Many have insufficient funds set aside to maintain their standard of living when they retire
By Matthew Fitch, JD, CLUMr. Fitch is Advanced Markets Consultant with The Hartford, Hartford, CT. He can be reached at [email protected].
Life insurance, as every sales professional knows, is something people know they need, tend to want, but procrastinate buying. This general attitude makes life insurance a natural fit for employee benefit packages of all stripes. When an employer provides something the employee wants, but knows she probably won’t buy on her own initiative, the benefit may be an incentive for her to remain with the employer.
Of course, not all plans are created equal. On the one hand, rank-and-file group benefits usually offer minimum coverage as the default option. In this case, the employee incentive is commensurate with the benefit – it’s on the smaller side.
Move up the pay scale, and the story gets more interesting. Permanent products with cash value enter the mix, and the employee incentive becomes about more than death benefit coverage. Many highly compensated employees have insufficient funds set aside to maintain their standard of living when they retire, because traditional retirement plans restrict the amount they can set aside on a pre-tax basis. Life insurance, while generally not available on a pre-tax basis, does allow net premium dollars to accumulate tax-deferred. So whether the employer wants to offer the employee direct access to policy cash, or use it to fund another benefit, the tax-advantaged cash buildup combined with the death benefit make it an extremely versatile tool in the executive benefits toolbox.
Over the past ten years, the markets for employer-owned and employer-funded individual life insurance have seen significant developments affecting many of their major “go-to” strategies. Much of the change has been regulatory. During the same period, life insurance products evolved to include revised and improved mortality benchmarks, as well as many market-driven product innovations. Yet for all the change, the corporate client’s thinking about life insurance remains molded to three of the remaining viable “go-to” models – non-qualified deferred compensation, split dollar, and executive bonus plans. This article explains how these strategies fit with today’s regulatory and product environment.
Non-Qualified Deferred Compensation Plans
Non-Qualified Deferred Compensation (NQDC) allows an employee to defer payment of current taxable earnings until retirement. Early termination of employment or another triggering event can result in total forfeiture of the income. This risk is exactly what makes the strategy viable – without it, all deferred amounts would be taxable to the participant in the year earned.
To the extent assets are earmarked by the employer for future payment of deferred amounts, they get no special treatment. They are subject to creditor claims, and earnings are currently taxable to the employer. The employer can dispose of the assets as it wishes – its only obligation under the agreement is to pay the benefit when the time comes. This “informal” funding exempts the plan from most of the requirements of the Employee Retirement Income Security Act of 1974 (ERISA).
Employers want ways to offset taxes on earnings, the loss of a current deduction, and other long-term costs of NQDC. The tax deferred cash value growth of a life insurance policy can help, because earnings on cash value are untaxed during the accumulation phase. On payout, the employer can access funds to pay plan benefits by using tax-advantaged policy loans and withdrawals (actually creating positive cash flow for the employer during benefit-paying years, because payouts are tax-deductible). Finally, the policy’s death benefit helps recover the premium and administrative costs, and fund key man replacement if the employee dies while employed. (The corporate alternative minimum tax could apply to the death benefit.)
Deferring compensation generally only makes sense for employees of C Corporations and for select employees of S Corporations and other pass-through organizations. Deferred wages in a pass-through organization are also treated as retained earnings and may be taxed as such. Compensation to S Corporation shareholders or pass-through members themselves does not generally qualify for a deduction.
Since 2005, all non-qualified deferred compensation (NQDC) arrangements, past and present, must meet the requirements of IRC Section 409A, which codified the loose body of rules that had governed such arrangements. Section 409A governs, generally, when amounts deferred under a plan can be distributed, the timing of initial elections to defer compensation, reporting requirements, and penalties for non-compliance. It also requires agreements to be in writing. Failure to comply with 409A can make the plan costly for employer and employee alike.
To ensure 409A compliance, the use of a third party fiduciary-administrator (TPA) is all but mandatory for NQDC. While many TPAs offer services at very reasonable cost, employers can no longer avoid costs entirely by relying (for example) on handshake agreements with employees. The new formality and costs of a TPA can deter the casual player simply looking for a place to park extra money.
A split dollar life insurance arrangement is created when an employer provides death benefits to a valued employee, but secures repayment for itself as part of the arrangement. Unlike NQDC, the services of a TPA are not usually required. There are several types, but two predominate: endorsement and loan regime arrangement.
Under a traditional endorsement split dollar life insurance arrangement the employer owns the policy, and endorses the death benefit in excess of the cash value (or its premium cost, whichever is greater) to the employee, who has no access to policy cash values. The employee reports the value of the death benefit protection provided by the employer as taxable income each year.
A split dollar loan regime arrangement is where the employer loans the money to pay premiums to the employee. (Often, the employer makes the loan by paying the premium directly to the insurer.) The employer is given a collateral interest in the cash value and death benefit to the extent of its loans. The employee has the right to any cash value and death benefit in excess of the employer’s interest. The employee pays loan interest annually to the employer; accrual would reduce the arrangement’s efficiency, and could result in the IRS treating the arrangement as equity collateral assignment – a type that was taxed out of existence with the publication of the 2003 split dollar regulations. Equity collateral assignment limited the employee’s obligation to premiums paid without interest, permitting effective arbitrage in the account value.
Split Dollar Today
The main benefit of split dollar today is low out of pocket employee cost of coverage. With loan arrangement, cash value arbitrage is still possible, but offset by the cost of borrowing. With endorsement split dollar, a problem tends to emerge as the employee ages, and the reportable economic benefit cost becomes less manageable. Giving the policy to the employee cures the problem, with tax consequences to the employee. Alternatively, the employer can cancel the death benefit endorsement and keep the policy, but the employee incentive is lost.
Additionally, Section 409A may apply in addition to split dollar rules when certain benefits are included in the agreement.
Section 162 Bonus
In a sense, a Section 162 Bonus Plan is hardly a plan at all. The employer pays part or all of the cost of an employee-owned life insurance policy. Assuming the payment is “reasonable” under the terms of IRC S. 162 and associated Treasury regulations, it is treated as employee compensation, taxable to the employee, and tax-deductible to the employer. The employee’s cost of the tax on the bonus can be amply offset by a “double bonus” from the employer; like the premium cost, it is also deductible to the employer.
As with split dollar, the services of a TPA are not required, and there are no record-keeping requirements specific to this kind of arrangement. Not even the relatively uncomplicated 101(j) reporting applies, since the employer does not own the policy.
Any “transition cost” problem is moot from the outset, since in the typical case the employee always owns the policy. As mentioned previously, there are tax costs and offsets, but they are largely known in advance since they are based on the premium, not an uncertain future fair market value.
The employer can incent continuing service by requiring the employee to accept restrictions on access to policy values. The restrictions can lift over time according to a vesting schedule.
As with NQDC, the deduction for reasonable compensation is for employees of C Corporations and for select employees of S Corporations and other pass-through organizations such as Limited Liability Companies (LLCs).
Section 162 Bonus Today
Alone among the “big three” strategies, Section 162 Bonus has not had a major regulatory overhaul.
Today, insurance features that used to be exotic, hard to underwrite, or just plain unimagined are now commonly available alongside traditional offerings – often in the same contract. While the underlying tax calculus of NQDC, split dollar, and Section 162 Executive Bonus has not fundamentally changed, the increased quality and variety of life insurance products contributes to the strategies’ ongoing viability.
For example, indexed universal life (IUL) now dominates a swathe of the risk-reward continuum that was mostly empty in previous decades. Employers who are bullish on markets, but won’t tolerate the bottomless risk associated with pure variable life have a new alternative for NQDC. Moreover, products built for the corporate-owned life insurance (COLI) market provide strong cash surrender value support to justify having NQDC on a balance-sheet.
However, lower product pricing due to improved mortality benchmarks has not done much to offset the costs of NQDC. While the cost of pure insurance has come down, this does not help with the fundamental mechanism of NQDC: maximum funding for maximum accumulation. Leaner mortality costs also result in lower contract funding limits relative to policy benefits under IRC Sections 7702 and 7702A.
Lastly, living benefits based on the health or age of the insured person can help a company fund its NQDC plan obligations, even providing access to funds in excess of the account value on a tax-advantaged basis. Employers should verify that they qualify for the favorable tax treatment before purchasing a policy with any of these types of benefit.
Split dollar can accommodate all of the above product features, and more. If a low-cost/low accumulation product is desired, and/or long-term death benefit guarantees, such products are now also widely available. These may suit employers and employees who are able to use funds other than policy values to pay the cost to terminate the arrangements.
Employers will find the most flexibility in the Section 162 Executive Bonus market. With the exception of COLI products, the only limitations on product selection depend on what benefits the employee wants and what the employer wants to spend. Living benefits are particularly attractive in this space, because the policy values are unconnected with any obligation of, or to, the employer.
In the discussion above, “employer” and “employee” may refer to a large operation with hundreds of key employees, or to the same individual, using the strategies to benefit him- or herself in both roles. “Incentive” may mean traditional corporate talent retention, or the artful self-dealing of an owner/employee. On each end of this employment spectrum, and everywhere in between, NQDC, split dollar, and S. 162 Bonus all fit as comfortably as they ever did. Some of the rules may have changed, but the game is still the same – and the new world of longevity and product innovation make it that much more interesting. Corporate players need to understand that in life insurance they have a tool as flexible as their retention strategies, and that if it isn’t ultimately needed to do one thing, it can do another, or several. And they need to be reminded of something else: with the rule allowing tax-free exchange of one life insurance contract for another, they and their employees are never really locked in – as insurers continue to innovate, clients can always “trade up” to a newer model. The true cost is in procrastination, because though much has changed, one thing never will: all things being equal, insuring a person when they are young is easier on the corporate purse than when they are older.