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22Oct2024

Supplemental Executive Retirement Plans

A supplemental executive retirement plan (SERP) is a form of nonqualified deferred compensation for a selected group of executives. In a SERP, the employer and the executive enter into an agreement where the employer promises to pay future retirement benefits to the employee. In doing so, a deferred compensation liability is created, which the employer will account for annually.

FUNDING THE SERP LIABILITY

A SERP generally involves only the employer’s unsecured promise to pay benefits. However, for the executive, security is often provided through informal financing arrangements such as corporate-owned life insurance (COLI). To segregate the funds earmarked for deferred compensation purposes from the employer’s general funds, many plans also utilize a specialized device known as a rabbi trust.

RABBI TRUSTS

A rabbi trust is an irrevocable trust in which an employer deposits deferred compensation payable to the employee, but where the trust’s assets are not protected against creditors.

This is the significant drawback of rabbi trusts: if a company becomes insolvent or goes bankrupt, both the beneficiaries and the company’s creditors have access to the trust’s assets.

CORPORATE OWNED LIFE INSURANCE (COLI)

Corporate-owned cash value life insurance is a common financial vehicle used to fund the SERP liability because of the benefits it offers the employer.

With this form of life insurance, policy cash values:

Accumulate tax-deferred
Can be considered a corporate asset
May be accessed to meet the SERP liability by way of tax-free policy loans and withdrawals
Are available to the employer for use at all times

The death benefit of the insurance can be used to:

Reimburse the employer for premiums paid
Provide money to fund retirement benefits for other executives
Provide a survivorship benefit to an employee’s heirs, should the employee die prior to receiving all of their deferred compensation

As the name implies, COLI is purchased by the employer and insures the lives of its employees. Each employee must consent to the purchase of the insurance policy.

SOME ADVANTAGES OF ESTABLISHING A SERP

A SERP can save the expense and administrative burden of maintaining a qualified plan such as a 401(k) or supplement a plan already in place through additional benefits to key employees.
Without violating any anti-discrimination requirements, the employer is free to choose which employees will be participants, as long as the plan is limited to management and highly compensated employees.
Almost any vesting schedule can be used.
A SERP can be a powerful employee retention device. The plan can be constructed so employees will forfeit benefits if they perform actions such as misconduct, resignation to work for a competitor, or termination of employment before retirement.

CONSIDERATIONS

SERPs, employers, and employees must comply with Internal Revenue Code Section 409A, enacted in 2004, which regulates several aspects of deferred compensation
SERPs are not appropriate for all employers:
- The employer must be in existence long enough to make the payments promised under the plan, as the full tax benefits of the plan cannot be provided unless the employer exists at the time of payment, so it can take its tax deduction
- Because of their pass-through tax structure, S corporations and partnerships may find SERPs useful for key employees who are not significant shareholders
- Additional restrictions exist when non-qualified plans are used in tax-exempt or governmental organizations

OVERVIEW OF NON-QUALIFIED DEFERRED COMPENSATION PLANS

A deferred compensation plan that is non-qualified falls largely outside the provisions and purview of the Employee Retirement Income Security Act (ERISA). Non-qualified plans do not receive some of the tax benefits associated with ERISA-conforming qualified plans.

The primary difference between a qualified plan and a non-qualified plan is that non-qualified plans do not generate an income tax deduction for the employer during the employee’s working years. Instead, the employer must wait until the year in which deferred compensation is actually distributed to its employee to take its deduction.

However, a non-qualified plan can provide tax deferral for the employee, as well as meet employer and employee compensation objectives.

COMPARISON TO A QUALIFIED PLAN

Non-qualified plans are similar to well-known qualified retirement plans, such as 401(k)s and 403(b)s, with a few key differences.

Unlike qualified plans, a non-qualified plan such as a SERP:

May be offered solely to a select group of managers or highly compensated individuals¹
Allows the employer to tailor benefit amounts, terms, and conditions for different employees
Is not subject to an annual limit on the amount of benefits it can provide (though it may only deduct amounts that are “reasonable compensation” for a given employee)²
Involves reduced IRS, ERISA, and other governmental regulatory requirements, including reporting and disclosure, fiduciary responsibilities, and funding requirements

Under ERISA, if a non-qualified plan is unfunded and maintained by an employer for the purpose of providing deferred compensation for a “select group of management or highly compensated employees,” the plan is exempt from all provisions of ERISA, except for the reporting and disclosure requirements, and ERISA’s administrative and enforcement provisions. The reporting and disclosure requirements can be satisfied by providing plan documents, upon request, to the Department of Labor, and by filing a simple one-time statement about the arrangement with the Department of Labor ↩︎
IRC Sections 162 and 83 ↩︎

22Oct2024

Income Protection Solutions for Business Owners

Individual disability insurance is an essential, but sometimes underrated, benefit that should be a key consideration for business owners and key executives.

INCOME PROTECTION

The ability to earn an income can be an individual’s most valuable asset. However, most people under- estimate the impact a long-term disability can have on their lifestyle, their financial plans, and their retirement goals. Although most working adults believe the odds of disability are one in 100, according to the U.S. Social Security Administration, a 20-year-old entering the workforce today has a one-in-four chance of becoming disabled before they retire.¹

Income protection, also known as individual disability income insurance (IDI), can be used to address the risk of disability to an individual’s personal planning or a business’s success by protecting the incomes of key employees and owners.

Less than 10% of disabilities are caused by accidents. The majority of disabilities result from common conditions related to one’s back, joints, heart, the circulatory and nervous systems, and cancer.

Many business owners purchase life insurance to address the impact of death on their operating expenses and business continuity, but often have not considered protecting the risk of disability. Insurance solutions are available to address the risk of disability on the business to provide benefits for salary continuation, overhead expenses, or funding the buy-out of a disabled owner or partner.

Chances Out of 1,000 that At Least One Long-Term* Disability Will Occur Before Age 65²

BUSINESS DISABILITY INSURANCE (DI) SOLUTIONS

KEY PERSON, BUY-OUT, OVERHEAD EXPENSE

Owners want their business to continue without interruption. When an owner or partner is unable to contribute to the company due to an accident or illness, there are several ways a business can be protected against loss.

BUY-OUT DI

Every co-owned business should have a buy-sell agreement in place to govern the buy-out of an owner’s or partner’s interest in the business, no matter the reason. The agreement should outline the events that trigger the available interest, who can purchase the interest and when, and the fair purchase price of that interest.

Life insurance planning is often used to ensure that if an owner or partner dies, the money is available to purchase the deceased’s interest in the business. But what happens if a principal has a prolonged or permanent disability? It is also important to consider a funding mechanism if a disability occurs.

One-in-three 45-year-olds has a 79% chance of disability for longer than 90 days before reaching age 65.

Risk of Death and Disability from Age 20 Until Retirement

Disability buy-out insurance provides funding to purchase a totally disabled business owner’s interest under a buy-sell agreement. Funding for the buy-out transaction is provided in a timely manner and without placing the business at risk by having to obtain loans, reduce profit, or draw from the company’s cash flow. There are several types of payout options to fund the agreement including monthly installments, a lump-sum payment, or a combination of both a lump-sum payment and monthly installments.

KEY PERSON REPLACEMENT DI

Many business owners and salespeople are key revenue drivers for a business. What happens if a key person is no longer able to work due to an illness or accident?³ Despite the probability of disability being much higher during working years, many businesses have not addressed the risk of a key person experienc- ing a disability in their business planning. Key person disability policies can help the business when it is identifying a replacement and when the successor is ramping up sales to support the business.

BUSINESS OVERHEAD EXPENSE (BOE) DI

If a business owner is unable to work due to a disabil- ity, it can become difficult to pay ongoing business expenses. BOE DI insurance provides reimbursement to the business of a disabled owner for their share of certain fixed operating overhead expenses. Covered expenses include employee wages, payroll taxes, rent, property taxes, office expenses such as utilities and equipment, accounting fees, insurance premiums for employees, and more. Some expenses such as personal taxes, travel, parking, and entertainment are excluded. Policies typically provide benefits for 12–24 months to give the business owner enough time to recover. If recovery is not possible, other arrangements for the business can be made. Business loan protection may also be available to cover business-related loan obligations.

HOLISTIC RISK PLANNING

There are many risks that business owners face, but the financial impacts to a business as the result of a death or disability can be mitigated with insurance. Successful businesses grow revenue and valuations over time. As a result, it is prudent to periodically review business agreements and insurance coverage to maintain proper benefit levels to keep the business operational if an unexpected event occurs.

This piece was created by M Financial’s Product experts and produced by the marketing team.

Social Security Administration, Fact Sheet 2023, https://www.ssa.gov/news/press/factsheets/basicfact-alt.pdf ↩︎
Source: Disability Fact Book, GenRe, Seventh Edition, 2013–2014 ↩︎
Social Security Administration, Actuarial Note, Number 2022.6, Disability and Death Probability Tables for Insured Workers Who Attain Age 20 in 2022, December 2022. ↩︎

22Oct2024

Business Protection and Benefit Planning Strategies

Life insurance is a powerful and flexible financial instrument with many useful applications for companies of all sizes. For business owners, it can help facilitate business continuity by protecting the company against the loss of a key person, providing liquidity to fund a succession plan, and ensuring the company can thrive well into the future. Used as a benefit, life insurance can help employers recruit, retain, and reward employees and executives.

KEY PERSON LIFE INSURANCE

Key person life insurance is coverage taken out by an organization to protect the business against financial loss in the event of a key person’s death. The key person may be an owner, an executive, or anyone else whose death could create a financial hardship for the company.

A key person insurance policy:

• Is owned and paid for by the company

• Insures the key person

• Names the company as the beneficiary

BUY-SELL AGREEMENTS

A buy-sell agreement ensures that surviving owners of a business have the right to purchase the interest of any owner when that owner dies. It also ensures that the deceased’s beneficiaries are fairly compensated for a business interest they inherit. Life insurance is often used in conjunction with a buy-sell agreement, as it provides liquidity to fund the succession plan exactly when it is needed — upon the death of an owner.

GROUP LIFE INSURANCE

Group life insurance is used as a benefit for the employees of a company. In this type of plan, each eligible employee is covered under a master contract at premium rates that are based on the age and gender of the insured. Group life insurance plans may be completely employer paid or have a contributory element where each insured picks up some or all of the premium. Group life insurance usually terminates when the employee leaves the company. However, some plans allow employees to convert coverage to an individual life insurance policy upon termination.

Used as a benefit, life insurance can help employers recruit, retain, and reward employees and executives.

SECTION 162 PLAN

Often called executive bonus plans, Section 162 plans are a simple way to reward top executives. Under this type of plan, an executive purchases a permanent life insurance policy on his or her life. The employer bonuses the employee the premium, which is usually taxable income to the employee and tax deductible to the employer. The employee controls the policy, including the death benefit and the cash value, which accumulates tax-free until it is withdrawn.

In some cases, a restrictive endorsement is used, which limits the employee’s access to the policy cash value until a qualifying event occurs, such as the attainment of a certain age or years of service, a disability, or normal retirement. This serves as a type of “golden handcuffs,” allowing employers a way to retain top employees.

DEFERRED COMPENSATION PLAN

In a deferred compensation plan, an executive defers a portion of his or her present compensation until retirement. These plans are often limited to a small group of top executives.

Under a properly designed plan, no income taxes are incurred by the participant until the money is received. However, an employer may not deduct any amounts paid to plan participants until funds are actually distributed. Often, life insurance policies are used as an informal vehicle for holding and growing the deferred funds.

SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

In a supplemental executive retirement plan, the employer provides funding for a defined benefit or defined contribution plan for a select group of employees. A supplemental executive retirement plan provides for a series of payments to be made to the executive at retirement. The plan also often promise to pay the executive’s spouse a benefit if the executive dies prior to retiring. Supplemental executive retirement plan benefits are often informally funded by life insurance.

SPLIT-DOLLAR LIFE INSURANCE

Split-dollar life insurance involves the purchase of life insurance where the ownership of the policy cash value and death benefit is divided. The executive owns a portion of each, and the employer, which typically pays all or most of the premium, owns the remainder. This type of insurance plan is often used when a company wishes to provide lifetime protection for an employee while retaining the ability to recover costs for its policy contributions.

CONSIDERATIONS

Each organizational structure (C-Corporation, S-Corporation, LLC, etc.) is subject to a unique set of rules affecting life insurance planning. Compliance with IRS rules and regulations, state and local laws, and in some cases the Employee Retirement Income Security Act of 1974 (ERISA) is required.
Not every plan type described above is appropriate for each organizational structure.
Internal Revenue Code Section 101(j) applies to all employer-owned life insurance contracts that are issued or materially modified after August 17, 2006. Section 101(j) requires employees to be given written notice before the issuance of a life insurance contract and provide written consent to such life insurance. In addition, the employer must annually report life insurance arrangements to the IRS by filing Form 8925 with the employer’s tax return.
In general, benefits provided to the employees of an organization will result in taxable income to the employee. Certain exceptions apply.
Professional tax and legal advisors should be consulted before entering into any insurance arrangement.

22Oct2024

Life Insurance Basics: Types of Life Insurance Policies

All life insurance policies fall into one of two general categories:

Term life insurance — temporary, providing protection for a set period of time.
Permanent cash value life insurance — can provide lifetime protection and involves an internal
savings component.
This M Intelligence article provides a basic overview of these categories and the types of life insurance contracts within each.

TERM LIFE INSURANCE

Term life insurance pays a specified face amount (i.e., death benefit) if the insured dies during the policy term. The level-term period is usually specified as a number of years, such as 10 or 20, or to a specified age, such as age 65. If the insured outlives the specified level-term period, the term life insurance can be continued, but at a premium cost that increases substantially each year and is frequently not economically viable to maintain. Term insurance has no cash value.

Premiums for most term contracts are fixed and guaranteed at issue. The majority of term contracts provide level death benefit coverage, although decreasing and increasing death benefit coverage is available as well.

There are two types of term policies:

• Renewable term — the term policy’s annual premium increases with the insured’s age.

• Level-term — the term policy’s annual premium remains the same throughout the level-term period.

Term policies with increasing premiums are called renewable. Renewable term insurance provides protection for a stated number of years and allows the policyowner to renew the policy for the successive periods without furnishing evidence of insurability. Yearly renewable term features premiums that increase annually. The right to renew is usually limited to a stated number of years or up to a specified age.

Level-term policies have premiums that remain the same each year. Level-term policies are typically used to cover a certain number of years — 10-year and 20-year term are most common. Some level term policies may have the ability to be renewed (i.e., become a yearly renewable term policy) after the specified number of years have passed.

A variation of level-term provides coverage intended to last an employee’s typical working life, but is not renewable. These contracts include life-expectancy term and term-to-age 65, and are not very prevalent in the marketplace.

Another variation of traditional level-term insurance is return of premium term insurance, which returns a portion or all premiums if the insured survives to the end of the specified term period. Return of premium insurance is considerably more expensive than traditional term insurance.

Many term insurance policies include a convertibility option, either as a rider or a separate product. Convertibility allows a policyowner to replace term coverage with permanent coverage within a specified period without evidence of insurability. Convertibility provisions allow the policyowner to obtain term insurance, or temporary coverage, and reserve the option to purchase permanent coverage for an amount equal to the term insurance face amount if needs change. Conversion typically must occur within a specified number of years no greater than the length of the term period.

PERMANENT LIFE INSURANCE

Cash value life insurance, also referred to as permanent coverage, differs from term because the premiums paid are sufficient to both cover the death claims and expenses of the insurer and potentially build a cash value, or savings fund, within the contract. The permanent life insurance variations described below are whole life (WL) insurance, universal life (UL) insurance, indexed universal life (IUL) insurance, variable universal (VUL) life insurance, and no-lapse guarantee (NLG) life insurance.

Permanent life insurance face amount will be paid at the death of the insured(s), not matter when the death occurs, as long as the policy is in-force.

WHOLE LIFE INSURANCE

The policyowner must pay the scheduled premiums on time and meet the requirements of the policy to keep the policy in force.

Premiums for most WL insurance contracts remain level and are calculated to ensure that the policy will remain in force for the lifetime of the insured (i.e., age 121). The initial annual premiums can be several times higher than those of a term policy with a comparable face amount. These higher premiums fund the permanent coverage while establishing cash values within the policy.

The cash value forms a reserve, enabling the insurance company to keep premiums level and still pay the policy’s full death benefit. Policyowners may borrow from cash values via policy loans pursuant to the terms and conditions of the contract. Optional riders and benefits, in addition to the policy death benefit, may be added to the policy.

WL insurance policies can be issued as participating or non-participating. Participating policies are entitled to share, via non-guaranteed policy dividends, in any distribution of the insurer’s surplus funds that it decides to make to those policies. Non-participating policies are not entitled to dividends.

UNIVERSAL LIFE INSURANCE TYPES

UNIVERSAL LIFE INSURANCE

All UL policies offer more flexibility and transparency than WL policies. The policyowner has the ability to modify or change the amount and duration of premium payments, within certain limits, and still maintain coverage for life as long as the cash value is positive. For all UL policies, the premiums paid into the policies are reduced by policy expenses, the remainder being cash value that can potentially earn interest depending on the type of UL policy being purchased. Death benefits in UL contracts may be fixed at a specified level or may increase each year by an amount equal to the premiums paid or current cash value of the policy. Similar to WL contracts, policyowners can access policy cash values. In addition to policy loans, UL policyowners can also take withdrawals of cash values up to the policy’s cost basis. Also similar to WL policies, riders and features can be added at the time of issuance to provide other benefits to the policyowner.

Fixed rate UL policies, many times referred to simply as Universal Life, are credited with interest determined by the insurer in the form of a crediting rate that reflects the fixed-rate environment at the time, with a minimum guaranteed rate. There are other UL policies that have different ways to invest the cash values that will be discussed next.

INDEXED UNIVERSAL LIFE INSURANCE

IUL is a UL with an interest crediting rate determined by reference to an investment index, such as the S&P 500 price index or a custom designed 3rd party index. The index return is typically adjusted by a participation percentage rate, then subject to a maximum interest rate cap (8-12%) and minimum interest rate floor (0-1%). IUL offers the potential for a higher yield than UL, with indirect participation in an equity market, as well as a guaranteed minimum crediting rate (i.e., floor) that provides downside protection for the policyowner. IUL policyowners also have the ability to invest in a fixed crediting rate offered by the policy in addition to the customized indexes offered should their needs change.

VARIABLE UNIVERSAL LIFE INSURANCE

VUL products permit the policyowner to allocate a portion of each premium payment into one or more “separate account” funds. Separate accounts, which are like mutual funds, typically have up to 70 or more options to choose from to properly allow policyowners to invest according to their risk tolerances. VUL policies are monitored and subject to the rules established by the Securities and Exchange Commission, as the investment options are deemed to be securities. All VUL policies must be accompanied by a prospectus that provides detailed information on policy mechanics, expenses, and changes, and general information regarding the inherent risks associated with securities. VUL is most appropriate for individuals willing to accept greater risk for greater reward, as the policy’s cash value may depend on non-guaranteed market value changes. VULs also may have fixed crediting rate and indexed accounts to invest in, in addition to the separate accounts. Separate accounts are also allowed extra policyowner protections should the carrier’s solvency be called into question.

NO-LAPSE GUARANTEE UNIVERSAL LIFE INSURANCE

NLG life insurance policies are UL policies with a guarantee that if a specified minimum premium is paid, the policy will not lapse for a specified period, or for life, even if the cash value decreases to zero. The guarantees are accounted for in what is referred to as a “shadow account”. The shadow account has its own assumptions that are guaranteed by the carrier and dictate the required premium to enforce the guarantees.

NLG insurance is often characterized as having minimal or no cash value accumulation. It is best suited for individuals focused on ensuring the life insurance death benefit will be available at a guaranteed cost, and where cash value accumulation may be less important.

NLG may also be offered as a rider on other forms of life insurance, including VUL and IUL. In contrast to a pure NLG insurance policy, NLG riders may be available on products where cash value accumulation is a key benefit of the policy. These types of contracts can serve the dual purpose of providing cash value accumulation and a death benefit that is guaranteed by the shadow account.

SUMMARY

Life insurance serves a wide variety of purposes, providing financial support to heirs and charitable organizations, indemnification against the loss of a key person of a business, funding of a business continuation plan, and as a benefit for executives and employees. Between the two basic types of life insurance, term and permanent, there is a solution for a wide range of planning needs and objectives.

TERM AND PERMANENT LIFE INSURANCE COMPARISON

Variable life insurance products are long-term investments and may not be suitable for all investors. An investment in variable life insurance is subject to fluctuating values of the underlying investment options and entails risk, including the possible loss of principal.

VUL insurance combines the protection and tax advantages of life insurance with the investment potential of a comprehensive selection of variable investment options. The insurance component provides death benefit coverage, and the variable component gives you the flexibility to potentially increase the policy’s cash value.

*Whole life policies do have the ability to reduce or eliminate the requirement for premiums via Premium Loans, Partial Dividend Offsets, Paid Up Additions or Reduced-Paid-Up options. These are typically more limited compared to Universal Life products.