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Securing Retirement Income from Supplemental Executive Retirement Plans (SERPs)Win-win strategies for executives, companies, and their shareholders.William L. MacDonald
Supplemental Executive Retirement Plans (SERPs) continue to play an increasing role in executive compensation packages. Most SERPs represent an unfunded obligation of the employer and usually are offered in addition to the company’s tax-qualified retirement plans, which are fully funded and fully secured under ERISA. Because most SERPs are unfunded, an executive's SERP entitlement usually is subject to the risk that at some point in the future the employer may be unwilling or unable to pay. Many executives who are counting on this asset for their retirement are now considering how to reduce or eliminate the risk that they might lose benefits if their employer is unwilling or unable to pay them. A second risk the executive has involves future tax rates. A premise of most SERP and deferred compensation plans is to defer taxation until retirement when, presumably, one would be in a lower tax bracket. But, at present, combined marginal income and capital gains tax rates are at an all-time low, and if rates increase, taxes will take a bite out of an executive’s SERP benefits. No one can accurately predict future tax rates. Consider these top US income tax rates (Chart I), and you make the prediction: Are tax rates going to go up or down in the future?
When you look at SERPs from the company’s standpoint, you need to look back to see why these arrangements became so popular, and to question whether they still make sense in their current form. Defined Benefit pension plans were a staple of corporate retirement delivery; however, DB plans (and DB SERPs) began to lose favor because:
Defined Benefit SERPs, though, were not often immediately redesigned. We are just now seeing companies reevaluate their nonqualified DB SERPs and examine methods to update/retool them. The right solution will depend on a balance of several factors that we will cover in this article. To further illustrate the issue, let’s imagine the case of a sample executive, age 58, who plans to retire at age 65. He expects a projected SERP pension benefit of $982,592 per year for life beginning at age 65. The actuarial present value of the company’s pension liability today (when the executive is age 58) is approximately $7.388 million.1 In addition, the company has budgeted additional accruals between now and the executive’s retirement at age 65, bringing the total liability to $10.3 million at retirement. There are several ways that his employer might reduce, or eliminate, the risk to the executive that he may not receive his pension due to the company's future unwillingness or inability to pay it. These risk-reducing steps include these strategies:
Each of these arrangements creates various tax and accounting issues. Also, if the executive is a Named Executive Officer under Item 402(a)(3) of SEC Regulation S-K, proxy statement disclosure issues also will be involved. The impact on shareholders must be evaluated (which we will examine in the Summary of this article). This article considers each of these issues, but, as always, an employer should obtain the advice of its counsel or accountant based on the specific circumstances involved.
1. Funding a Rabbi TrustUnder this arrangement the employer would transfer assets to a trust for the exclusive purpose of paying benefits to the executive. The Rabbi Trust must have a provision in which the assets would remain subject to the claims of the general creditors in the event the company becomes insolvent. To the extent that assets are held in the Rabbi Trust, the executive is assured of payment of his SERP benefit—unless the company becomes insolvent. The company also remains primarily liable for the payment of the SERP, so it must pay the SERP benefit to the extent that assets in the Rabbi Trust are insufficient to meet the pension obligation. The risk to the executive, as just noted, is that his employer might become insolvent, which would leave the executive to stand in line with other general creditors in claiming his pension. From a tax standpoint, a SERP funded by a Rabbi Trust has the same consequences to the executive, and to the company, as an unfunded SERP. The executive is taxed only when pension payments are made to him, and the company has a tax deduction at the same time that the executive is taxed. Assuming the executive is taxed at an overall effective marginal tax rate of 40% (taking into account federal, state, and local taxes) he will be left with approximately $589,555 of the $982,592 annual SERP payment. Another risk that we discussed above is tax risk. If tax rates increase to 50%, his net benefit will drop to $491,296 (a 16.67% decrease). Accounting, of the SERP, by the company should not be affected by the establishment of a Rabbi Trust. Generally, the costs of pensions are charged over the anticipated period of employment and, therefore, the costs of the executive’s pension should have been taken into account prior to his retirement. For our sample 58-year-old executive, a company utilizing this strategy would deposit the current accruals and future accruals into the Rabbi Trust, which would have some impact on cash flow, but not on earnings. Finally, assuming the executive is a "Named Executive Officer" for SEC disclosure purposes funding of a SERP with a Rabbi Trust requires limited disclosure in the proxy statement. Currently, a Rabbi Trust of the sort described for this executive is most frequently reported as a funding of the SERP in the section of the proxy statement dealing with pension plans and the amount put into the Rabbi Trust sometimes is not even disclosed. However, under the new SEC proxy requirements, the dollar value of the SERP must be disclosed. For certain proxy officers, the SERP benefit can/will be quite large. Executive defined benefit SERPs, such as the one in our example, are in disfavor with stockholder rights groups. Chart II provides an example of SERP proxy disclosure under the new regulations.
2. Lump-Sum PaymentLump-sum Payment upon Executive's Retirement. Many executives are not troubled by the risk of company insolvency as long as they are employed and “running the show.” However, many are less comfortable leaving a significant retirement asset in the hands of new management after their retirement. This will cause many to elect a lump-sum payment of their SERP benefit. In this case, the company would make a single payment to the executive upon his retirement, the amount being equal to the actuarial present value of a pension for the executive’s life, which we have assumed to be $11.2 million. Of course the executive would be taxed on the lump-sum payment (approximately $4.5 million), and the company would receive a tax deduction at the same time.2 In order to take advantage of a lump sum election, under 409A, one must elect to do so prior to December 31, 2008 according to transition rules. From an accounting standpoint, if the company has fully accrued the cost of the pension as of the date of the executive’s retirement, there should be no further accounting charge with regard to the pension. From an SEC disclosure standpoint, the lump-sum payment presumably will be disclosed in the Summary Compensation Table of the proxy statement, under the column "All Other Compensation." As of today, this lump-sum payment would not be subject to the deductibility restrictions under §162(m), but there have been recent moves in Congress to extend these restrictions to retired executives. If this happens, once an executive is included in the §162(m) group, they will always be included. Thus, retirement payments that push the total compensation amount of $1 million would not be deductible. Once the executive receives the lump-sum payment representing the then-current value of his pension, he is "on his own" in assuring that he will have amounts sufficient in the future to provide himself with an adequate pension. As noted, the executive’s "nest egg" of $11.2 million will be reduced by taxes upon its payment to him. If he is taxed at an overall effective tax rate of 40 percent, as already assumed in Section 1 above, he will be left with approximately $7.0 million of the lump-sum amount (if he’s taxed at 50%, he’ll be left with $5.6 million). We will assume that the executive will seek to handle the investment of this amount so as to produce a return, after taxes, as close as he reasonably can to the after-tax return from an unfunded SERP (or the Rabbi Trust funded SERP described in Section 1 above). This amount, as discussed in Section 1, would be approximately $589,555 annually after-tax on an unfunded basis. Assume that our sample executive will manage the fund so that it will be exhausted when he reaches his anticipated mortality age of approximately 82.3 Over this 18-year period, assuming a non-taxable return from municipal bonds at 4.5 percent, each payment to him will be non-taxable. There will be no tax on the portion of each periodic payment representing a return of the $7.0 million original principal amount. We assume the other portion, the return from municipal bonds, will be non-taxable for purposes of federal as well as state and local taxes, although this is not always the case for state and local taxes. But assuming a 4.5 percent return and full payout of the fund over the executive’s expected remaining life of approximately 18 years, the annual payments, with no tax due, would be approximately $548,621 per year. This compares with approximately $589,555 annually after taxes on an unfunded SERP or a Rabbi Trust funded SERP, as described in Section 1. The above example assumes mortality at age 82. However, to avoid the risk that he will outlive his retirement fund, our sample executive might invest the $7.0 million in an annuity contract providing him with a pension for life. This would mean lower periodic payments than he might distribute to himself if he invested the $7.0 million himself and "bet" on living to his projected age of approximately 82 (risking, as noted, that he might outlive the fund). This is because part of the investment in the annuity contract goes to the insurance company as a charge for its assuming the risk that he will live longer than his life expectancy, and part of it goes to provide the insurance company with a profit from the contract.4 The following section discusses an annuity contract purchased by the executive’s employer and transferred to the executive. This would provide tax consequences to the executive similar to those described in Section 2 above, but might have different consequences in proxy statement disclosure, as described below.
3. Annuity PurchasePurchase of an Annuity by Employer. On the executive's retirement, his employer might purchase an annuity from an insurance company (along the lines noted in the preceding section) and transfer ownership of the annuity to the executive. This is normally done at retirement and is not pre-funded, although some companies have adopted the strategy of pre-funding. To provide current benefit security, and to help reduce the company’s overall cost, we have assumed in our example that the company would pre-fund the annuity over the next seven years (until age 65). The executive will be taxed on the annuity transfer in much the same way he would have been for a lump-sum payment of cash. Presumably the company will provide him with a combination of cash and the annuity contract so that, after all taxes are paid, our sample executive has an annuity contract with the same intrinsic value (based on its price of $7.0 million) as would be the case if the company had paid him cash of $11.2 million as described in Section 2 above so that after taxes, at an effective rate of 40 percent, the executive would have had the $7 million to purchase the annuity contract himself. Our sample executive also could obtain from the insurance company a joint and survivor benefit for his life and his wife's life if she survives him. This, of course, would be at a lower payment rate than the single life annuity. For accounting purposes, there should be no additional charge against earnings for the company at the time of the executive’s retirement, again assuming it has charged its earnings for the cost of the pension over the period of the executive's employment preceding his retirement. It also is assumed, as in the case of Section 2 above, that the insurance company's charges for assuming the risk of guaranteeing payments and for making its own profit from the transaction are "taken out of" the $7.0 million and are not additional charges to the company. (Some employers have been willing to pay these insurance company charges in addition to the principal amount, $7.0 million, being transferred. In such a case, there would be an additional charge against the employer's earnings for that additional cost. This is not assumed to be the case for purposes of this example.) For SEC disclosure purposes there may be a difference between a purchase of the annuity by the company and its transfer to the executive and the purchase by the executive of an annuity following a distribution to him of cash. Purchase and transfer to our sample executive of an annuity by his employer might be considered as a funding of a pension not requiring disclosure under "All Other Compensation" in the Summary Compensation Table. This is not likely to be the view if the executive has the right under the annuity contract to cash it out at an amount comparable to its cash value. As already emphasized, review by SEC counsel should be obtained by any company contemplating a SERP funding arrangement that includes the purchase of an annuity and its transfer to an executive. The specific arrangements entered into by the company will be critical to a determination of whether the proxy statement disclosure should be made.
4. Funding of a Secular TrustLike the lump-sum payment of cash and the transfer of an annuity, the funding of a Secular Trust results in tax to the executive at the time of the transfer of assets and a tax deduction at the same time for the employer. This is so because the trust is for the exclusive benefit of the executive, without an exception being made for the claims of creditors as in the case of a Rabbi Trust. The trust is for the executive's benefit without qualification. For tax purposes, at the time of transfer, it is not unlike a transfer to the executive of a lump-sum amount in cash as described in Section 2 above. It is common to see a company pre-fund the trust rather than wait until retirement, as with the annuity or lump sum concepts. If this alternative is followed, the company would most likely arrange for funding of a Secular Trust would be to transfer the actuarial present value of the executive's pension, $7.388 million, to the executive, spread over the balance of his working life (7 years), and then deposit the additional annual accruals each year. The executive would then pay tax on the annual deposits and the trust would be funded with the net amounts. This arrangement of transfers from XYZ Company to the executive to the trust is generally recommended for federal income tax purposes in order to comply with the grantor trust rules of the code and, thereby, to avoid double-taxation on future earnings of the trust (that is, on the trust and again on the executive when amounts are distributed from the trust). Like the alternatives described in Section 1 through Section 3 above, the funding of a Secular Trust at the executive's retirement should not result in any further accounting charge, assuming the cost of the pension has been accrued over the period up to the date of his retirement. Under this arrangement, the company is simply taking the current accruals as well as the future annual accruals until retirement and currently expensing them (in the same manner) and taking a current tax deduction. The cost of setting up the trust and the trustee's fees may be an additional cost to the employer, or perhaps they may be split with the executive (e.g., the company pays the cost of setting up the trust and the company pays the ongoing trustee's fees). After-tax benefits to the executive should be $633,092 based on a similar investment return of 4.5% non-taxable (or pre-tax at 40%) as discussed in §3.
5. The Executive Roth PlanSMThe Executive Roth PlanSM is a pre-funding strategy (similar to the secular trust) with the objective of moving the liability off the balance sheet so it is not subject to the company’s general creditors, and putting the asset in the hands of the executive. This strategy provides the executive with non-taxable income at retirement and a non-taxable death benefit to their named beneficiary. Like a qualified Roth and the secular trust discussed above, the plan is funded with after-tax dollars. Similar to the lump sum, annuity, and Secular Trust strategies, the company’s contributions are tax-deductible by the company and taxable to the executive. The after-tax amounts are deposited into the Executive Roth PlanSM, and then grow tax-deferred. Like the qualified Roth, the income from the plan is non-taxable. To provide tax-favored accumulation and distribution, contributions are invested in institutional variable life insurance contracts. The institutional contracts have low sales loads (similar to the annuity discussed above), low cost of insurance, and no surrender charges. The executive contract has 100% cash value in year one, and can be invested in 60-plus alternative mutual fund-type investments called “subaccounts” that are offered by leading money managers such as Fidelity, Franklin Templeton, American Funds, and others. The executive controls the investment decisions, just as he does with his 401(k) plan and some of the strategies discussed above. One of the disadvantages of an after-tax plan is the loss of the investment principal on each year’s contribution due to taxes. At the participant’s discretion, after-tax contributions to the plan can be supplemented by an account internal to the insurance contract. This policy loan is used to restore the taxes on each contribution, so the executive is receiving the investment returns on the full pre-tax contribution. Features of this loan include:
Under this arrangement, the company will take the current accrual of $7.388 million and deposit it into the Executive Roth over the next 7 years. In addition, the company will deposit the annual accruals each year until the executive’s retirement at age 65 (same funding strategy as secular trust). As illustrated in Chart III, the executive will have the after-tax amount deposited ($960,000 per year) and then the policy will restore the tax ($640,000). In addition, the company will deposit the annual accruals each year until retirement (assumed to be $1.6 million annually). Based on these deposits, the executive would expect to receive an annual benefit of $589,555 each year for 18 years (total $10.6 million). Assuming death at age 82, an executive’s beneficiary would receive $12.3 million of non-taxable life insurance benefits. If the executive lives beyond age 82, the Executive Roth PlanSM will continue to pay the $589,555 annually.
In our example, the Executive Roth PlanSM will provide the executive with $589,555 of non-taxable income beginning at age 65. In addition, assume the executive’s death at age 82, his beneficiary would receive $12.3 million of non-taxable life insurance over and above the $10.6 million ($589,555 per year/18 years at 7.5%) he received. Unlike the annuity, the executive has full control over the investment choices and distribution options.
6. ConclusionThere is an argument that, for SEC disclosure purposes, the transfer to the secular trust should be described in the retirement section of the proxy statement rather than "up front" in the Summary Compensation Table. However, in view of the transfer of cash to the executive and his transfer of the net amount, after taxes, into the trust (in order to accommodate the grantor trust rules of the code) it is possible that the SEC counsel will take the view that the arrangement requires reporting in the Summary Compensation Table for the same reason that a lump-sum payment of cash requires reporting in that table. The Executive Roth PlanSM is settled and could be viewed similarly to the Secular Trust. In all cases, it would seem to be a better strategy than simply conceding to the current proxy rules for a SERP. As already emphasized, this is one of the issues that any employer considering such an arrangement should discuss with counsel based on the specific attributes of the arrangement. From a financial standpoint there could be favorable treatment of retirement income that is situated in an Executive Roth PlanSM, as that income is non-taxable. The company’s economics should also be examined in light of these strategies, as there could be a positive impact to earnings for pre-settling SERP liabilities. Chart IV examines the company economics of the five strategies. Under the lump sum, we assumed the company would wait until retirement to fund, all others we assumed pre-funding over a 7-year period (age 58 to 65). Chart V gives us a summary of the after-tax benefits that the executive could assume based on a 40% tax rate, and death at age 82. All strategies, except the Executive Roth, would be subject to future income tax risk (Executive Roth PlanSM is non-taxable). Also the annuity is assumed as life only, premature death will reduce payments. As discussed above, a joint and survivor benefit will produce a lower annual benefit. With the heightened optics of SERPs and the continued concern over benefit security, companies should look to these alternatives.
FOOTNOTES: 1 The $7.388 million is based on an interest rate of 5.55 percent and 1983 GAM (unisex) Table which produces an annuity factor of approximately 11.4. This annuity factor is multiplied by the annual pension benefit of $982,592 to obtain an actuarial present value (as of executive's age 65) of approximately $11.2 million. 2 In fact, the company in all likelihood would withhold taxes from the $11.2 million to the extent necessary to meet its tax withholding obligations, and the executive would pay the rest of the tax due. In the article’s discussion of taxes incurred by the executive, distinction is not drawn between taxes withheld by the employer and taxes paid by executive. (Also, the article does not address the withholding and payment of FICA and other payroll taxes.) To the extent income taxes withheld by the employer do not satisfy the tax obligation of the executive, the net amount is paid by the executive. 3 Consistent with the life expectancy indicated by the 1983 GAM (unisex) Table (noted in footnote 1), we have assumed an 18-year life expectancy after our sample executive retires at age 65. This is also consistent with mortality tables published by the Internal Revenue Service (IRS). 4 The "flip side" is that if the executive (and his spouse, if he elects a joint and survivor annuity) dies before age 82, he (and his spouse, if he elects a joint and survivor annuity) loses all future payments of an annuity, while in the case in which he himself invests the $7.0 million, the balance remaining at his death is available to his heirs. 5 Under Code §72, each annuity payment is partly a non-taxable return of investment and partly a taxable income. The non-taxable portion is determined by multiplying the amount of the annuity payment by an "exclusion ratio." The exclusion ratio is the ratio that the investment in the contract bears to the total expected return. The total expected return is determined by multiplying the sum of one year's annuity payments by the life expectancy multiple contained in the appropriate IRS annuity table.
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