Executive Compensation: Navigating Top-Tier Earnings
Encouraging Key Employees to Stay
Employees may be very loyal to the owner of the business, but there are still a number of reasons why employees are more likely to leave during a transition, including:
- unhappiness with the successor
- dislike of change
- disapproval of the new owner’s ideas in general or the new direction for the business in particular
Losing a key person’s skills, experience, relationships, loyalty and talent can be troublesome at any time, but it is especially harmful during a time of transition. Life insurance can provide a financial incentive for key employees to remain with the company during transition with an executive bonus arrangement or a nonqualified deferred compensation agreement.
These are both simple, flexible, and cost-effective ways to reward and retain key employees. Let’s look at these options in more detail.
What Is an Executive Bonus Arrangement?
An executive bonus arrangement (sometimes known as “golden handcuffs”) is designed to reward key employees and keep them with the company. It does so by providing needed personal life insurance along with important financial incentives:
- portable policy benefits
- tax-deferred cash accumulation
- full (or delayed) borrowing and withdrawal privileges
- income tax-free death benefits to the employee’s family
How an Executive Bonus Arrangement Works
Let’s take a closer look at how executive bonus arrangement works:
- The employee applies for and owns a permanent life insurance policy and selects the beneficiary.
- A separate written agreement provides that the business will pay the premiums on the policy by way of a bonus as long as the employee remains with the company. The bonus is treated like any other compensation by the company and the employee.
- A business owner may choose a restricted executive bonus arrangement, using a policy endorsement to place restrictions on the employee’s rights under the policy. These may include restrictions on (1) access to the cash values, (2) loans using the policy as collateral, or (3) the ability to surrender the policy.
- All restrictions end at a specified time—upon retirement, on a certain date, or with the employer’s permission.
- Some employers enter into a corresponding employment agreement stating that if the employee leaves the company prior to the specified time, the employee must pay back all bonus payments.
Take a look at the graphic to see how everything fits together.
Tailored to Fit
The most appealing feature of an executive bonus arrangement for business owners is its extraordinary flexibility. The owner can tailor each arrangement to fit the needs of individual employees. An owner can set up an arrangement:
- for a single employee or more than one employee
- with no IRS or ERISA rules to complicate matters
- using differing amounts for individual employees
- with some restrictions or none at all
- to include a double bonus that pays both the policy premium and the tax the employee owes on the bonus
- to allow employees access to the cash value of the policy whenever they wish, only in a pinch, or not at all
- so the proceeds can be used to provide for the employee’s family
In addition, the business owner can terminate the arrangement at will simply by stopping the bonus.
What Is Nonqualified Deferred Compensation?
Another way to reward key employees is with a nonqualified deferred compensation arrangement. This is a contractual commitment between an employer and an employee that specifies when and how future compensation will be paid. When properly arranged, employees are able to defer taxation until benefits are paid at some future time.
This arrangement provides key employees with an opportunity to accumulate substantial and meaningful retirement benefits beyond the restrictive contribution limits and discrimination rules that apply to qualified retirement plans.
How Does It Work?
Here’s how nonqualified deferred compensation works:
- The business agrees to pay key employees a stipulated amount of future compensation.
- Payments may be for a fixed period or for the employee’s lifetime.
- Deferred compensation is typically not a true salary deferral, but rather a commitment to pay an amount in addition to current compensation at a designated time in the future.
- The plan is unfunded, so key employees pay no income tax on the promised benefit until funds are received.
- The business unofficially “funds” the plan by buying life insurance on key executives.
Why Life Insurance?
Since avoiding current income taxation is a primary objective in these arrangements, key employees who will receive promised benefits must not enjoy a current economic benefit. Life insurance is ideally suited to meet these unfunded arrangement requirements because the policy is owned by the business. As a corporate asset, the policy is available to creditors, and the employee has no beneficial ownership rights in the policy.
Life insurance also ensures that funds are available to pay promised benefits with no drain on future earnings. The graphic below summarizes how deferred compensation works.
