SERPs: funded plans challenge the unfunded.

SERPs: funded plans challenge the unfunded

With recent changes in benefits regulation, executives must reexamine some of their steadfast policies on financing executive retirement benefits. Should companies consider funding their unfunded plans and thus buy some security--even if that may mean incurring an extra cost?

To fund or not to fund? This question is being addressed by more and more board members and compensation executives in light of the growing security concerns and escalating liabilities associated with supplemental executive retirement plans (SERPs).

Historically, the nonqualified plans that provide the benefits--including ERISA excess and supplemental executive retirement--have been unfunded. Thus, most employers today pay such benefits from general assets when payments become due. Although this approach puts executives in the position of being long-term unsecured creditors, the practice has prevailed for two reasons: 1) executives avoid current taxation, and 2) companies retain use of plan assets in the business.

Now, however, these priorities may be changing. Recent developments are producing large unfunded benefit liabilities and greater sensitivity about the security of these benefits. Employers are starting to reassess their basic philosophy on financing these arrangements. Some employers have adopted "pseudo" funded approaches, such as earmarked assets, corporate-owned life insurance, and "rabbi" trusts. But while these assets are invested or held in trust for the purpose of paying nonqualified plan benefits, they remain assets of the employer. By legal definition, such plans are unfunded.

A growing number of employers are examining other vehicles that allow an employer to set aside assets exclusively for nonqualified plan benefits. They did not consider such funded plans in the past because of tax and other financial implications. But with today's heightened concern over unfunded benefit liabilities, both employers and executives may find that the "price tag" for security is worth paying, especially in light of the lower individual top tax rates enacted in the 1986 Tax Reform Act.

Recent developments that impact funding

What developments are creating interest in funded plans? One factor is the current business environment. In an unfunded plan, executive benefits are not protected in the event of bankruptcy or insolvency, so the promise of future retirement income has become less certain. The wave of merger activity also has created psychological fears among executives about the safety of supplemental retirement benefits.

Another factor is the Tax Reform Act of 1986, which increased the restrictions on benefits available to highly paid employees from qualified retirement plans. Specifically, tax reform lowered existing Section 415 limits for early retirement. The Act also imposed new restrictions, including a $7,000 annual limit (indexed for increases in the CPI) on employee contributions to 401(k) plans and a $200,000 limit on annual compensation that can be considered for qualified plan purposes. In addition, tax reform added a 15 percent excise tax on aggregate distributions from all tax-favored plans, including qualified arrangements, IRAs, and tax-sheltered annuities. Generally, the tax is 15 percent on the excess over $150,000 per year (and $750,000 for distributions paid in a lump sum at retirement). In combination, these limits on qualified plan benefits will result in more executives depending on nonqualified plans for more of their retirement income. In short, a greater proportion of retirement income is now "at risk."

The shift in liabilities from qualified plans to nonqualified plans also has a balance sheet implication for employers. Effective in 1989, FASB Statement 87 requires that balance sheets reflect unfunded plan liabilities. Most employers are not eager to disclose what likely will be a large and growing unfunded liability in their financial statements.

The good--and bad--of funding non-qualified plans

Many alternatives--both funded and unfunded--exist for the financing of nonqualified plans. No single method is ideal. Choosing the "right" method requires balancing the needs of the employer and the employee and considering the various tax and legal consequences.

The primary advantage of a funded alternative is benefit security. Under a funded approach: * Assets are for the exclusive benefit of plan participants. * Assets are not available to the employer. * Assets are not available to creditors in the event of bankruptcy. Another advantage to funded plans is that they may be designed to cover any employee or group of employees, whereas unfunded plans (excepting ERISA excess plans) must be restricted to a select group of management or highly compensated employees. Also, for balance sheet purposes, funded plan assets offset liabilities.

What is the trade-off? Under a funded approach, an employer does not have use of--or access to--plan assets. And in some cases, the rate of return achieved on funded plan assets may be lower than the opportunity or borrowing cost of capital. In addition, employer contributions to a funded plan--and the earnings--are taxable when they become vested to the executive.

This immediate taxation of executives has been a major deterrent to funded plans in the past. One solution is for employers to equalize the tax effects of a funded plan with those of an unfunded plan. That is, they provide executives with "gross up" payments to cover tax liabilities.

Initially, employers may view the "cost" of a tax-equalized funded plan as a draw-back. However, employers are finding that paying executive taxes does not necessarily create an incremental cost. Why not? To the extent that taxes on executives for contributions to funded plans are paid upfront, distributions from the plan are nontaxable. So employer contributions to a funded plan can be reduced to a certain level, and the after-tax value of benefits will be the same as in an unfunded plan. Under both approaches, an employer pays taxes on asset earnings, but with a tax-equalized funded plan, the employer makes the payments for executives and may take a tax deduction. Tax payments made by employers on behalf of executives are based on the lower individual rate rather than the corporate tax rate (28 percent versus 34 percent). For those who believe tax rates are at an all-time low, upfront taxation at 28 percent makes funded plans even more attractive.

What is the relative cost of the two approaches? The longer the deferral period, the greater the cost of an unfunded plan relative to a tax-equalized funded plan--assuming different tax rates also will affect the cost comparison. At higher employer tax rates (i.e., more than 34 percent), the cost of a tax-equalized funded plan drops compared to an unfunded plan. Conversely, at a zero percent tax rate, the cost of an unfunded plan decreases and the cost of a funded plan increases. An unfunded plan, therefore, may be more suitable for tax-exempt employers. At higher employee tax rates (i.e., more than 28 percent), the cost of a tax-equalized funded plan increases slightly.

Choose from three funding methods

Three important methods for funding nonqualified plans are secular trusts, annuities, and life insurance.

A secular trust, some say governed by rules in Section 402(b) of the tax code, is an irrevocable trust with separate employee accounts. (It is referred to as a "secular" trust to distinguish it from a "rabbi" trust.) Thus, it is more suitable for defined contribution plans than defined benefit plans, which typically are funded and administered on an aggregate basis.

Secular trusts offer employers a greater degree of investment flexibility than do annuities or life insurance. One disadvantage of a secular trust is that earnings are taxable to the executive as soon as they become available (unless funds are invested in tax-exempt bonds). Under annuity and insured arrangements, earnings are tax deferred.

Expenses associated with a secular trust include the cost of trust administration and investment management. However, unlike insured and annuity arrangements, secular trusts do not have any expenses related to agent commissions or risk charges.

Annuities will provide employee retirement benefits under Section 403(c) of the tax code. An employer purchases annuity contracts for selected executives in order to supplement either a defined benefit or a defined contribution plan. If the supplemental promise is a defined benefit, fixed annuities are purchased based on the benefit accrued at the time of purchase. Additional annuities are purchased for future accruals under the plan. If the arrangement is a defined contribution, a variable annuity is purchased based on the amount of the defined contribution at the time of purchase. The same variable annuity contract can be used for future contributions. Variable annuities are offered with a guarantee of principal and fixed interest or with equity-type products similar to mutual funds.

What is the primary advantage of annuities? It is the tax-deferred inside build-up of earnings, for both fixed and variable types, although the initial amount paid for the annuity is taxed to the employee when purchased. Another advantage is that an insurance company guarantees the benefit against any losses. On the downside, investment flexibility is limited to the offerings of the insurance carrier. And, since most supplemental plans cover small groups of employees, fixed annuities that allow the employer to participate in gains and losses relating to mortality and interest assumptions usually are not available.

The cost of annuities includes a small commission to an agent and, in some states, premium taxes. Other charges relate to benefit guarantees and investment management. Administrative costs for annuities are lower than for a secular trust to the extent that investments and disbursements are handled as part of regular operations.

Life insurance is also used to fund nonqualified plans. An employer purchases the insurance and retains ownership of the pure term element, while cash value ownership is assigned to the executive. The cash value of a life insurance policy is better suited to a defined contribution plan than a defined benefit plan.

Like annuities, the inside build-up of life insurance earnings is tax deferred. Moreover, if the benefit is received as death proceeds by an executive's beneficiary, the earnings are tax free. In addition, the cash value of the insurance may be borrowed by the executive before or after retirement without incurring taxation. However, Congress continues to scrutinize this tax advantage and may legislate a cutback in the attractiveness of these products sometime in the future.

Investment flexibility with life insurance also is limited to the products offered by insurance carriers. Universal life policies, however, are offering an increasing variety of investment vehicles. This, in addition to the fact that the cash value is clearly separate from the pure insurance element, makes universal life insurance an appealing insurance product for funded plans.

A major disadvantage of life insurance as a funding approach is the additional cost incurred for the pure term insurance element. In addition, agent commissions for life insurance can be quite substantial--especially in the first year. But perhaps the biggest disadvantage is the uncertain future of life insurance as a flexible investment tax shelter.

A philosophical decision

What are an employer's objectives and philosophical approach regarding executive benefits? That remains paramount in determining whether to fund or not to fund a nonqualified plan. In light of new benefit security needs and balance sheet requirements, employers may wish to reexamine this question. Based on the reevaluation, a funded plan may be best suited to meet the future benefit obligations created by nonqualified plans.