The tamperproof benefits package.
Aside from equity holdings, a CEO's most valuable asset may be a non-qualified benefits plan. But recent changes in tax codes and corporate compensation policies--to name but two factors--have placed many such plans at great risk.
Moreover, because of increasing restrictions on qualified benefits plans--including 401(k)s, and pension and profit-sharing plans--non-qualified benefits now comprise a larger component of CEO net worth and post-retirement compensation. In fact, for some top-level executives making over $200,000 per year, non-qualified plans may represent over 75 percent of capital accumulation and retirement benefits.
With that much at stake, the development of a protection strategy for these assets is essential. Here's how to preserve and maximize the value of your non-qualified package.
Qualified plans are governed by the Employee Retirement Income Security Act (ERISA) and must be offered to all employees. But tax law changes have steadily restricted the benefits that can be offered to middle- and senior-level executives through these plans, thus hampering the ability of executives to plan for retirement. Today, executives can receive no more than $112,221 annually from qualified pension plans, down from $136,000 in 1982. The maximum amount that can now be contributed to an executive's qualified defined contribution plan is $30,000 per employee, down from $45,475 in 1982. Qualified benefits have also been curtailed on a stand-alone basis. For example, the maximum that an employee can contribute to a 401(k) plan is $8,728, down from $30,000 in 1982.
Because of such restrictions--and the fact that not all companies offer an array of qualified benefits--many executives earning over $75,000 are likely candidates for a non-qualified plan. This plan can be custom-tailored to enhance benefits for top management and to help the corporate sponsor attract, motivate, and retain top-level talent.
Both qualified and non-qualified benefits rely on compounding and investment appreciation for maximum growth over time. By definition, qualified plans grow on a tax-deferred basis. Non-qualified plans can also defer taxes, depending on the underlying asset that is employed. The similarities, however, usually end here.
Funds for qualified plans must be secured in a financial institution or trust, i.e., they are placed outside the company and disbursed by a third party upon the beneficiary's retirement, disability, or death. Non-qualified plans are most often held in the corporate treasury and are disbursed at the corporation's discretion.
Non-qualified plans are therefore subject to the claims of general creditors should the corporation become insolvent. They can also be subject to the risk that the corporate sponsors may refuse to pay in spite of a contractual obligation, thus necessitating that the participant sue for the benefit, likely resulting in a discounted settlement.
These actions could occur either prior to, or during, retirement. To be sure, a retired executive's negotiating power is limited, at best.
In addition to mergers and acquisitions, several factors pose unprecedented threats to non-qualified benefits. These include the leveraged position of many corporations, pressure by institutional investors to reduce executive compensation, the increased likelihood of boards of directors making changes in senior management and their compensation and benefits, and the need of companies to generate cash and to improve earnings in difficult economic times.
Most plans for CEOs have been established by a corporation, at its discretion. The plans are generally, but not always, substantiated by a written agreement and/or board resolution.
As a result, the first step many CEOs should take is to project and quantify the current and future value of qualified and non-qualified benefits to determine the magnitude of their exposure to a possible loss of the latter. This will include a thorough and diligent examination of records and documentation. Calculating the worth of non-qualified plans requires an evaluation of the savings and investment vehicles being employed, a determination of the benefits that can be expected from qualified plans, and an intimate knowledge of how tax laws and regulations affect both types of benefits.
Failure to do so can have dramatic consequences. In one case, a CEO expected his qualified and non-qualified plans to provide annual income that was approximately half of his compensation at the time of retirement. However, when the various limitations imposed by government regulations and the company's own rules were calculated, it was discovered the CEO would receive an annual benefit of 8 percent of his final year's salary. Upon learning this, the CEO remarked to the head of human resources, "This would have been an even more interesting conversation the day before my retirement."
Following a determination of the plan's value, the next step is to look for ways to safeguard the benefits. The funding methods, and their status, should be scrutinized.
Many companies today are placing non-qualified monies in "rabbi trusts." With this funding vehicle, a third party has control of the assets from which the retirement benefit will be paid. The corporation is thus precluded from being able to indiscriminately seize the funds for general business purposes, because the obligation to pay is the decision of the trustee. In the event of a bankruptcy, however, the CEO or executive would be a general creditor.
An even safer alternative is a secular trust, under which an executive owns the funds outright at the time they are set aside. The executive, however, must pay tax in the year the funds are contributed to the trust. Companies can deduct this expense in the year the contributions are made to the secular trust.
As a general rule, CEOs and other executives should request that their non-qualified plans be funded over the time they work with the company. Indeed, this is in the best interests of both the company and the executive.
From the executive's standpoint, future management will probably be less inclined to allocate funds that have not previously been budgeted and set aside, especially when economic times are bad. From the company's perspective, it will be better able to retain top-level executives by funding the plans and demonstrating its commitment to their post-retirement well-being.
Whatever the funding method, it may be meaningless if proper legal documentation is not in place. Even with a rabbi trust, the CEO may be at risk if the plan documentation contains caveats or outright assertions allowing the corporation or board to effectively terminate or amend a non-qualified plan at its discretion.
Once a working knowledge of the facts is gained, key board members and the compensation committee should be approached regarding proposed changes and their cost. Changes usually involve taking steps to ensure the company will honor its promises with respect to a benefits package.
MAXIMIZING A PLAN'S VALUE
Like qualified plans, most non-qualified benefits are subject to income tax when received by the beneficiary or his/her heirs. An estate tax, at the time of death, is also applicable.
Unlike their qualified counterparts, non-qualified plans are not subject to possible excise taxes, but also cannot be rolled into an Individual Retirement Account at retirement to delay taxation. Thus, careful income tax and estate tax planning, along with the use of appropriate payout options, is essential.
Expanded life insurance coverage is one benefit that can help to maximize the value of non-qualified plans to an executive's estate. Generally, group term life insurance terminates or is greatly reduced in value at the end of employment. Thus, upon retirement, executives who have accumulated sizable estates lose their primary source of estate tax liquidity.
One solution that usually benefits both the company and the executive is "split-dollar" life insurance. With this whole life-type product, the premiums, death benefits, and cash values are divided between the executive and the company for a specified period of time.
Typically, an executive pays competitive term rates for an interest in the policy. After a specified period of time, usually 15 years, the split-dollar arrangement terminates, the company recovers the premiums it has paid, and the executive is left with reduced but permanent coverage. In the event the executive dies before retirement, the company will also recover the premium payments it has made through an interest in the policy death proceeds. Unlike group term life insurance, the corporate portion of the split-dollar premiums generates a corporate asset, thereby providing a more favorable effect on the profit-and-loss statement.
TAKING A HANDS-ON APPROACH
The permanent coverage the CEO and other executives receive from split-dollar insurance can safeguard the value of an estate. The proceeds can be structured to avoid estate taxation but still be available to pay estate taxes that would otherwise be incurred based on the value of qualified plan benefits, other non-qualified benefits, and the value of stock options and restricted shares.
Also keep in mind: Full and prudent use of the annual gift-tax exclusion ($10,000 per year, per donation) and a lifetime gift-tax exemption ($600,000 each for both an executive and spouse) can also be used to maximize the value of benefits that can be passed on to one's heir.
Given recent changes in tax law and a host of other factors, it is essential that a CEO take a hands-on approach to managing a non-qualified benefits plan. Certainly, that includes staying abreast of modifications of the tax code and changes in corporate benefits policies.
Nonetheless, because non-qualified benefits plans are highly complicated vehicles, it is also advisable for those involved to evaluate them in conjunction with both a benefits consultant and an attorney. When properly protected, non-qualified plans can provide true retirement security.
R. David Sprinkle is president of The Todd Organization of the Carolinas, and a principal with The Todd Organization, a nationwide leader in the design, implementation, and administration of executive benefits. Todd is comprised of 10 member offices in the U.S., which serve Fortune 500 companies, entrepreneurial concerns, and other companies and associations.
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|Title Annotation:||CEO Finance|
|Author:||Sprinkle, R. David|
|Publication:||Chief Executive (U.S.)|
|Date:||Mar 1, 1993|
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