What Is a Supplemental Executive Retirement Plan?
Definition & Examples of Supplemental Executive Retirement Plans
A supplemental executive retirement plan, or SERP, is a non-qualified deferred compensation plan offered by a company to its executives or other highly compensated employees.
Learn how the plan functions, its eligibility requirements, and whether you stand to gain from participating in one.
What Is a Supplemental Executive Retirement Plan?
A SERP is a type of non-qualified plan deferred compensation plan that a firm only provides to certain management personnel or highly compensated employees (HCEs) to supplement the retirement benefits it offers under qualified retirement plans.
The "non-qualified" nature of a SERP means that it functions outside the rules of IRS qualified plans such as 401(k) plans. Moreover, the "deferred" status of the plan represents an agreement to pay the employee at some time in the future. When a SERP is unfunded, the employer promises to pay compensation benefits in the future, but that promise is not secured. When the plan is funded, the employer places the assets in escrow or in a trust where the employer's potential creditors cannot claim them.
- Alternate name: top-hat plan, golden-handcuff plan
- Acronym: SERP
How a Supplemental Executive Retirement Plan Works
While every employee at a company has value, some employees are harder to replace than others. Companies don’t want to hire executives or other key HCEs who will only stick around until the next opportunity presents itself. Not only is there a lot invested in a top-level employee, but they're also often brought in to implement complex, multi-year plans such as restructuring. As such, companies might offer a SERP as part of key employees’ benefits packages to incentivize them to stay for a long period of time; it serves as an added benefit for the employee and an informal insurance policy for the company.
Because a SERP isn’t offered to all employees, you’re not likely to find a pre-defined package in the employee handbook. In addition, the details of the plans vary widely among companies. However, in a typical unfunded arrangement, the employer agrees to provide a retirement benefit to its executives or HCEs financed with its own dollars. With a defined-benefit SERP, the most common, the employer usually calculates the benefit using a flat dollar amount or a percentage of the employee's average final pay. It then pays that amount over a period of years starting when the employee reaches retirement age. Another arrangement is a defined-contribution plan where the employer makes periodic contributions to an employee account until retirement, much like a pension plan. The money is invested on the employee’s behalf until the employee's retirement triggers the payment.
For example, under a defined-benefit SERP, upon retirement at age 65, a firm might agree to provide its COO with compensation equal to 70% of his average salary over the last three years, over a period of 20 years.
The employer may invest the funds allocated to be paid out under the SERP in annuities, life insurance policies, or securities, with the intent to allocate these assets to employees in the future. Life insurance policies are often taken out on executives or HCEs to shield the employer 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 company 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 in that it entices a highly compensated employee to stay with a company long enough to be eligible to receive the full benefits in the plan.
Requirements for Supplemental Executive Retirement Plans
Unlike qualified plans, employers don’t have to offer a SERP to all employees. SERPs are generally only available to personnel in the "top-hat" group—that is, executives (such as CEOs, CFOs, and COOs) and other employees normally considered to be “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 indispensable enough to be offered a SERP.
The IRS defines an HCE as one who owns at least 5% of the company during the current or previous year or earns at least $130,000 in the preceding year if the preceding year is 2020 or 2021.
Whereas qualified retirement plans require testing to ensure that employers don't exceed contribution limits (and employees don't exceed benefit limits), a non-qualified plan like a SERP doesn't require the fairness test and doesn't have contribution or benefit limits.
What Are the Penalties?
Employees pay income tax on funds from an unfunded SERP as they’re received, at which employers become eligible to deduct the payouts. As the income taxes are deferred, the employee shouldn’t have to pay any upfront taxes. This arrangement allows the funds to grow without taxes negatively impacting the balance.
However, if the employer establishes a funded SERP wherein it sets aside funds for employees to shield them against the employer's creditors, the funds may be treated as currently includible income, and the employee may have to pay taxes on those funds.
SERPs don't impose penalties for withdrawing from them before age 59.5. And unlike qualified retirement plans, they don't impose required minimum distributions, either.
Assets in a funded SERP can become immediately taxable to an employee, making an unfunded SERP a more tax-advantageous option for employees.
Is a Supplemental Executive Retirement Plan Worth It?
A SERP is useful in a few scenarios:
- You're in a high-level position and are considering a job change: A SERP could become part of your negotiating package in later stages of your career with a new employer or a renegotiation of your compensation package at your current employer.
- Your qualified retirement contributions are limited: While regular employees can contribute up to $19,500 to their 401(k) in 2020 and 2021, HCEs cannot contribute more than 1.25% or the lesser of 2% or two times the actual deferral percentage of non-HCEs. Because of this limitation, employers sometimes offer a SERP to provide employees an easier way to save for retirement and eventually enjoy a standard of living that's similar to the one they enjoyed while working.
- You expect to be in a lower tax bracket in retirement: Once an employee enters retirement, their income level normally drops, putting them in a lower tax bracket than when they were actively employed. This might lower your tax liability on your SERP distributions.
A SERP may be risky if:
- SERP funds are subject to the claims of the company’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 (putting them in a trust, for example).
- It's subject to forfeiture: Forfeiture for the purpose of a SERP is the clause that dictates the circumstances in which the executive will not receive the benefits under the SERP. Grounds for forfeiture could include leaving the company before the funds have vested, not meeting agreed-upon performance goals, or being terminated with cause (gross negligence or a felony conviction, for example).
- A Supplemental Executive Retirement Plan is a non-qualified deferred compensation plan that a company offers only to select employees such as executives and other key HCEs.
- Employers contribute with their own dollars and can choose either funded plans or unfunded plans.
- Employees generally get to defer paying taxes on employer contributions to unfunded SERP plans, and employers get a tax deduction on employee distributions.
- The plan is best suited for workers who are further along in their careers and will benefit from a SERP as a negotiating chip or a means to make increased retirement contributions.