This article is reprinted with
permission from the
March 20, 2002
New York Law Journal.
© 2002 NLP IP Company.
Securing Payouts of Supplemental Executive Retirement Plans
By Joseph E. Bachelder
SUPPLEMENTAL EXECUTIVE retirement plans (SERPs) are playing an increasing role in executive compensation packages. Most SERPs represent an unfunded obligation of the employer. SERPs usually are "on top of" tax-qualified retirement plans, which are funded but are limited in amount.
Because most SERPs are unfunded, an executive's SERP entitlement usually is subject to a risk that at some point in the future the employer may be unwilling or unable to pay. The column considers how to reduce, or eliminate, the risk of future non-payment of accrued SERP benefits, at least as of the date of retirement.
To illustrate, assume Charles Avery, age 65, is about to retire from his employer, XYZ Co. He has a pension of $300,000 a year for life. The actuarial present value of Avery's pension at age 65 is approximately $3.5 million.1 There are several ways that XYZ Co. might reduce, or eliminate, the risk that Mr. Avery may not receive his pension due to XYZ Co.'s future unwillingness or inability to pay it. These risk-reducing or risk-eliminating steps include funding through a trust, paying a lump-sum amount in settlement of the pension and purchasing an annuity for Mr. Avery.
Each of these arrangements involves tax and accounting issues. If Mr. Avery is a Named Executive Officer under Item 402(a)(3) of SEC Regulation S-K, proxy statement disclosure issues also will be involved.
This column considers each of these issues but, as to any such issue, an employer should obtain the advice of its counsel or accountant based on the specific circumstances involved.
1. Funding a Rabbi Trust
Under this arrangement XYZ Co. would transfer assets to a trust for the exclusive benefit of Mr. Avery with the proviso that the assets would remain subject to the claims of the general creditors of XYZ Co. To the extent of the assets held in the rabbi trust, Mr. Avery is assured of payment of his SERP benefit - unless XYZ Co. becomes insolvent. XYZ Co. remains primarily liable for the payment of the SERP so that it must pay the SERP benefit to the extent assets in the rabbi trust are insufficient to meet the pension obligation. The risk to Mr. Avery, as just noted, is that XYZ Co. becomes insolvent and he must stand in line with other general creditors in claiming his pension.
From a tax standpoint, a SERP funded by a rabbi trust has the same consequences to Mr. Avery, and to XYZ Co., as an unfunded SERP. Mr. Avery is taxed only when pension payments are made to him and XYZ Co. has a tax deduction at the same time that Mr. Avery is taxed. Assuming Mr. Avery is taxed at an overall effective tax rate of 43 percent (taking into account federal, state and local taxes) he will be left with approximately $171,000 of the $300,000 annual SERP payment.
Accounting by XYZ Co. for the pension should not be affected by the establishment of a rabbi trust. Generally, the costs of pensions are charged over the anticipated period of employment and therefore the costs of Mr. Avery's pension should have been taken into account prior to his retirement.
Finally, assuming Mr. Avery is a "Named Executive Officer" for SEC disclosure purposes (an assumption made in the other sections of the column), funding of a SERP with a rabbi trust requires limited disclosure in the proxy statement. In the author's experience, a rabbi trust of the sort described for Mr. Avery is most frequently reported as a funding of the SERP in the section of the proxy statement dealing with pension plans and the amount put into the rabbi trust sometimes is not even disclosed.
2. Lump-sum Payment Upon Executive's Retirement. In this case, XYZ Co. would make a lump-sum payment to Mr. Avery upon his retirement, the amount being equal to the then actuarial present value of a pension for Mr. Avery's life, which we have assumed to be $3.5 million. Mr. Avery would be taxed on the lump- sum payment to him of the $3.5 million and XYZ Co. would receive a tax deduction at the same time.2
From an accounting standpoint, if XYZ Co. has fully accrued the cost of the pension as of the date of Mr. Avery's retirement, there should be no further accounting charge on account of the pension. From an SEC disclosure standpoint, the lump-sum payment presumably will be disclosed in the Summary Compensation Table of the proxy statement, under the column "All Other Compensation."
Once Mr. Avery receives the lump-sum payment representing the then present value of his pension, he is "on his own" in assuring that he will have amounts sufficient in the future to provide himself with an adequate pension. As noted, Mr. Avery's "nest egg" of $3.5 million will be reduced by taxes upon its payment to him. If Mr. Avery is taxed at an overall effective tax rate of 43 percent, as already assumed in §1 above, he will be left with approximately $2 million of the lump-sum amount. We will assume that Mr. Avery will seek to handle the investment of this amount so as to produce a return, after taxes, as close as he reasonably can to the after-tax return from an unfunded SERP (or the rabbi-trust-funded SERP described in §1 above). This amount as discussed in §1 would be approximately $171,000 annually after-tax on an unfunded basis.
Assume that Mr. Avery will manage the fund so that it will be used up when he reaches his anticipated mortality age of approximately 85.3 More likely, he will be prudent and plan to spread the payout of the fund over a period extending beyond his age at death, but, for purposes of this column, we have assumed he plans payout based on age 85. Over this 20-year period, assuming a tax-free return from municipal bonds at 5 percent, each payment to him will be tax-free. This is conservative based on current rates which, for top-rated municipals, would be closer to 5.4 percent. (There will be no tax on the portion of each periodic payment representing a return of the $2 million original principal amount. We assume the other portion, the return from municipal bonds, will be tax-free for purposes of federal as well as state and local taxes, although this is not always the case as to state and local taxes.) Assuming a 5 percent return and full payout of the fund over Mr. Avery's expected remaining life of approximately 20 years, the annual payments, with no tax due, would be approximately $152,000. This compares with approximately $171,000 after tax on an unfunded SERP or a rabbi-trust-funded SERP of $300,000 per year for life as described in §1.
Rather than risk that he will outlive his retirement fund, Mr. Avery might invest the $2 million in an annuity contract providing him with a pension for his life. This would mean lower periodic payments than Mr. Avery might distribute to himself if he invested the $2 million himself and "bet" on living to his projected age at death of approximately 85 (risking, as noted, that he might outlive the fund). This is because part of the investment in the annuity contract goes to the insurance company as a charge for its assuming the risk that Mr. Avery will live longer than his life expectancy and part of it goes to provide the insurance company with a profit from the contract.4
At current annuity rates applicable to Mr. Avery at age 65 the annual annuity payments would be approximately $143,000 with a portion being subject to tax pursuant to §72 of the Internal Revenue Code. After taxes pursuant to §72, Mr. Avery should have approximately $126,000 per year.5
Mr. Avery also could obtain from the insurance company a joint and survivor benefit for his life and his wife's life if she survives him. This, of course, would be at a lower payment rate than the single life annuity assuming the same $2 million investment in the contract by Mr. Avery.
The following section of the column discusses an annuity contract purchased by XYZ Co. and transferred to Mr. Avery. This would provide tax consequences to Mr. Avery similar to those described in this §2 but might have different consequences in proxy statement disclosure as described below.
3. Purchase of an Annuity by XYZ Co. On Mr. Avery's retirement, XYZ Co. might purchase an annuity from an insurance company (along the lines noted in the preceding section) and transfer the ownership to Mr. Avery. The transfer to Mr. Avery will be taxed to him in much the same way as a lump-sum payment of cash. Presumably XYZ Co. will provide Mr. Avery with a combination of cash and the annuity contract so that, after all taxes are paid, Mr. Avery has an annuity contract with the same intrinsic value (based on its price of $2 million) as would be the case if XYZ Co. paid Mr. Avery cash of $3.5 million as described in §2 above so that after taxes at an effective rate of 43 percent (as described in §2) Mr. Avery had the $2 million to purchase the annuity contract himself.
For accounting purposes, there should be no additional charge against earnings for XYZ Co. at the time of Mr. Avery's retirement, again assuming it has charged its earnings for the cost of the pension over the period of Mr. Avery's employment preceding his retirement. It also is assumed, as in the case of §2 above, that the insurance company's charges for assuming the risk of guaranteeing payments and for its own profit from the transaction are "taken out of" the $2 million and are not additional charges to XYZ Co.
(Some employers have been willing to pay these insurance company charges in addition to the principal amount, $2 million, being transferred. In such a case there would be an additional charge against the employer's earnings for that additional cost. This is not assumed to be the case for purposes of the column.)
For SEC disclosure purposes there may be a difference between a purchase of the annuity by XYZ Co. and its transfer to Mr. Avery and the purchase by Mr. Avery of an annuity following a distribution to him of cash. Purchase and transfer to Mr. Avery of an annuity by XYZ Co. might be considered as a funding of a pension not requiring disclosure under "All Other Compensation" in the Summary Compensation Table. This view is not likely to be taken if Mr. Avery has the right under the annuity contract to cash it out at an amount comparable to its cash value. As already emphasized, review by SEC counsel should be obtained by any company contemplating a SERP funding arrangement including the purchase of an annuity and transferring ownership of it to an executive. The specific arrangements entered into by XYZ Co. will be critical to a determination whether the proxy statement disclosure should be made.
4. Funding of a Secular Trust. Like the lump-sum payment of cash (§2) and the transfer of an annuity (§3), the funding of a secular trust results in tax to Mr. Avery at the time of the transfer of assets and a tax deduction at the same time for the employer. This is so because the trust is for the exclusive benefit of Mr. Avery without an exception being made for the claims of creditors as in the case of a rabbi trust described in §1 above. The trust is for Mr. Avery's benefit without qualification. For tax purposes, at the time of transfer, it is not unlike a transfer to Mr. Avery of a lump-sum amount in cash as described in §2 above.
If this alternative is followed, the most likely way that XYZ Co. would arrange for funding of a secular trust would be to transfer the actuarial present value of Mr. Avery's pension, $3.5 million, to Mr. Avery and Mr. Avery then would transfer that amount, less taxes, to the trust. The $3.5 million less taxes of approximately $1.5 million (assuming a 43 percent tax rate) would leave approximately $2 million going into the trust. This arrangement of transfers from XYZ Co.-to-Avery-to-the-trust is generally recommended for federal income tax purposes in order to comply with the grantor trust rules of the code and thereby to avoid double-taxation on future earnings of the trust (that is, to the trust and again to Mr. Avery when amounts are distributed from the trust).
Like the alternatives described in §§1 through 3 above, the funding of a secular trust at Mr. Avery's retirement should not result in any further accounting charge assuming the cost of the pension has been accrued over the period up to the date of Mr. Avery's retirement. The cost of setting up the trust and the trustee's fees may be an additional cost to the employer or, perhaps, they may be split with Mr. Avery (e.g., XYZ Co. pays the cost of setting up the trust and the trust pays the ongoing trustee's fees).
While there is an argument that the transfer to the secular trust should be described, for SEC disclosure purposes, in the retirement section of the proxy statement rather than "upfront" in the Summary Compensation Table, in view of the transfer of cash to Mr. Avery and Mr. Avery's transfer of the net amount, after taxes, into the trust (in order to accommodate the grantor trust rules of the code) it is possible that SEC counsel will take the view that the arrangement requires reporting in the Summary Compensation Table for the same reason that a lump-sum payment of cash as described in §2 requires reporting in that table. As already emphasized, this is one of the issues that any employer considering such an arrangement should discuss with counsel based on the specific circumstances of the arrangement.
1 The $3.5 million is based on an interest rate of 5.5 percent and 1983 GAM (unisex) Table which produces an annuity factor of approximately 11.5. This annuity factor is multiplied by the annual pension benefit of $300,000 to obtain an actuarial present value (as of Mr. Avery's age 65) of approximately $3.5 million.
2 In fact, XYZ Co. in all likelihood would withhold taxes from the $3.5 million to the extent necessary to meet its tax withholding obligations and Mr. Avery would pay the rest of the tax due. In the discussion in the column of taxes incurred by Mr. Avery, distinction is not drawn between taxes withheld by the employer and taxes paid by Mr. Avery. (Also, the column does not address the withholding and payment of FICA and other payroll taxes.) To the extent income taxes withheld by the employer do not satisfy the tax obligation of Mr. Avery, the net amount is paid by Mr. Avery.
3 Consistent with the life expectancy indicated by the 1983 GAM (unisex) Table (noted in footnote 1), we have assumed a 20-year life expectancy for Mr. Avery at age 65. This is also consistent with mortality tables published by the Internal Revenue Service (IRS).
4 The "other side of the coin" is that if Mr. Avery (and his spouse if he elects a joint and survivor annuity) dies before age 85, Mr. Avery (and his spouse if he elects a joint and survivor annuity) loses all future payments of an annuity, but in the case in which Mr. Avery himself invests the $2 million the balance remaining at his death is available to his heirs.
5 Under Code §72, each annuity payment is partly non-taxable return of investment and partly a taxable income. The non-taxable portion is determined by multiplying the amount of the annuity payment by an "exclusion ratio." The exclusion ratio is the ratio that the investment in the contract bears to the total expected return. The total expected return is determined by multiplying the sum of one year's annuity payments by the life expectancy multiple contained in the appropriate IRS annuity table.