What Is a Supplement Executive Retirement Plan and How Do You Get One?

A Retirement Plan for Attracting and Retaining Upper Executives

Companies know that attracting and retaining key executives is a difficult task. To solve this problem, a company might offer a Supplement Executive Retirement Plan or SERP as part of certain employees’ benefit packages.

Every employee has value, but some employees are harder to replace than others. An entry level employee working in a company’s manufacturing plant who leaves probably isn’t going to impact the company as much as the CEO, CFO, or other high-level executive’s departure. Ideally a company board wouldn’t allow a single employee departure to cripple the company but that’s easier said than done.

What is a Supplement Executive Retirement Plan?

A Supplement Executive Retirement Plan is a non-qualified plan allowing it to function outside the rules of qualified plans. Unlike qualified plans like a 401(k) or pension plan, employers don’t have to offer the plan to all employees and the SERP doesn’t fall under the required rules like not being able to touch it before 59 ½ without a tax penalty. There are no required minimum distributions at age 70 ½ either. Think of a SERP like a private pension plan for selected key executives.

Why Offer SERPS?

Companies don’t want to hire key executives who will only stick around until the next great opportunity presents itself. Not only is there a lot of investment that goes into a top-level employee, often they are brought in to implement a multi-year restructuring plan. Or, over time the executive might prove to be highly valuable—enough to make them an offer that would keep them at the company for a number of years.

A SERP is that extra piece of compensation that incentivizes the executive to stay for a long period of time—an added benefit for the executive while also acting as an informal insurance policy for the company.

Why Not Just Use the Company’s Normal Retirement Plan?

Because high-level executives are normally considered “highly compensated” by IRS rules. A highly compensated employee is one that makes at least $120,000 per year or owned at least 5% of the company during the current or previous year. The IRS has non-discrimination rules designed to keep the highest paid employees from enjoying all the benefits of a company 401(k).

While regular employees can contribute up to $18,500 in 2018, highly compensated employees could see their limits cut in half or more and contributing to an IRA doesn’t come with the tax break like it would with non highly compensated employees. Because of this reality, employers sometimes offer a SERP to provide an easier way to save for retirement and live at a similar standard of living that they enjoy while employed.

How Does a SERP Work?

Because a SERP isn’t offered to all employees, you’re not likely to find a pre-defined package in the employee handbook. A typical arrangement would be for the employer to provide compensation equal to 70 percent of the executive’s highest 3-year average compensation but the details of the plans vary widely between companies. That doesn’t mean the SERP alone will provide the entire 70 percent. The company will look at contributions to the company 401(k) plan, Social Security income, and other sources to reach the 70 percent number.

Each agreement is individualized based on agreed upon performance metrics and vesting conditions. Often, the employee is required to stay with the company until retirement to receive the full package.

The most common SERPS are in the form of a cash value life insurance policy. Here’s an example: Let’s assume that the employer and employee agree on a SERP that will pay the employee $65,000 per year for 10 years from ages 61-70. The employer would purchase a life insurance policy owned by company large enough to finance the agreement while leaving some surplus for the company. Since the company pays the premiums, it has access to its cash value and also receives a tax deduction for each year that it pays the premiums.

Because the company structured the policy to leave a substantial amount of cash value in place after paying the 10 years of benefits, the policy continues to accumulate value even once the employee is separated from the company. When the employee passes away, the company takes the life insurance benefit tax free. This allows the company to recover the cost of the SERP. Additionally, when the benefits are paid to the employee, the company gets a tax deduction.

This is the most common type of SERP although others exist. Another common arrangement is a defined contribution plan where the employer makes periodic contributions to an employee account, much like a pension. The money is invested on the employee’s behalf until retirement, death, or disability triggers the payment.

Tax Treatment of a SERP

Since a SERP is a form of income, there’s no getting around taxes. Recipients will pay ordinary income tax on the funds as they’re received but much like traditional retirement plans, the employee shouldn’t have to pay any upfront taxes. This arrangement allows the funds to grow without taxes negatively impacting the balance.

Another advantage of a SERP is that 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 the tax liability on the SERP payment.

Risk to the Employee

The primary risk is that a SERP is 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 is not safe unless certain planning is done to protect those assets. Also, the SERP must have conditions that make it subject to forfeiture. In other words, it’s not a guaranteed payout. If the employee leaves the company early or doesn’t meet the performance goals agreed upon, they won’t receive the benefits. If there is no risk of forfeiture, the IRS may label the benefit to be “funded” and immediately tax the employee.

How Do You Get a SERP?

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 to be offered a SERP. As you gain experience as a high-level executive, a SERP could become part of your negotiating package with a new employer or a renegotiation of your compensation package at your current employer.