Definition and Example of a Supplemental Executive Retirement Plan (SERP)
A SERP is a type of deferred compensation plan that a firm only provides to certain people in management or to highly compensated employees (HCEs). They receive a SERP to go along with the retirement plans offered to all workers in the firm.
- Alternative names: Top-hat plan; "golden handcuffs"
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 future time.
The firm makes a promise to pay benefits in the future when a SERP is not funded. It places the assets in an escrow or trust account when the plan is funded. The firm's creditors cannot claim the money in that account, even if the firm were to get into financial trouble or cease operations.
For example, suppose that Company ABC and you, its COO, agree on a SERP that will pay $65,000 per year for 10 years, from age 61 through age 70. Company ABC would purchase a life insurance policy that names the firm as the owner and the policy beneficiary. When you begin to receive benefits at age 61, they'll be taxable to you and tax-deductible to the company for each year that they're received. Company ABC will receive your death benefit tax-free when you pass away.
A SERP is said to work like "golden handcuffs," because 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.
How a Supplemental Executive Retirement Plan Works
Every worker at a firm has value, but some 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. They put a lot of effort into hiring and keeping top-level people.
These employees are often brought in to help firms address complex problems. A firm might therefore 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 it provides some security for the firm that wants to keep that person around. But SERPs aren't offered to everyone who works for a firm. Details of the plans vary among the companies that offer them.
The Standard SERP
Typically, the firm agrees to provide a retirement plan to its executives or HCEs, paid for with its own dollars in most unfunded deals. The employer usually chooses the amount of the benefit using a flat dollar amount or a percentage of the worker's average final pay with a defined-benefit SERP. (This is the most common type of plan.) The firm pays that amount over many years. Payments start when the person reaches retirement age.
The Defined Contribution SERP
Another type of deal is a defined contribution plan. 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 they retire and receive the payment.
The Defined Contribution SERP
Under a defined benefit SERP, a firm might agree to provide its COO with a benefit equal to 70% of their average salary over the last three years when they retire at age 65. That money would then be paid over a certain time, like 20 years.
Other Forms of SERPs
The firm may invest the funds to be paid out under the SERP in annuities, life insurance policies, or securities. The intention is 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.
Requirements for Supplemental Executive Retirement Plans
Firms don't have to offer SERPs to all people who work for them, unlike qualified plans. SERPs are mostly only given to people in the "top hat" group, such as CEOs, CFOs, COOs, and other people the IRS considers "highly compensated."
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 in your early years when you're climbing the corporate ladder. The IRS defines an HCE as someone who owns at least 5% of the firm during the current or previous year, or who earned at least $135,000 in the preceding year if that year is 2022 or later.
A qualified retirement plan requires testing to ensure that a firm doesn't exceed contribution limits and that workers don't exceed plan limits. But a non-qualified plan like a SERP doesn't have to pass a 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. The worker shouldn't have to pay any upfront taxes, because the income taxes are deferred. This arrangement allows the funds to grow without taxes chipping away at the account balance.
Assets in a funded SERP can become immediately taxable to a worker, making an unfunded SERP a more tax-advantageous option for some people.
The funds may be treated as current income if the firm creates a funded SERP that sets aside funds for workers to shield them against the firm's creditors. 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. They don't impose required minimum distributions, either, unlike qualified retirement plans.
Advantages and Disadvantages of Supplemental Executive Retirement Plans
Financial security in late-career stage.
No contribution limits.
Taxation occurs in lower tax bracket.
Funds are not safe from creditors.
Funds are subject to forfeiture.
- Financial security in the late-career stage: You might be in a high-level job and 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 a way to ask for a better pay package at your current firm.
- No contribution limits: Your qualified retirement contributions might be limited. Regular workers could put up to $19,500 in their 401(k)s in 2021, increasing to $20,500 in 2022. But HCEs can't put in more than 1.25% or the lesser of 2% or two times the actual deferral percentage of non-HCEs. Employers may at times offer a SERP to give people who work for them an easier way to save for retirement because of this limit. Retirees may be able to enjoy a standard of living that's comparable to the one they enjoyed while working.
- Taxation occurs in a lower bracket: You might expect to be in a lower tax bracket when you retire. Workers' income levels drop in many cases when they retire from their jobs. This puts them in a lower tax bracket than when they were working, which might lower their tax liability on the money they get from a SERP.
- Funds are not safe from creditors: 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 automatically safe from creditors unless certain planning is done to protect these assets. Putting them in a trust could help keep the assets safe.
- SERPs are subject to forfeiture: This is why SERPs include a clause that spells out the events in which the person will not receive the money or assets in the plan. Grounds for not getting SERP funds might include leaving the firm before the funds have vested, not meeting work goals, or being fired for 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.
- Workers can usually 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 have the most to gain from such a plan.