Now that baby boomers are approaching retirement, we are receiving a number of inquiries regarding SERPs. Here are answers to some of the most frequently asked questions:
- What is a SERP?
A SERP is a supplemental executive retirement plan or supplemental executive retention plan that provides retirement or retention benefits to supplement the basic retirement benefits or regular compensation to which the employee is otherwise entitled. The arrangement is typically a non-qualified deferred compensation plan that is limited to a select group of management or highly compensated employees (e.g., a top-hat employee).
- What is the difference between a retirement SERP and a retention SERP?
A retirement SERP supplements a top-hat employee’s qualified retirement benefits if the employee remains in service until retirement (or another defined “triggering” severance, such as normal retirement, death or disability). A restorative SERP is a common form of retirement SERP that provides non-qualified deferred compensation to a top-hat employee to restore qualified plan benefits to which the employee is not entitled because of the limitations on contributions and benefits imposed by Internal Revenue Code on highly compensated employees under qualified plans.
A retention SERP provides a cash award, typically in the form of a bonus, to a top-hat employee for remaining in service for a number of years, which is not based upon retirement. Most retention SERPs are defined contribution arrangement as discussed below.
- What is deferred compensation?
For federal income tax purposes, deferred compensation is compensation that is paid in a year that is later than the year in which the services were performed, or for which the compensation was earned or accrued, regardless of whether it is funded, vested or subject to a substantial risk of forfeiture.
- What is a qualified plan?
A qualified plan is a retirement plan, or other deferred compensation arrangement, in which the benefit, pursuant to the federal income tax laws, is not included in the employee’s gross income and employment taxes until it is paid, while the employer is entitled to a deduction from gross income for the amount contributed annually to fund those benefits. All other plans are non-qualified plans.
- What different kinds of SERPs are there?
SERPs may be a defined benefit, defined contribution, cash balance or target benefit arrangement.
- A defined benefit SERP defines the benefit (occasionally a fixed-dollar amount, but more frequently an amount based upon an employee’s compensation or a combination of compensation and years of service) for which the employer bears the investment risk. A common form of defined benefit SERP provides a benefit upon retirement in the form of an annuity that, when added to the employee’s projected qualified retirement plan and Social Security benefits, will equal a specified percentage of the employee’s final average compensation.
- A defined contribution SERP provides for (i) an individual account for the employee and (ii) benefits based solely on the amount contributed to the employee’s account and any income, expenses, gains and losses for which the employee bears the investment risk. A common form of defined contribution retention SERP provides a contribution of a fixed-dollar amount to an individual account that is invested until the employee completes a period of service, at which time the employee receives the account in one lump sum. A common form of a defined contribution retirement SERP provides a contribution of periodic contributions, typically annually, to an individual account that is invested until the employee has a triggering severance (typically, normal retirement, death or disability), at which time the employee receives the account in one lump sum.
- A cash-balance SERP has characteristics of a defined contribution plan, and is intended to constitute a defined benefit plan. Typically, the employee receives a pay credit, such as a percent of his or her compensation over the years of participation, and an interest credit based upon a fixed or variable rate (often an index rate such as the one-year Treasury Bill rate) on the pay credits over the same period. There is a hypothetical accounting of the credits, and the benefit to the employee is the accounted value of the credits at the date of payment. As with other defined benefit plans, the employer bears the investment risk.
- A target-benefit SERP has characteristics of a defined benefit plan, and is intended to constitute a defined contribution plan. Typically, the plan defines a target benefit upon reaching retirement age, and then defines a contribution that, using actuarial assumptions (such as interest rates, mortality and employee turnover) determined pursuant to the plan, is projected to result in that target benefit at the payment date. The contributions are credited to an individual account for the employee, and the account also is credited or debited with the actual (not the assumed) income, expenses, gains and losses from the investment of the account. As with other defined contribution plans, the employee’s benefit is the account value at the date of payment, and the employee bears the investment risk.
- Are there any limitations common to SERPs?
The following are limitations generally common to all SERPs:
- Top-hat limitation. A SERP must generally be limited to a select group of management or highly compensated employees.
- No constructive receipt. An employee cannot be in constructive receipt of any SERP benefit or any of the assets securing its payment. The rules of constructive receipt require that (i) an employee’s rights to payment of any SERP amount may be no greater than those of general unsecured creditors of the employer; (ii) the obligation of the employer to pay the SERP may constitute no more than a mere promise to the payments in the future; and (iii) the employee’s rights to payment may not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment or garnishment by creditors of the employee or his or her beneficiary.
- Time and form of payment determined upon commencement of participation. The events triggering payment, and the time and form of payment, of the SERP’s benefits must be determined before the employee has a legally binding right under the SERP, which is generally at the time the employee commences participation or, in some circumstances, by the 30th day after the employee first becomes eligible to participate. The time and form of payment generally is irrevocable and cannot be accelerated, and may be postponed only in limited circumstances.
- Inclusion in gross income or wages for employment taxes. The value of non-qualified deferred compensation such as SERP benefits must be included in the gross income and reported as wages of an employee for purpose of federal employment taxes, including Social Security and Medicare taxes, as of the later of when the underlying service is performed or when there is no substantial risk of forfeiture. Some SERPs are designed to require an advanced payment of an employee’s SERP benefit equal to the employment taxes required to be withheld, and if so, the employee’s SERP benefit is reduced by the amount of the advanced payment.
- How may SERPs be funded?
Assets may or may not be reserved on the employer’s books for the SERP, and any reserved assets may be held by a Rabbi trust:
- Subject to the no-constructive receipt limitation common to all SERPs discussed above, the employer may reserve assets on the employer’s books to satisfy the employer’s obligation to pay the SERP’s benefit in the future. Any reserved assets may be transferred and held in a Rabbi trust discussed below.
- In absence of an asset reserve, SERP benefits will be paid from what assets exist on the books of the employer as SERP payments become due.
- A Rabbi trust is a grantor trust used to receive and hold assets reserved to satisfy an employer’s obligation in connection with deferred compensation arrangements and comply with no-constructive receipt limitation. The assets of the Rabbi trust are held for the exclusive purpose of satisfying the employer’s obligation to make payments to the employees or their beneficiaries except in the case of insolvency of the employer. In the case of insolvency, the assets of the trust will become subject to the claims of the employer’s general creditors under federal and state law. If the trustee becomes aware of the employer’s insolvency, the trustee is required to discontinue payments to employees or their beneficiaries and is required to hold the assets of the trust for the benefit of the employer’s general creditors. Because the Rabbi trust is a grantor trust, all income of the trust and items of deduction against that income or credit against any taxes on that income are passed through to the employer pursuant to the grantor trust rules.
- May SERPs be used by tax-exempt or governmental organizations?
Yes, but there are a few differences. Unlike employees of taxable organizations whose non-qualified deferred compensation such as SERP benefits is not included in gross income for federal income taxes, the value of non-qualified deferred compensation of employees of tax-exempt and government organizations is includible for federal income taxes for the first taxable year in which the compensation is not subject to a substantial risk of forfeiture. A SERP for an employee of a tax-exempt or government organization is typically designed to require the employee’s service through the last day of the service period, for a retention SERP, or until retirement (or another triggering severance such as death or disability) for a retirement SERP. If the employee’s service is terminated before the last day of such period or other than by a triggering severance, the employee typically forfeits his or her entire SERP benefit.
- May the receipt of benefits under a SERP be subject to conditions?
Yes. Benefits may be conditioned upon the completion of a specified term of service, the satisfaction of a vesting schedule, the achievement of specified goals, or some other term. Until the terms are satisfied, the benefits may be considered to be subject to a substantial risk of forfeiture.
- Is there a monetary limit to the amount of the benefit that may be provided under a SERP?
No, but some governance commentators dislike SERPs other than restorative arrangements designed to restore qualified plan benefits to which the employee is not entitled because of the limitations on contributions and benefits imposed by the Internal Revenue Code on highly compensated employees under qualified plans. Compensation committees should not be so limited as long as they are confident that the value of the potential benefit to the employee is taken into account in determining total compensation and nothing excessive is hidden.
- Why should an organization consider implementing a SERP?
A properly designed SERP can not only attract and retain a highly-compensated employee important to the organization, but also can facilitate a transition by the employee after a period of service or upon retirement.
- How are SERPs taxed to the employee?
The rules for federal employment (Social Security and Medicare) taxation are different than the rules for federal income taxation of nonqualified plans such as SERPs. For federal employment taxation, SERP benefits of employees of all employers are subject to Social Security and Medicare taxes (i) when the related services are performed or (ii) when there is no substantial risk of forfeiture with respect to their right to receive payment of their SERP benefits. For federal income taxation, SERP benefits of employees of tax-exempt and government employers are subject to federal income taxes when there is no substantial risk of forfeiture with respect to their right to receive payment of their SERP benefits, which generally is earlier than for employees of taxable employers whose SERP benefits are subject to federal income taxes as the SERP benefits are paid or made available for payment.
Succession planning is a key strategy of any organization. Planning succession is often most successful if the organization helps plan the retirement of its key executives.