Successful businesses and key employees go hand in hand. Often, a successful business has at least one key employee who is responsible for the success or failure of the business. If a business loses one of these key employees, a business can experience several problems.
- Reduction in Earnings – If a few key employees are responsible for a significant portion of sales or receipts, a loss of even one of these employees can be detrimental to a business.
- Disruption of Management – When one employee is in charge of business management, the loss of that employee can affect the performance of a business which can lead to monetary loss.
- Replacement Costs – The cost to recruit, hire, and train a replacement for a key employee can become costly.
- Credit Problems – Creditors may react negatively to the loss of a key employee.
- Confidence Problems – Customers, suppliers, and other employees may react negatively to the loss of a key employee.
- Competition – A former key employee may try to establish a competing business or take their knowledge to a competitor.
Often, salary alone is not enough to retain key employees. Many smaller corporations face a dual problem of hiring and retaining key employees and providing adequate qualified retirement plan benefits that are payable to key employees and owners. Therefore, a business must take other steps to keep key employees at their company. A SERP can be used as an additional benefit to keep these employees satisfied.
“Reverse Discrimination” of Qualified Retirement Plans
An often-unknown fact is that many qualified retirement plans tend to discriminate against employees who are highly compensated. Qualified retirement plans are strictly limited by the size of the benefits that can be accumulated for highly-compensated employees with certain restrictions that do not affect lower-paid employees.
When comparing higher and lower paid employees, the restrictions placed on benefits can often produce a “reverse discrimination” effect that leaves the key employee with an inadequate percentage in a qualified retirement plan. This equates to an inadequate percentage of a higher paid employee’s income available for investment or saving for retirement.
For example, an employee who received over $270,000 a year in 2017 was capped at that amount in regards to eligible compensation. There is a solution to the problem of an inadequately funded qualified retirement plan benefit—a Selective Executive Retirement Plan (SERP).
A Supplemental Executive Retirement Plan (SERP) provides key employees, such as executives, with benefits above and beyond typical retirement plans such as IRAs or 401 (k)s. A SERP can often be used to reward and ensure that key employees are not penalized in retirement with a standard of living that is less than the one they had during their career.
The SERP Breakdown
Often used by companies to reward and retain particular key employees, executive deferred compensation packages, may times, include SERPs. As a nonqualified retirement plan, a SERP may be offered to chosen key employees who are limited by top-heavy rules that limit their qualified plan contributions.
The key employee and company enter into a formal agreement in regards to retirement income. Usually, the agreement spells out eligibility conditions and vesting options that must be met by the key employee. Then, the company provides the funds for the plan with a cash value life insurance policy which allows for a tax-free deferred benefit to the key employee. Once this key employee reaches retirement, the employee receives the income and the proceeds are taxed as ordinary income.
Advantages of a SERP
There are several advantages for a company to utilize a SERP to retain key employees:
Maximizes key employee’s retirement income
Require no IRS approval
Controlled by the company
Reported as an annual expense
When paid, benefits can be deducted as an expense
Cost can be recovered if structured correctly
In addition, there are also advantages for key employees who receive access to a SERP:
Tailored to meet specific retirement needs
No tax consequence while benefits accrue
Death benefits on the cash value life insurance policy
Different Types of SERPs
There are four types of SERPs in which a business owner may choose to use: defined benefit SERP, defined contribution SERP, cash-balance SERP, and a target-benefit SERP.
A defined benefit SERP states clearly the amount based on a combination of compensation and years of service in which an employer takes the investment risk. Commonly, this can be seen as an annuity paid out upon retirement. When this amount is added to the Social Security benefit, a specified percentage of the employee’s final average compensation is received.
A defined contribution SERP is based on an individual account for the key employee and the investment risk is tied to the amount contributed where any income, expenses, gains, or losses are taken by the key employee. Commonly, a defined contribution SERP will provide a contribution of a fixed amount to an account that is invested until the key employee completed a predetermined period of service. After this period of time, the employee will receive the account in a lump sum.
A cash-balance SERP has aspects that include characteristics in a defined contribution plan and a defined benefit plan. Normally, the key employee receives a credit based on the percent of compensation over the years of participation with an interest credit based on an index rate (such as a one-year Treasury Bill rate). The investment risk is taken by the employer.
A target-benefit SERP combines aspects of the defined benefit plan, but is intended to mimic defined contribution plan. This type of SERP defines a benefit goal or target based on reaching a particular retirement age. A contribution that is projected to result in a target benefit at the predetermined payment date. Contributions are credited and debited to this account with actual income, expenses, gains, or losses from the investment account. The employee bears the risk of this type of investment.
By using a Selective Executive Retirement Plan, a smaller corporation can attract and retain key employees who will benefit the company over time. This non-qualified arrangement between a company and those key employees puts a smaller corporation in a position to compete with larger corporations. Since the receipt of a continued salary benefit depends on continued employment with a corporation, a SERP serves as a long-term incentive plan that is designed to encourage continued loyalty from the company’s most valued key employees.
As with any complex financial endeavor, a qualified financial advisor can guide business owners to the most advantageous SERP for their key employees. Attract and keep key employees with many different benefits, including a SERP.