Financial advisors generally recommend most people will need 70 percent to 80 percent of their final income to maintain their standard of living during retirement. While most employees can achieve this objective using a qualified plan, such as a 401(k), it is becoming increasingly difficult for key executives because of government limitations on the amount of money that can be contributed to a qualified plan.
For tax year 2011, an employee can defer $16,500 of pay into the plan. If the employee is more than 50 years old, an additional catch-up contribution of $5,500 is allowed for a total of $22,000. Additionally, a company can contribute a percentage match of an employee’s deferral or make a profit sharing contribution at the end of the year. The total from all contributing sources cannot exceed $49,000 per person if the employee is younger than 50 years of age, or $54,500 if the employee exceeds the age threshold.
In addition, qualified plans are subject to coverage and discrimination testing that can further limit contributions. Highly compensated employees are restricted disproportionately due to these testing requirements.
Limitations on contribution amounts make it difficult for highly compensated executives to rely solely on their tax-qualified plan to provide their standard of living throughout retirement. They must look to other sources of income to provide the balance needed during what could be a 30- to 40-year retirement period. Because of these restrictions, more companies are turning to nonqualified benefit plans for new, current and retiring executives and key staff.
Nonqualified plans are contracts between a company and a key executive stipulating the employer will provide some type of supplemental benefit to that executive. The plans are not subject to the limitations of traditional retirement plans and therefore provide an organization with flexibility in designing a benefit package.
Nonqualified executive benefit plans come in different forms; choosing the right one for a particular company depends on a number of factors, including the size of the business, the number of employees to be covered, the type of business entity, company resources and objectives, the executives’ specific needs and the company’s succession plan.
Three common types of executive benefit plans are a deferred compensation plan (DCP), a supplemental executive retirement plan (SERP) and an executive bonus plan (EBP). A DCP enables executives to defer compensation on a pre-tax basis in excess of qualified plan limits. This plan is similar to a qualified 401(k) plan, but without the corresponding reporting, funding and non-discrimination testing requirements. The company also may contribute an additional amount or match the executive’s contributions. Earnings on the executive and corporate contributions grow on a tax-deferred basis, and the accumulated contributions, as well as any earnings, are paid out at a specific date in the future.
A SERP is an agreement between an employer and one or more of its executives to provide corporate-sponsored supplemental retirement benefits. The plan can be structured as a defined benefit plan or a defined contribution plan. With a defined benefit structure, the company promises to pay an executive a certain amount of retirement income for a specified period of time. With a defined contribution structure, the company promises to contribute a certain amount for a specified period of time into an executive’s retirement account. Upon retirement, the accumulated contributions and any earnings are paid out as retirement income over a specified period of time.
With an EBP, a company uses compensation bonuses to assist executives in saving for their own personal retirement goals. The company pays the premiums on a specially designed, executive-owned life insurance policy and treats the premium amount as a compensation bonus to the executive. The premium amount is tax deductible to the corporation and taxable income to the executive. If properly structured, the tax-advantaged cash value accumulation in the policy and the death benefits can provide the employee with significant retirement income and survivor benefits.
To adequately prepare for retirement, owners and key executives must look beyond traditional savings methods. Nonqualified plans can provide organizations with a recruitment and retention tool to reward key executives and remain competitive in a challenging business environment.