Innovation in Pension Design

Nonqualified Benefit Plans - One Size Does Not Fit All

Engineering stability, and retention, with SERPs

by Randy Kohls

Mr. Kohls is a senior consultant with NFP, an employee benefits administrator, in its executive benefits department.

Employers have long struggled with the ability to attract, retain and reward key talent at their company.

Government limits and restrictions on the amount that employees and employers may contribute toward qualified retirement plans, such as an IRA, 401(k) or 403(b), leave many highly compensated executives – usually key executives – without enough retirement income to sustain their current standard of living.

Simultaneously, over the past several years, we have seen an increase in older executives retiring as baby boomers age. While this generation exits the workforce, recruiting and retaining the next generation of executives has proven difficult. Younger professionals tend to chase fulfillment and fast-paced career moves; however, financial stability remains a concern. When retirement is far-off and more pressing financial needs are in focus, employers need to consider customization.

A supplemental executive retirement plan (SERP) is a Defined Benefit and a great way to solve the issue of governmental limits and the ability to attract, retain and reward key talent.

SERPs are typically designed to compensate for the retirement income shortfall caused by limits and restrictions in qualified retirement plans, often because there are more ways to use SERPs than just for retirement income. The executive benefit planning industry has long focused solely on retirement income because that is how most consultants were trained and introduced to SERPs. Executives at most companies tend to be in their late 40s and 50s, which is where the focus on retirement income originated.

When consultants design SERPs solely for retirement income, because the decision-makers are concerned about retirement, they often make the mistake of designing a plan that fails its primary goal – attracting, retaining and rewarding key talent.

Consider the following:

Executive A is 57 years old. He is married with adult children that live on their own. He is maxing out his deferrals into the company 401(k) plan but still has not saved enough for retirement. His employer wants to reward him for his 15 years of service and keep him around another 10 years until he plans on retiring. Putting a defined benefit SERP in place that promises to pay him 40 percent of his final pay for 15 years will accomplish the employer’s goal because he is only 10 years from retirement and it’s foremost on the executive’s mind.

Now let’s take a look at his successor in training:

Executive B is 40 years old. He is married with three children ages four, six and eight. He is contributing to his 401(k) but is nowhere near maxing out contributions. His employer wants to retain him long term to succeed Executive A. The employer offers him the same defined benefit SERP that will pay him 40 percent of final pay at retirement. Three years go by, and Executive B leaves the company for a higher paying job offer. The plan did not achieve the employer’s goal. Why did it fail?

To most 40 year olds in his situation, short-term incentives are paramount. To promise a benefit 27 years down the road does little to retain an executive, as retirement is not on their radar yet.

That is where many consultants and employers make mistakes in the design process of plans. They don’t put themselves in the shoes of their executives and ask themselves if they were in a similar stage in life, what would matter most to them? They fail to ask each executive being considered if the plan would be valuable to them. Many employers may feel awkward asking their executives, and some executives may be reluctant to answer honestly. That’s where a consultant can be invaluable during the planning process. Asking questions relative to life stages, family dynamics and short- and long-term goals is key to making a plan work effectively.

The executive benefit planning industry has long focused solely on retirement income because that is how most consultants were trained and introduced to SERPs

Once a consultant and employer have a good understanding of what is important to their top talent, a plan can be designed to accomplish the goals. Nonqualified benefit plans can be designed to pay out benefits at certain pre-set dates or life events while still employed. Benefits can be paid to accomplish goals other than retirement.

Here are a few examples:

  • Lump sum in five years for mission work
  • Annual payments starting in 10 years to help pay for children’s college
  • Lump sum at age 50 to buy a boat, etc.

Consider the following alternative benefit design for Executive B and its value to him. Would this plan have been better for retaining him both short- and long-term?

Executive B is 40 years old. Again, he is married with three children ages four, six and eight. After being interviewed, we learn that he is most concerned about paying for college for his children. Therefore, instead of offering him a defined benefit SERP that pays out at retirement, his employer offers him a defined contribution plan that allows the executive to receive part of the money out while still employed.

This plan allows Executive B to direct up to half of the employer contribution into a short-term or “college funding” bucket. This bucket will be set to start paying in 10 years when his oldest child starts college. This will be a valuable source of additional income to help pay for his children’s college tuition. Now the employer has helped solve a near-term financial concern for Executive B and will most certainly work to retain him for the next 10 – 15 years.

The other half of the employer’s contribution will go into a “retirement” bucket. This is set aside and builds for supplemental retirement income. When his last child finishes college, and now retirement is only nine years away, retirement income becomes very important to him. This plan design has already addressed his retirement because there is a sizable account balance already set up for him, and now 100 percent of the employer contributions will be going into the retirement bucket. The employee also may be given the option to defer his own salary and/or bonus in later years to help grow the retirement bucket even more.

Two-Bucket DC Plan Approach

Will this accomplish the employer’s goal? It definitely has a better chance. This two-bucket defined contribution approach is of great value to Executive B. It helps him today with his immediate need of saving for college and also starts to build a retirement account, which once his children are done with college, will become very important to him.

Good young talent can be hard to find, and the cost of hiring and training a new executive is very high. Therefore, if you have one or more individuals in your organization that you have identified as key to the future success of your organization, you want to do your best to retain them.

Younger executives taking over have different needs than their predecessors. If we don’t listen to the needs of these younger executives and customize a plan that meets those needs, we will not get the desired outcome of retaining these executives. If on the other hand, we take the time to engage them in the process, we can significantly increase the chances of success. Loyalty is a two-way street.

Taking an alternative approach to the traditional design of simply focusing on retirement is needed more now than ever. This approach has been well-received by our clients over the past several years and non-traditional designs are becoming more common.

Employer goals of retaining, recruiting and rewarding executives can be accomplished utilizing a Nonqualified Plan as long as we remember that, “one size does not always fit all”. ◊