Executive Compensation: An Overview for Business Owners

In today’s competitive job market, hiring the best employees is only half the battle. Retaining them is just as crucial. The most valuable assets of your business are your top-performing employees and providing them with additional benefits can help secure their loyalty. One approach is to offer supplemental retirement savings plans, tailored to reward and retain key talent.

Let’s explore how nonqualified deferred compensation plans and executive bonus arrangements can help your business retain its best employees.

What are nonqualified deferred compensation plans?

An NQDC plan allows key employees to set aside income above the limits of qualified retirement plans, like a 401(k). These plans are informally funded. This means that while the employer sets aside assets to cover future benefit liabilities, these assets are not legally separated from the employer’s general assets. This setup provides a psychological assurance to employees that their benefits will be paid when due, but it does not offer the same legal protections as formally funded plans. NQDC reserves, even though they cannot be specifically earmarked as such, exist as assets on the books of the employer and must be at a substantial risk of forfeiture to the employer’s creditors.

One common method of informal funding is through corporate-owned life insurance and is exempt from stringent nondiscrimination rules. This means you can focus these benefits on select employees without including the entire workforce.

Learn more about life insurance offered by Ameritas.

Types of NQDC plans:

• Traditional deferred compensation: Employees elect to defer a portion of their salary, bonus or future compensation.
• Supplemental Executive Retirement Plan (SERP): Fully funded by the employer, a SERP offers additional retirement income for selected employees.
• 401(k) look-alike plans: These allow key employees to voluntarily defer income on a tax-deferred basis, with optional employer matching contributions.

How NQDC plans work

NQDC plans provide additional retirement benefits for key employees. Here’s how they typically operate:

• Funding: The employer purchases a life insurance policy on the employee’s life. The policy’s cash value grows tax-deferred, providing a funding mechanism for future benefits¹.
• Vesting schedule: A vesting schedule can tie benefits to years of service, incentivizing employee retention.
• Benefits: Upon retirement, the employer uses the life insurance proceeds to pay the agreed-upon benefits to the employee. These payments are tax-deductible for the employer and taxable income for the employee.
• Death benefits: If the employee passes away before retirement, the policy’s death benefit can be paid to their beneficiaries.

Learn more about how executive benefits, like the NQDC plans, work at Ameritas.

Hypothetical example: Retaining a top employee

Rachel Chen and Ethan Kim, founders of Green Acre Group, Inc., faced a challenge in retaining Jordan, a rising star in their real estate company. Despite offering competitive salaries and a qualified retirement plan, they worried other firms might lure him away. Their financial professional suggested an NQDC plan tailored specifically for Jordan, providing additional retirement income and death benefits.

With a life insurance policy as the funding vehicle, Green Acre could offer Jordan extra benefits without extending them to other employees. The plan also tied benefits to Jordan’s continued service, encouraging his loyalty.

Because the plan is not a qualified plan, they can select the employees they wish to offer this benefit without worrying about nondiscrimination rules or mandated maximums on contributions or benefits. In fact, they can customize the arrangement to benefit only Jordan.

They set up a plan in which the company promises to make payouts to Jordan beginning at a specified retirement age. This future income does not reduce Jordan’s current compensation. To avoid current taxation on his deferred income, allowing it and any earnings to grow tax-free, Jordan must have only an unsecured promise to receive these benefits in the future.  This ensures that the income is not considered “constructively received,” which would trigger current taxation.

The company purchases a life insurance policy on Jordan’s life to informally fund the arrangement (after giving notice and getting Jordan’s consent). If Jordan dies after payments have begun, the death benefit will be paid to his named beneficiary.

Executive bonus plans: A flexible alternative

Another powerful tool for retaining key employees is an executive bonus plan. This type of arrangement uses life insurance to provide both pre-retirement protection and supplemental retirement income. Unlike NQDC plans, executive bonus plans are simple to set up.

How executive bonus plans work:

1. The employer chooses which employees will participate and determines the benefit amount.
2. The employer pays the life insurance premium, which is reported as taxable income to the employee.
3. The employee can access the policy’s cash value for retirement or other financial needs¹.
4. The employee’s beneficiaries receive the death benefit generally income-tax-free if the employee passes away.

To enhance the benefit, the employer can provide a “double bonus” to cover the taxes on the bonus amount, eliminating out-of-pocket costs for the employee.

Hypothetical example: Securing creative talent

Mark Styles, founder of Alpha Graphics, Inc., credits much of his company’s success to Ava Jones, a creative genius and technical expert.

Mark is fearful that another company might try to lure Ava away. He wants to reward her in a way that encourages her to stay with the company. He already pays Ava a competitive salary and annual bonuses, and she participates fully in the company’s retirement plan.

Mark’s financial professional suggests that he use an executive bonus arrangement. Mark could use tax-deductible funds to provide valuable benefits to Ava, without having to include any other employees.

Mark is on board with the idea and instructs his attorney to create a written agreement. Ava applies for a life insurance policy on her life and names her husband as the beneficiary. Mark pays Ava an additional annual bonus in an amount designed to cover the life insurance premium and the tax Ava will pay on the bonus. (Mark can deduct the cost of this bonus, but it is taxable to Ava as compensation.) And if Mark should ever want to end the agreement, he could simply stop paying the bonus.

The agreement grants Ava delayed access to the policy’s cash value starting at age 50, using tax-free loans or withdrawals¹. This can help provide an important supplement to her retirement income.

Because Mark is concerned with keeping Ava with the company, he also enters into a second agreement with her. If she leaves the company before age 40 (10 years from now), she is required to pay back all bonuses received under the executive bonus arrangement.

Why consider these plans?

Businesses often insure physical assets like buildings and equipment but overlook the need to protect their most critical asset: their people. Losing a key employee can disrupt operations, reduce profitability and create significant costs associated with hiring and training replacements.

Key benefits:

• Selectivity: Unlike qualified plans, NQDC and executive bonus plans can target specific employees.
• Tax advantages: Contributions and premiums are often tax-deductible for the employer.
• Employee loyalty: Tying benefits to tenure or performance strengthens employee retention.
• Simplicity: Executive bonus plans are generally easy to establish and administer.

The labor market is more competitive than ever. Offering enhanced benefits like NQDC or executive bonus plans can set your business apart, making it an employer of choice for top talent.

Next steps

If you’re ready to protect your business by rewarding and retaining your key employees, consider these strategic compensation plans. Consulting with a financial professional can help you design a strategy tailored to your business’s unique needs and goals. With the right plan in place, you’ll not only secure your company’s future but also demonstrate your commitment to the people who make its success possible.

Sources and References:

¹ Loans and withdrawals will reduce the policy’s death benefit and available cash value. Excessive loans or withdrawals may cause the policy to lapse. Unpaid loans are treated as a distribution for tax purposes and may result in taxable income.

Representatives of Ameritas do not provide tax or legal advice. Please consult your tax advisor or attorney regarding your specific situation.

In approved states, life insurance is issued by Ameritas Life Insurance Corp. In New York, life insurance is issued by Ameritas Life Insurance of New York. Policies and riders may vary and may not be available in all states. Optional riders may have limitations, restrictions, and additional charges.