What is a Supplemental Executive Retirement Plan (SERP)?
A Supplemental Executive Retirement Plan (SERP) is a deferred compensation agreement between the company and the key executive whereby the company agrees to provide supplemental retirement income to the executive and his family if certain pre-agreed eligibility and vesting conditions are met by the executive. The plan is funded by the company out of cash flows, investment funds or cash value life insurance. Any deferred benefits are not currently taxable to the key executive. When paid, the benefits become taxable to the executive as income and tax deductible to the company. A typical example of a plan would provide the executive a retirement benefit from all employer provided retirement benefit plans equal to 70% of the executives highthree yearaverage compensation. Another example would be an annual corporate contribution equal to a percentage of base salary that vests over ten years.
How do Supplemental Executive Retirement Plans Work?
The company will book an annual expense equal to the present value of the stream of current or future benefit payments. Because of its many advantages, most companies use cash value life insurance to finance the SERP agreement. The company purchases a life insurance policy on the key employee’s life that is sufficient to recover the cost associated with the future benefits outlined in the agreement. The company pays the premiums, owns the policy and is the policy beneficiary. The policy cash values grow tax deferred and can be used at any time by the company at its discretion.
At retirement, the key executive receives supplemental income, paid by the company, based upon the terms of the agreement. In the event of the keyemployee’s death, the policy’s death benefit is payable to the company to recover the cost of the plan and which can also be used to provide continued supplemental benefits or to provide a lump sum benefit to the executive’s named beneficiary.
Company Advantages with SERPs
Supplemental executive retirement plans using life insurance have several advantages to the company:
- SERPs are relatively easy to implement and require no IRS approval or involved administration.
- The company can select the executives it wants to reward with supplemental benefits.
- The company controls the plan, owns thepolicyand has book income from policy cash value growth.
- Cash value within the life insurance policy accumulates tax deferred.
- When the supplemental income benefits are paid to the key employee, the company gets a tax deduction.
- The life insurance policy can be structured to allow the company to recover its cost.
Executive Advantages with SERPs
Supplemental executive retirement plans using life insurance also have several advantages to the key executive:
- The plan can be custom designed to meet the key employee’s specific needs.
- Supplemental retirement income can be accumulated without incurring anyup fronttaxes.
- In the event the executive dies, the life insurance policy death benefits are available to fund the plan and provide a lump sum benefit to the executive’s beneficiary subject to the terms of the agreement.
Disadvantages of SERPs
- The company does not get an immediate tax deduction on the premium payments. The deductions come for the business when plan benefits are paid to participant.
- The cash valuebuildup that accumulates inside the life insurance policy used to fund the SERP is subject to the creditors of the company and is not protected if the company becomes insolvent.
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