How SERP benefits can be paid by a company to the executive typically when one of the three events occur:
- the participating executive retires
- the survivors of the executive at the death of the executive before all retirement benefits have been paid
- the participating employee becomes disabled
The methods how SERP benefits can be paid depends which situation requires their payment.
Funding Benefits at the Executive’s Retirement
Paying the benefits at the executive’s retirement may be accomplished using the employer’s revenue from operations at the time they are due. Depending on the financial situation of the company, this can be the best way of how to pay the benefits of a SERP to the executive.
However, it is advised that the company create a sinking fund to pay SERP benefits to the key executive in the future. Mutual Funds, Annuities or Life Insurance are typically used to informally fund a SERP benefit. Funds from these assets may be made available to the employer by accessing these asset. Regardless of whether funding comes entirely from the employer’s current revenue or by accessing the cash value of these assets used as an informal funding vehicle, the employer has two options with respect to the them in order to pay SERP benefits to the executive:
- Access the value of the asset and liquidate it
- keep the asset on the company’s books
Because life insurance provides the most benefits to informally fund a SERP benefit and provides advantageous options other assets do not, I will discuss life insurance for the remainder of this article on how SERP benefits can be paid to the executive.
Surrendering the Life Insurance Policy to Pay SERP Benefits
An employer that surrenders a life insurance policy that informally funds a SERP experiences two important consequences, neither of which is attractive:
- The employer will be required to recognize current income to the extent that the policy’s cash value exceeds the employer’s cost basis (the employer’s cost basis is generally equal to its total net premium payments).
- The employer forgoes its ability to recover its plan costs because the death benefits will no longer be payable upon the participant’s death.
Of course, the employer receives the policy’s cash value on surrender and may use those funds in any way it chooses, including using them to pay the SERP benefits. Due to these two adverse consequences, however, employers using life insurance to informally fund SERP benefits will usually keep the policy in force.
Maintaining the Life Insurance Policy while Paying SERP Benefits
If the employer elects to keep the life insurance policy in force, it may get the answer of how SERP benefits can be paid in retirement from:
- The company’s current revenue
- Choose to take funds from the life insurance policy’s cash value
- Or use a combination of the two approaches to pay the benefit*.
*When the cash value of a life insurance policy is used to pay SERP benefits, any loans or cash value withdrawals will diminish the eventual death benefit payable to the employer.
If the SERP benefits at retirement are to be paid by using policy values and the type of policy used to informally fund the plan benefits is a whole life policy, the employer should normally use any dividends to purchase paid-up additional insurance as this increases cash value during the accumulation phase. Upon commencement of retirement benefits, the employer can then surrender sufficient dividend additions to pay the SERP retirement benefit. When dividends have been exhausted, the employer may continue to use policy values by taking cash value loans. The flow of funds in a universal life insurance policy is even more advantageous because of the availability of cash value withdrawals and their favorable income tax treatment. (See SERP Income Tax Treatment here)
Benefits at the Executive’s Disability
How SERP benefits can be paid at the executive’s disability generally come from disability income policies paid for by the employer. These policies should be conditionally renewable, and continued renewability of the coverage should be conditional on the executive’s continuing to be employed by the employer. Conditionally renewable policies owned by the employer are not generally taken into consideration in determining the amount of disability income coverage available to the executive.
Disability income policies used to provide pre-retirement disability benefits under a deferred compensation agreement are normally owned by and benefits are payable to the employer. However, in some cases, employers elect to pay the premiums for disability income coverage owned by the employee. The income tax treatment of the disability policy premiums and benefits will vary, depending on the approach taken. (See SERP Income Tax Treatment here.) If the executive and employer opt for this approach, the SERP agreement should clearly indicate that the employer’s obligation is limited to the payment of disability income insurance premiums. If the disability income policy is owned by the executive, it will affect the executive’s ability to obtain other disability income coverage.
Preretirement Survivor Benefits
If the executive covered under the SERP dies while in the service of the employer or before all promised SERP retirement benefits have been paid, benefits will normally be paid to his or her survivors. The survivor benefits paid in such a case are typically at the level that would have been paid to the executive at retirement.
The life insurance policy used to informally fund the SERP is normally owned by the employer who is also its beneficiary and premium payer. Benefits are payable to the executive’s survivors in accordance with the terms of the SERP agreement.