Most people consider life insurance as a product that provides protection for surviving family members should one die. However, businesses have a unique use for life insurance in the way of executive bonus plans.
Most Fortune 500 companies offer executive bonus plans, but it is becoming increasingly common for smaller and privately owned businesses. Supplemental Executive Retirement Plans (SERPs) and Section 162 Plans are commonly used as incentives to motivate and retain highly compensated executives.
A SERP is a contract by the employer to pay a retirement benefit, usually over a 10-, 15- or 20-year period beginning at a specific age, such as 65. That future obligation is a liability on the company’s books, so companies frequently “informally fund” these plans by offsetting the liability with an investment in a cash-value life insurance policy owned by the company on the life of the executive.
Section 162 plans also use life insurance. In these plans, companies can make premium payments on a life insurance policy, or provide executives with a bonus to purchase life insurance. Ideally, the policies build cash value. Generally, cash value accumulation grows tax deferred and may be accessed by the executive income-tax-free through withdrawals, policy loans and from the insurance policy’s surrender values.
Insurance can make a financial adviser’s hair stand up, as many people tend to forget that insurance is a tool—not a plan itself. Likewise, companies may become enamored with the terminology when it comes to insurance policies because insurance is one of the few products that can use the word “guaranteed.” Guarantees are subject to the claims-paying ability of the issuing insurance company. Still, cash-value life insurance policies can be a very appropriate funding tool for executive bonus plans, as nearly two-thirds of executive bonus plans are funded with life insurance.
Using life insurance requires the management of the company to thoroughly review the performance and overall suitability of the policy for its intended use. Large corporations have a very particular framework the way policies are constructed for bonus plans. However, when smaller companies try to implement some of the same features for their executives, they can often get overwhelmed in nuances of the policies.
Policies are often sold with a large death benefit and a small cash value that doesn’t build. A substantial death benefit often comes with exceedingly large fees that can eat into the cash balance, prohibiting growth. When a policy has minimal death benefits reducing the actual expenses in the policy, the cash-value can then create some sizeable gains on a tax-favored basis.
Additionally, a company’s promise to the executives generally grows as the years go on, leaving the company hoping the cash value of the policies will grow to meet the obligation. If the policy does not perform as planned, there is a real risk the company will not have the necessary financial resources to pay the benefit promised to the executive. The structure of insurance policies needs to be managed correctly. Quite simply, it is not a “set it and forget it” investment.
If you are interested in implementing an executive bonus plan, or if you would like to have your existing plan and the underlying polices reviewed, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
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