How to Use a Supplemental Executive Retirement Plan

How to Use a Supplemental Executive Retirement Plan

We can help you decipher the pros and cons of a SERP before setting up an account.

Some employers provide a supplemental executive retirement plan to select employees. A SERP may be used by companies to help attract and retain key officials, such as high-level executives and CEOs. This type of account can be an extra incentive to reward employees and motivate them to stay with the firm.

Unlike a 401(k), a SERP doesn’t have a contribution limit or rules that all employees can use the account. “SERPs are not subject to the same rules as qualified plans,” says Stewart Darrell, president of Harris Financial Advisors in Torrance, California. Read on to learn how a SERP works and the potential benefits and drawbacks of this plan.

What is a SERP?

A SERP is a non-qualified retirement plan that doesn’t have to be offered to all employees. Many companies provide SERPs to employees with significant salaries. “Typically, they are negotiated as part of a larger compensation package with the employee,” says James Philpot, an associate professor of finance and general business at Missouri State University.

An employer may design the plan so an employee receives a benefit at a later date, such as the employee’s retirement. The benefit might be issued as a lump sum or a series of payments. Another option involves the employer agreeing to invest a certain amount in an investment fund that the employee will later own. “Sometimes to fund this arrangement, a firm will buy a large cash-value life insurance policy on the life of the key employee,” Philpot says. When the employee retires, the company could transfer the ownership of the policy to the employee, or the employer may choose to use the cash value of the policy to pay the employee benefits at retirement.

Advantages of a SERP

There is no limit on the amount that can be contributed to a SERP, so the retirement payout could be substantial. “Contributions to SERP plans can be as large as many millions or tens of millions of dollars per individual,” says Thomas O’Shaughnessy, senior director at Marcum Financial Services in Chicago. This is different than other retirement plans, which have annual contribution limits.

In addition, a SERP can be customized for each covered employee. This makes it possible for executives to negotiate terms of their individual package. A SERP can also present tax advantages for workers. For example, if the company structures the plan as a life insurance policy, taxes are not paid on the contributions from either the employer or executive until retirement.

The plan can be especially beneficial for employees at privately held companies. Unlike public companies, which might offer stock options to high performers, privately held companies can use SERPs to retain individuals. “SERPs are a great way to reward key employees above and beyond traditional retirement plans,” Darrell says.

Disadvantages of a SERP

While a SERP generally promises a future benefit, this type of account has several risks. Depending on the investments in the account, the compensation an employee will later receive could be subject to the company’s performance. “If the company files for bankruptcy prior to payment, the promised SERP money would be subject to the claims of creditors,” O’Shaughnessy says.

A SERP may also have specific requirements that need to be met by the employee. This often includes an agreement to work for the company for a certain number of years. “If the conditions of the agreement are not met, the key employee may not qualify for the benefits,” says Sam Brownell, founder of Stratus Wealth Advisors in Silver Spring, Maryland.

When distributions are made to the employee in retirement, the income will be subject to taxes. This could “create tax liability management issues in retirement, depending on the taxable ordinary income from other sources of retirement savings,” Brownell says.

How to Get a SERP

Since employers usually reserve SERPs for high-ranking officials, employees at entry-level or mid-management positions may not be eligible. Firms are not required to offer SERPs, and the plans may only be available to certain individuals. A company might offer a SERP only to its CEO or a sports team could make a plan available exclusively to its star player.

Due to the SERP’s customized nature, the details of any plan should be carefully laid out before any agreements are signed. “It is necessary to review all performance requirements,” O’Shaughnessy says. It is also important to look at tax implications for both the employer and employee when constructing a SERP. Each plan can be negotiated to fit the needs of the executive and the company.

Source: U.S. & World Report News
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