Rewarding Commitment
Many businesses have several key employees who provide more value to the organization than others. Their skills and expertise are critical to keeping the business successful. Key employees are hard to find and difficult to replace. It could take a long time to recover if one of them leaves or joins a competitor. Businesses will provide extra financial incentives to retain and motivate key employees to stay with them for the long term.
But structuring these incentives can be challenging. Many businesses aren’t interested in incentive plans that require them to do all the funding. They want their key employees to be as committed to the plan as they are. They want incentive plans in which their key employees have “some skin in the game.” They want their key employees to be personally invested in the plan by contributing some of their own money.
“Skinny benefits” are incentive benefit arrangements in which businesses and key employees work together to build the employee’s net worth and retirement security. They both have “skin in the game.” Rather than being a handout from the business, “skinny benefits” are a jointly-funded strategy based on the idea that people appreciate benefits more when they pay part of the costs.
Cash value life insurance (CVLI) policies are often used in skinny benefit incentive plans. CVLI is regularly used because it provides several important potential benefits:
• Income tax-free death benefits for an employee’s family if he dies prematurely.
• Income tax-deferred cash value growth while the employee is working.
• The potential for income tax-free distributions to supplement the employee’s retirement income.
“Skinny Benefit” Strategies
There are four commonly used skinny benefit strategies. We’ll review them in the context of Robert Smith (age 50), vice president for sales and marketing at ABC, Inc. During his five years with ABC, Smith’s efforts have helped the company triple its revenues. ABC wants to retain him and motivate him to continue this productivity until he retires in 15 years at age 65. One day ABC’s president asked Smith if he was saving enough so he could retire on schedule. When Smith admitted he wasn’t and needed to save more, the president said ABC would be willing to help. He asked Smith how much more he thought he could save toward retirement. Smith indicated he could save $10,000 annually to improve his retirement readiness.
1. The Salary Deferral Match Plan. This strategy is sometimes known as a 401(k) look-alike plan. In it Smith and ABC enter into a written deferred compensation arrangement in which Smith agrees to defer $10,000 of his salary during the coming year and ABC agrees to match that deferral for a total of $20,000. ABC will use the $20,000 to purchase a cash value life insurance policy on Smith’s life to informally fund the plan. This annual deferral and match will continue until Smith turns 65. ABC will maintain a bookkeeping account for Smith which will be credited with the $20,000 in combined contributions. The agreement specifies how growth on these contributions will be credited in the bookkeeping account. Some options include using an agreed upon interest rate, the performance of a specified index (e.g., the S&P 500), or mutually agreed upon investments. When Smith retires, ABC will begin to pay him the bookkeeping account balance under the terms of their agreement. ABC can use withdrawals or loans from the life insurance policy to fund its payments to Smith.
This plan looks similar to Smith’s 401(k) account in ABC’s plan. However, because it’s a non-qualified plan, there are some important differences.
First, Smith doesn’t own either the 401(k) look-alike plan bookkeeping account or the policy. ABC owns the policy, pays the premiums and manages the policy as it sees fit. Second, Smith’s benefits are not vested. The agreement controls when and how Smith will receive benefits. He is a general creditor of ABC to the extent of the account balance. ABC may use the policy to fund Smith’s payments (after age 65) or it may use other assets. Third, if Smith leaves early, he may forfeit his benefits. ABC’s obligation to pay money to Smith only kicks in when Smith retires at age 65.
2. The Loan Match Plan. Either Smith or ABC (or both) may decide that the salary deferral match plan doesn’t meet their objectives. Smith may not like having to wait fifteen years before starting to receive any benefits from his $10,000 salary deferral and ABC’s match. He may not like the fact that some of his benefits are forfeitable and that he may not have access to them in the event of a personal or financial emergency. On the other hand, ABC may not want to incur the costs and problems that can come from administering the plan. If Smith and ABC want a simpler, more flexible way to provide incentives, they may want to consider a different strategy that uses employment loans—the loan match plan. In this approach, Smith will own the life insurance policy and will pay the premiums from a combination of personal funds and a matching annual loan from ABC. The loan match plan provides Smith with an ownership interest in the funding, but still provides ABC with some control over the benefit and the potential for cost recovery.
In the loan match plan, Smith doesn’t defer any of his salary. His $10,000 contribution comes from personal savings/assets or after-tax salary. ABC matches this with a $10,000 loan. This loan can be a demand loan or a term loan lasting for a specific number of years. It can bear an interest rate that is at the current market rate (as determined monthly by the IRS) or it can have a below market rate. It could even be an interest-free loan. Whatever method they use for interest on the lone, the annual interest costs must be accounted for. Smith could pay it personally or ABC could give him an annual bonus to cover the interest costs. Smith will execute a collateral assignment of the policy to ABC to secure repayment of the employment loans.
In this strategy Smith has $20,000 in contributions working for him in the policy immediately and ABC has a secured right to recover its outstanding loan balance. ABC gives Smith the use of outstanding loan balance which (depending on policy performance) could potentially grow into a significant sum over time. If Smith manages the policy correctly, cash value distributions he decides to take should be income tax-free.* The loan match incentive gives Smith an immediate life insurance death benefit and cash value benefits that aren’t available when ABC owns the policy under the salary deferral match plan.
*Income tax-free distributions are achieved by withdrawing to the cost basis (premiums paid) then using policy loans. Loans and withdrawals may generate an income tax liability, reduce available cash value and reduce the death benefit or cause the policy to lapse. This assumes the policy qualifies as life insurance and is not a modified endowment contract.
3. The Bonus Match. The loan match plan can be effective, but over time the incentive it gives Smith may diminish. He may not find the additional life insurance death benefits and the use of ABC’s money to be a worthwhile incentive. If Smith owns the policy, ABC could make its contribution through a year-end bonus, instead of a loan. It could even elect to make the bonus large enough so that after paying the taxes due, Smith would net $10,000 after income taxes to match his own contribution of post-tax dollars. This is often called a “double bonus” plan. Smith would purchase a CVLI policy on himself with the $20,000 premium (the sum of his own savings and ABC’s after-tax bonus). He would own the policy personally and continue to pay both the premiums and the taxes on the bonus each year.
The bonus match strategy could be appealing to Smith and it could also have some benefits for ABC. Since ABC will not have a loan balance that needs to be repaid, Smith will receive more death benefit protection and own all the policy’s cash value. This strategy will likely grow Smith’s supplemental retirement savings faster. ABC will be able to deduct the bonus (assuming Smith’s total compensation, including the annual bonus, is reasonable), so its net cash flow will improve. The biggest disadvantage to ABC is that it will not be able to recover the bonuses if Smith dies or leaves the company.
4. The Bonus/Loan Match. While Smith will like the bonus match strategy, ABC may find it less appealing. That’s because it retains no control over the benefit and can’t recover any of its costs when Smith retires or leaves. The bonus/loan match plan (also known as the hybrid executive benefit, or “HEX benefit” strategy) combines the loan match and bonus match strategies into a hybrid approach that has benefits for both Smith and ABC. Instead of contributing by either a loan or a bonus, ABC will do both—it will match Smith’s $10,000 with a $5,000 loan and a $5,000 bonus. Smith will execute a collateral assignment of the policy to ABC to secure repayment of the loan balance.
Businesses like this strategy for several reasons:
• They get an immediate income tax deduction for the bonus portion of the premium.
• They control the policy through the loan and the collateral assignment.
• The plan is flexible so, from year to year, they can change how much they contribute and how it is allocated between loans and bonuses.
• The loan balance is an asset on their balance sheet.
• Administration is relatively simple—the loans need to be documented and interest must be accounted for.
• The loan balance provides some cost recovery potential.
Key employees also like the strategy because:
• They own the policy and its accompanying death benefits and cash values (subject to the collateral assignment).
• Only the bonus portion of the policy is taxable.
• The policy is portable so they can take it with them if they leave the company (the loan balance will need to be repaid).
• Remaining policy cash values may help supplement their retirement income.
Adding Flexibility With Benefit “Ladders”
A valuable aspect of skinny benefits is that it is possible to string several benefits together to keep key employees engaged. These benefit strings are called “executive benefit ladders” and they can increase the overall value of the incentive plan to the employee over time. When used in a series, they can build on each other and give businesses more flexibility in providing selective benefits. These ladders can help businesses adapt to new situations and avoid a key employee’s “what have you done for me lately?” concerns.
This is apparent in skinny benefits in which the key employee owns the policy. For example, ABC can begin by offering Smith the loan match option. After several years it can “upgrade” Smith’s benefit by adding a bonus element to the match and reducing the amount of the loan component—the bonus/loan match (the HEX benefit). After several more years, ABC can upgrade the benefit again by eliminating the loan component and going to a bonus match plan. Finally, it could increase the size of the bonus enough to create a “double bonus” to help Smith pay the taxes.
Incentive plans in which the business owns the policy are usually more restrictive because they often fall under IRC Section 409A. Still, it is possible to build a benefit ladder. For example, ABC can begin the plan with the deferral match (the 401(k) look-alike plan). After several years it can add a protection component for Smith’s family by adding a death benefit only (DBO) benefit if Smith dies before retiring. Later it can upgrade this part of the plan by instituting an endorsement split dollar (ESD) plan which should make that pre-retirement death benefit income tax-free for Smith’s beneficiaries. ABC will own the policy at all times, but by adding DBO and then ESD elements, it can create more value for Smith and his family.
Conclusion
Most key employees will need to save money in order to enjoy a financially secure retirement. They’ll be able to retire sooner and/or more comfortably if their business is willing to help. Employers can work with their employees to help them build retirement funds while keeping the business strong and profitable. Businesses that understand the importance of recognizing their key employees’ work are open to creating incentives to motivate them to continue their high level performance. Skinny benefits are flexible incentive strategies that can help keep key employees engaged and productive for the balance of their careers.
These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor.
The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. You should seek advice from your tax and legal advisors regarding your individual situation.
