A supplemental executive retirement plan, or SERP, is a non-qualified deferred compensation plan offered by a company to its executives or other highly paid employees.
Learn how the plan works, what it takes to qualify, and what you stand to gain from signing up for one.
What Is a Supplemental Executive Retirement Plan?
A SERP is a type of deferred compensation plan that a firm only provides to certain people in management or highly compensated employees (HCEs). They receive a SERP to go along with the retirement plans offered to all workers in the firm.
The "non-qualified" nature of a SERP means that it doesn't have to follow the same rules of IRS qualified plans such as 401(k)s. The "deferred" status of the plan means that the firm agrees to pay the worker at some time down the line. When a SERP is not funded, the firm makes a promise to pay benefits in the future. When the plan is funded, the firm places the assets in an escrow or trust account. This means that even if the firm were to get into financial trouble or cease functions, the firm's creditors cannot claim the money in that account.
Another name for a SERP is a top-hat plan or golden handcuffs.
How a SERP Works
While every worker at a firm has value, some people are harder to replace than others. Firms don’t want to hire executives or other key HCEs who will only stick around until they get a better job offer. Firms put a lot of effort into hiring and keeping top-level people to work for them. They are often brought in to help firms deal with complex problems. As such, firms might offer a SERP as part of key workers' benefits packages to convince them to stay for a long period of time. The SERP serves as an added benefit for the worker and some security for the firm that wants to keep that person around.
SERPs aren't offered to all people who work for a firm. Details of the plans vary among the firms that offer them. In most unfunded deals, the firm agrees to provide a retirement plan to its executives or HCEs paid for with its own dollars. With a defined-benefit SERP, which is the most common, the employer usually chooses the amount of the benefit using a flat dollar amount or a percentage of the worker's average final pay. The firm pays that amount over many years. Payments starts when the person reaches retirement age.
Another deal is a defined contribution plan where the firm puts funds into an account for certain workers until it's time for them to retire. This functions much like a pension plan. The money is invested on the worker’s behalf until the person retires and receives the payment.
For example, under a defined-benefit SERP, upon retirement at age 65, a firm might agree to provide its COO with a benefit equal to 70% of his average salary over the last three years. That money would then be paid over a certain time like 20 years.
The firm may invest the funds to be paid out under the SERP in annuities, life insurance policies, or securities, with the intent to give these assets to employees in the future. Life insurance policies are often taken out on executives or HCEs to shield the firm from the taxes owed on the investment gains of securities.
For example, assume that Company ABC and its COO, Linda, agree on a SERP that will pay Maria $65,000 per year for 10 years from age 61–70. Company ABC would purchase a life insurance policy that names the firm as the owner and policy beneficiary. When Linda begins to receive her benefits at age 61, they will be taxable to her and tax-deductible to her company for each year that they are received. When Linda passes away, Company ABC will receive her death benefit tax-free.
A SERP is said to work like golden handcuffs. It entices a person who makes a lot of money to stay with a firm long enough to be eligible to receive the full benefits in the plan.
Rules for SERPS
Unlike qualified plans, firms don’t have to offer a SERP to all people who work for them. SERPs are mostly only given to people in the "top-hat" group. This group is made up of executives (such as CEOs, CFOs, and COOs) and other people who are looked upon as “highly compensated" by the IRS. In your early years, when you’re climbing the corporate ladder, you’re not likely to be at a high enough level in a company or crucial enough to the running of the firm to be offered a SERP.
The IRS defines an HCE as one who owns at least 5% of the firm during the current or previous year or earns at least $130,000 in the preceding year if that year is 2020 or 2021.
While qualified retirement plans require testing to ensure that firms don't exceed contribution limits (and workers don't exceed plan limits), a non-qualified plan like a SERP doesn't require the fairness test and doesn't have contribution or plan limits.
What Are the SERP Tax Rules?
People pay income tax on funds from an unfunded SERP as they’re received. At the same time, employers can deduct the payouts. As the income taxes are deferred, the worker shouldn’t have to pay any upfront taxes. This deal allows the funds to grow without taxes chipping away at the account balance.
If the firm creates a funded SERP that sets aside funds for workers to shield them against the firm's creditors, the funds may be treated as current income. The worker may have to pay taxes on those funds.
SERPs don't impose penalties for taking money out of them before age 59 1/2. Unlike qualified retirement plans, they don't impose required minimum distributions, either.
Assets in a funded SERP can become immediately taxable to a worker, making an unfunded SERP a more tax-advantageous option for some people.
Is a SERP Worth It?
A SERP is useful in a few cases, such as:
- You're in a high-level job and are thinking about a job change: A SERP could become a way to get what you want in the later stages of your career with a new employer or asking for a better pay package at your current firm.
- Your qualified retirement contributions are limited: While regular workers can put up to $19,500 in their 401(k) in 2020 and 2021, HCEs cannot put in more than 1.25% or the lesser of 2% or two times the actual deferral percentage of non-HCEs. Because of this limit, employers may at times offer a SERP to give people who work for them an easier way to save for when they retire and be able to enjoy a standard of living that's like the one they had while working.
- You expect to be in a lower tax bracket when you retire: Once workers retire from their jobs, their income levels drop in many cases. This puts them in a lower tax bracket than when they had a job where they made money. This might lower your tax liability on the money you get from a SERP.
A SERP can be risky because:
- SERP funds are subject to the claims of the firm's creditors: Unlike a 401(k) where the money is safe even if the company ceases to exist, a SERP isn't safe from creditors unless certain planning is done to protect those assets. For instance, putting them in a trust could help keep the assets safe.
- It's subject to forfeiture: Forfeiture for the purpose of a SERP is the clause that spells out the events in which the person will not receive the money or assets in the SERP. Grounds for not getting SERP funds could include leaving the firm before the funds have vested, not meeting work goals, or being fired with cause.
- A SERP is a non-qualified deferred payment plan that a firm offers only to high-up workers such as executives and other key HCEs.
- Firms add to SERPs with their own dollars and can choose either funded plans or unfunded plans.
- Most of the time, people get to defer paying taxes on employer contributions to unfunded SERP plans. Firms also get a tax deduction when people who worked for them receive anything from a SERP.
- The plan is best suited for workers who are further along in their careers and will get the most from a SERP.