Executives gain big benefits from supplemental retirement plans

This article was produced by the Financial Planning Association and provided by William O. Woody of Stovall Woody Associates.

Because of the contribution limits of qualified retirement plans and individual retirement accounts, an increasingly popular method to enhance the retirement income of highly paid executives is the supplemental executive retirement plan.

A supplemental executive retirement plan is a nonqualified plan, which in general doesn't have the same restrictions and limitations imposed on 401(k) and profit-sharing plans.

Consider a highly paid executive in a large company who might make several hundred thousand dollars a year.

The most the executive can contribute out of pay to a 401(k) plan is $11,000 in 2002 ($12,000 if age 50 or over), and it might be less than that under nondiscrimination rules.

The $11,000 limit is scheduled to rise to $15,000 by 2006. The employer's contribution plus the employee's contribution can't exceed $40,000.

Furthermore, under a defined benefit pension plan, the maximum amount of salary and incentive compensation the employer can base its payout on is also limited to $200,000 under the new act. Either type of plan leaves a shortfall for the executive what's sometimes called "reverse discrimination" because maximum qualified retirement benefits make up a smaller percentage of the executive's pay than lower-earning employees.

To compensate for this shortfall, many companies offer supplemental executive retirement plans or other nonqualified plans.

A 1999 survey of Fortune 1,000 companies by the accounting firm of KPMG found that 93 percent have supplemental executive retirement plan plans, though many aren't active.

A supplemental executive retirement plan is a contractual agreement with great flexibility.

Typically, the employer agrees either to pay in a certain amount annually based on a percentage of the executive's pay, or to pay out a certain amount (such as 75 percent of salary) upon termination, retirement or death, either over a period of time or in a lump sum.

In a defined contribution approach, the amount set aside is credited with tax-deferred earnings based on either a fixed return or on corporate performance, or perhaps on the performance of the mutual fund investments mirrored in the employer's 401(k) plan.

The executive also can agree to defer current salary or bonuses, with the deferred amount earning a fixed return or a variable amount.

How much the company agrees to contribute or the executive decides to defer is up to the employer and the executive.

The law imposes no limits and filing regulations are minimal.

The plan is nonqualified because the employer does not receive a tax deduction for the contribution until the employee receives the benefits, which will be taxable as ordinary income to the employee. A supplemental executive retirement plan can only be offered to a "select" group of highly compensated employees, typically not to exceed 5 percent of the company's work force.

Employers can pay for the plans in a number of ways.

About half buy corporate-owned life insurance. The employer also can set aside cash, company stock or bonds on an ongoing basis, though it has to pay taxes annually on the income. Or the employer simply agrees to pay the benefits out of company earnings at the time the payments are due.

Supplemental executive retirement plans offer several advantages and disadvantages to the employer and the employee.

For employees, the biggest advantage is that they can fund a retirement plan that more accurately reflects their high salary. There also are no regulatory restrictions, such as minimum distributions or forced withdrawals beginning at age 59 1/2.

However, the big risk for the employee is that the company won't be in a financial position to pay benefits when due. The company can't set aside funds with a trustee and keep them protected from creditors as they can with a 401(k) or profit-sharing plan. It's strictly based on the company's promise to pay up when it's time.

In short, the executive is an unsecured creditor. Furthermore, executives fired for cause also risk losing the promised benefits.

For the employer, a big advantage is that the plan allows it to reward a select number of employees, which makes it easier to attract and retain highly qualified people. It also can tie the plan to certain requirements.

In a public company, the only requirement usually is that the executive becomes vested in the plan. Private companies also may impose noncompete clauses or require the executive to consult after retirement.

On the other hand, although the employer can't take an immediate tax deduction for the benefits as they accrue, the deferred amount shows up as a liability on the company's books.