THE FUNDAMENTALS OF AN EXECUTIVE BONUS PLAN
The word bonus is important to executives. In certain professions, a year-end bonus may be as large as or larger than an executive's annual salary. Regardless of whether the bonus an executive receives is a blockbuster or something more modest, it sends a message:
"You are responsible for the success of this organization, and this organization believes that you should participate in its rewards".
No matter where the executive is in the hierarchy, this message is a powerful incentive to do an even better job next year.
Executive bonus plans are often referred to as Section 162 Plans because this section of the Internal Revenue Code states that an employer may deduct all ordinary and necessary business expenses including a reasonable allowance for salaries or other compensation for personal services actually rendered. (Section 162 establishes limits on the amount of compensation that may be deducted by employers as a business expense — generally speaking, $1 million). Section 162 provides the legal basis for the income tax deduction of bonuses and other compensation that is paid.
An executive bonus plan is an arrangement under which an employer pays the premiums on a permanent, cash value life insurance policy. Although the employer pays the premiums, the executive — not the employer — owns the life insurance policy. The basic executive bonus plan is simplicity itself. It is in the application of the plan that some complexity enters the arrangement.
The need for an executive bonus plan often arises out of an employer's desire to add a certain extra incentive to its executive compensation. Sometimes this is coupled with the employer's desire to provide death protection for its executives, give its executives an opportunity to make contributions and give itself a current income tax deduction. The executive bonus plan does all of those things.
Although the emphasis in an executive bonus plan is on death benefits, the policy's cash value also may provide additional retirement income for an executive. That income may supplement an existing qualified retirement plan or represent the only retirement program offered by the employer-not an uncommon situation in young companies in which sufficient, stable earnings may not be available. Even if a qualified plan is installed, the employer may wish to single out one or more key executives for special treatment, reflecting their contribution to the enterprise.
In an executive bonus plan, the employer pays an executive a bonus — all of part of which is in the form of a premium payment on a permanent life insurance policy.
Although an employer may design the bonus arrangement in almost any fashion, including agreeing to pay an annual premium amount without regard to business results, the maximum business benefit often is obtained by tying the granting of a bonus to the executive's achievement of particular benchmarks.
What this means is that if the executive doesn't perform well, he or she receives little or no bonus. Making such a bonus arrangement work in the business requires that the employer identify the results that it wants to reward.
Let's assume that the employer's objective is to achieve sales growth of 20 percent—from an existing $10 million to $12 million—for the current year and it looks to its Sales Vice President to make that growth happen.
The employer could provide no bonus for achieving the first $10 million of sales, 1/2 percent bonus for the next $1 million and 1 percent for every additional $1 million of sales in excess of $11 million.
A similar approach can be used in areas other than sales. For example, the bonus for the Production Vice President may be based on a 10 percent increase in output that meets existing quality control standards.
The bonus, if based on the meeting of some goal or objective, should be based on criteria that:
stretch the individual and his or her area of responsibility; and
are within the executive's control.
It would make no sense and would be counterproductive to base the sales officer's bonus on production or the production manager's bonus on sales.
When we discuss bonus design later in this course, we will look at formulas, flat amounts and combination approaches that help businesses to achieve results that they may never have thought possible. The key to making the bonus arrangement attractive to the employer usually lies in determining the objective that the employer wants to achieve and providing a bonus for it.
The board of directors of a company should authorize major expenditures that may be outside of the routine, day-to-day expenses incurred by the business. Management compensation adjustments, such as executive bonuses, are such major expenditures.
In order to authorize an executive bonus plan, the board of directors should pass a written authorization. The authorization should:
identify the specific executives who will participate;
state that the bonus is intended as additional compensation to each named executive;
state that the bonus will be used to purchase individual, permanent, cash value life insurance (unless the key executive is uninsurable);
establish that each participating executive is a member of the select group of corporate management (so that the favorable ERISA provisions will apply); and
define the claims procedure.
The resolution should define the claims procedures to meet plan document requirements for ERISA. According to ERISA requirements, the procedure must call for providing written notice in the event of a claim denial and an opportunity for a beneficiary to receive a full hearing. Because of the nature and operation of an executive bonus plan, the claims procedure requirement is somewhat academic. In other words, an insured bonus plan should be established only for the select group in order to avoid ERISA reporting and disclosure requirements.
Corporate counsel should draft the board resolution. Even if the financial professional recommending and installing the plan is an attorney, he or she should resist the impulse to prepare any documents used to authorize or install the plan. A separation of these activities helps to avoid any appearance of a conflict of interest.
Use of Life Insurance
Although other financial vehicles may be used to fund an executive bonus plan, life insurance provides a substantial number of benefits and tax advantages that make it particularly suitable. Any type of individual, permanent life insurance policy may be used as the funding vehicle in an executive bonus plan. Certain policy types may work better in plans whose bonus amount may vary from year to year. In many cases, the most desirable product is a universal life insurance policy. While the individual policy used may provide for cash value growth on a declared-rate, equity indexed or variable basis depending on the particular executive's investment risk tolerance, the use of universal life insurance more easily adapts to:
variations in premium deposits; and
tax-advantaged access to cash value through withdrawals.
Irrespective of the type of policy used, the executive owns the policy, names the beneficiary (which should not be the employer) and chooses the appropriate settlement option.