Funding SERPS: how to reduce the pain.
Before the 1986 Tax Reform Act, minimum-deposit (leveraged) life insurance had been used as a way to fund the increasingly popular Supplemental Executive Retirement Plan (SERP). But because companies had begun to abuse the technique, Congress and the U.S. Treasury introduced restrictions in TRA 1986 that made leveraged life much less desirable. Financial executives have been in pursuit of new ways to fund SERPS ever since. And those that should have leveraged life plans on the books have a problem: how to extricate themselves from these policies in such a way that the benefits are secure and the cost to the company is minimal.
First, some background on SERPs. The concept was introduced after tax laws in 1982 and 1984 curtailed benefits that could be provided under qualified retirement plans. The 1982 tax law lowered the ceiling on pension benefits for qualified plans from $136,000 to $90,000 and reduced the maximum annual contributions to a defined contribution plan from $45,475 to $30,000. The 1984 tax law removed the tax advantages of discriminatory group life insurance. As a result, companies began looking for new approaches to make up for what the tax laws had taken away from an executive's retirement income. Their solution--the SERP.
The concept caught on quickly. In 1986, Towers, Perrin, Forster & Crosby estimated 67 out of the Fortune 100 companies and 59 out of the nation's top 100 service companies had SERPs. And a more recent survey of 87 of the top 100 industrial companies by Hewitt Associates indicated that 93 percent have some sort of SERP.
They became--and continue to be--so popular in part because companies can adapt the concept to fit their fiscal policies and objectives, such as rewarding executives for past service or providing incentives for increased productivity. For example, one corporation's SERP can provide lifetime benefits calculated on the executive's final pay. A second company's SERP can provide a pension that equals the average of the highest five annual supplemental bonuses, while a third can pay a percent of compensation times years of service.
As SERPs became more popular, insurance agents began to market leveraged life policies to fund them. Under the leveraged life insurance funding approach, the corporate employer purchased, owned, and was the sole beneficiary of a permanent life insurance policy on the life of each participating executive. The corporation borrowed against the policy cash value to pay the premiums and the benefits to the executive after retirement. At the death of the executive, the corporation received the life insurance policy proceeds tax free, which effectively reimbursed the corporation for both the cost of providing the executive benefits and the cost of the insurance.
Non-taxable cash buildup
The approach was attractive because the cash buildup of the life insurance policies was not taxed unless the policies were surrendered before death. And, by borrowing from the policy, companies reduced the corporate cash flow required to fund the benefits. What's more, they could deduct the interest paid on the borrowed cash value of the life insurance policies.
But, seeing a tax-free form of borrowing, companies began to abuse the advantages of leveraged life insurance. So the U.S. Treasury and Congress set about eliminating deductions for borrowing on life insurance policies, and, with the Tax Reform Act of 1986, interest on aggregate loans in excess of $50,000 on any life insured by a policy owned by a business is not deductible.
A second problem surfaced under TRA 86: as corporate tax rates dropped, deductions for those interest payments had less value. For example, at the old tax rate of about 50 percent, a $1 million interest payment actually cost $500,000 after taxes. But at the new rate of 34 percent, the $1 million interest costs $660,000 after taxes, a 32-percent increase in after-tax costs. If interest payments reach $5 or $10 million, the increased after-tax costs could dramatically alter the plan's original assumptions.
TRA 86 also contains provisions to curb the systematic borrowing from life insurance policies to pay premiums, the cornerstone of leveraged life.
But the hundreds of companies with leveraged-life policies that have been in effect for several years can't simply walk away from them. Because the cash value in an older policy usually exceeds the premiums paid, the company will have taxable income if the policy is ended for any reason other than the insured executive's death. So once the company surrenders policies to relieve its responsibility to repay the loans, the company is taxed on the phanton income.
In order to extricate themselves from their leveraged life SERPs, companies have several alternatives: (1) take a portion of the policy's remaining cash value and purchase a reduced paid-up policy to avoid tax consequences; (2) kill the plan and pay the taxes; (3) do an IRS Section 1035 tax-free exchange, using a funding mechanism that avoids future leveraging of corporate-owned life insurance.
Option three is the most palatable for most companies, and, for the reasons just mentioned, the sooner they make the change, the better: too long a delay in terminating the leveraged policies may result in serious financial ramifications.
New funding methods
Since 1986, companies have been searching for other means to fund SERPs. They have several options: these include the pay-as-you-go method, the sinking fund, and trust-owned life insurance (TOLI).
The pay-as-you-go method allows a corporation to keep its cash fully invested in the business, but it represent an absence of planning. If one or more executives die early, there can be a significant corporate cash drain. And if the company should fall on hard times, benefits to executive retirees could be reduced or eliminated entirely.
With the sinking fund, the company systematically sets aside amounts it projects will be sufficient to pay deferred executive benefits as they become due. These funds can be invested in stocks, bonds, bank accounts, and other investments. But there is always the risk that with premature executive deaths, poor investment results, or a downturn in the company's profitability, the fund may be insufficient to pay plan obligations as they become due. Further, dividends, interest, and capital appreciation are taxable, thereby reducing real returns. And there is no tax-free death benefit of life insurance to reimburse the company for its costs in providing the benefits.
While there are many investment vehicles that can match corporate liabilities and provide security to the executives, the tax-sheltered investment results and death benefits of life insurance still make it a desirable funding vehicle for non-qualified plans. Insurance can provide flexibility in adapting to changing business conditions, and if the policies are not leveraged, real--not phantom--income is available to pay taxes due if the policies need to be surrendered.
Trust-owned life insurance (TOLI) is arguably the best funding alternative to leverage life insurance plans. With TOLI, the company funds the SERP liability by structuring a non-qualified irrevocable benefit trust, also referred to as a rabbi trust. Rabbi trusts are grantor trusts set up by a corporation exclusively to provide specified benefits. They provide security to plan participants in the event of a change of control--or a change of heart. One caveat: plan participants are at risk should the company encounter financial difficulty.
A number of fully funded TOLI policies can be used to provide the benefits, such as variable life or policies indexed to outside indicators such as Moody's Bond Index.
Modified split-dollar policy
But the most attractive TOLI option is a modified split-dollar policy, under which the corporation makes cash premium payments during the participant's employment and takes an assignment of the cash values equal to these payments. The company projects the amount of cash required to fund promised benefits, and the insurance policy is structured so that when the executive retires, the corporation receives a lump sum equal to cumulative premiums paid out from the cash value of the policy and releases its collateral assignment in the policy. Since the employee is the beneficiary of the policy the corporation is not taxed upon termination of the plan. Neither is the company taxed when it is repaid the premiums from the cash value of the policy and releases its security interest (as in the event of a policy transfer). In essence, the company has purchased a non-income-producing asset. The executive gains security, and the company transfers benefit liability off its books.
The corporation cannot deduct its premium payments, so annual cash value increases of the policy do not constitute taxable income to the firm or the participants. But the participants are taxed on the retirement income payments they receive under the plan.
At retirement, the executive has several options: cash out the policy; convert it to an annuity and receive taxable annual payments from the trust; or keep the policy as a tax-free death benefit. Since the assets are owned by participants, they are beyond the reach of creditors in the event the company goes bankrupt after the executive retires.
The shift from unfunded to funded SERPs in many large corporations indicates the concern about benefit security that corporations and key executives share. Corporations want to attract and retain key personnel while minimizing benefit liabilities, and executives want secured retirement benefits. Given the current tax climate, the conversion of leveraged life insurance funding of existing SERPs to trust-owned life insurance makes both dollars and sense.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||supplemental executive retirement plans|
|Date:||Jul 1, 1991|
|Previous Article:||Don't take the cost of multiemployer benefit plans for granted.|
|Next Article:||Executives should earn their retirement income.|