits are paid to the executive directly or when he or she has an unfettered right to them. If the employer provides benefits on a pay-as-you-go basis, executives are taxed on receipt of the benefits.

If the employer establishes an informal funding mechanism such as a rabbi trust, the executive will not pay tax on the benefit until it is paid out of the trust. The IRS consistently has ruled that properly structured rabbi trusts do not result in current income to the employees.

Certain other informal funding vehicles (for example, escrow accounts) used to provide increased security to plan participants similarly delay taxation until the executives actually receive payments. However, before adopting an arrangement, the employer should review all relevant authorities to see how the IRS and courts classify such arrangements--ensuring the arrangement does not cause the plan to be "funded" for tax purposes. Unlike a qualified plan distribution, no forward-income averaging or tax-free rollover is available for a lump-sum SERP distribution.

The employer generally is entitled to a federal income tax deduction at the time when the income is

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taxable to the employee. Since the executive is not taxed on amounts contributed on the executive's behalf until those amounts actually or constructively are received, the employer receives no compensation deductions until that time.

Compensation deferred in a nonqualified compensation plan is deemed to be wages for FICA purposes either when the related services are performed or when there is no substantial risk of forfeiture of the executive's rights to the deferred amounts, whichever comes later. For example, if a SERP requires employment until retirement age for an executive to qualify, the risk of forfeiture exists until the year of retirement. If the risk of forfeiture lapses during the executive's final year of employment rather than in the year following retirement, in all probability the executive already will have exceeded the Social Security wage base.

Similarly, if the deferred compensation is not subject to a substantial risk of forfeiture and, therefore, is considered wages for FICA purposes when the services are performed, then the executive is likely to have already exceeded the Social Security wage base.

In either case, once the FICA wage base is exceeded for a year, no additional FICA tax would be due on the deferred compensation.

A CONTINUING TREND

In view of the advantages to both the employer and executive as well as the likely trend of future tax legislation limiting benefits payable to senior executives in qualified retirement plans, it seems clear SERPs will continue to become an increasingly important element of many compensation packages.

DAVID J. KAUTTER, CPA, JD, is a partner in the national tax department of Ernst & Young, Washington, D.C. He is chairman of the American Institute of CPAs employee benefits taxation committee and editor of the Federal Bar Association taxation section newsletter. MARK A. WEINBERGER, JD, is a tax manager in Ernst & Young's national tax department. A member of the American Bar Association's sections on business law and taxation and the Ohio and District of Columbia bar associations, he is admitted to practice before the U.S. Tax Court.