The actual executive bonus plan design can take many forms. Such plan design flexibility is both an advantage and a potential pitfall. If the plan is overly complicated, the employer and the executives may not feel comfortable with it. As a general rule, the simpler the plan design, the happier all involved are with it. A simple plan design leads to clear solutions for readily perceived needs. No government approval of the executive bonus plan design is required, and it may be changed periodically to better fit the organization's requirements. Let's turn our attention now to some basic approaches to executive bonus plan design.
Setting the Benefit
Some employers use a formula approach in determining the benefits of and contributions to an executive bonus plan. Yearly retirement benefits could be equal to a percentage of final compensation, such as 30 or 40 percent or more, and the annual bonus paid would be equal to the amount of annual premium needed to purchase a life insurance policy on the executive that would generate the agreed on lifetime retirement income.
Another common formula approach ties the retirement benefit to Social Security benefits. In essence, the result is an executive bonus plan "integrated" with Social Security, is similar to "permitted disparity" in a qualified plan. However, unlike a qualified plan there are no formal integration rules to comply with it. An example of this type of formula would be a benefit equal to 15 percent of the first $500 of monthly compensation and 50 percent of monthly compensation thereafter.
Qualified retirement plans must generally provide for contributions or benefits that are proportional to compensation. In particular, discrimination in contributions or benefits that favor highly-compensated employees is prohibited. An exception to this rule allows a qualified plan to be integrated with Social Security — that is, to provide extra contributions or benefits that are limited to an amount the highly-compensated employee could pay or receive at regular Social Security rates if Social Security were not capped at a modest income level. The extra amount is known as a "permitted disparity".
While either of these formula plan design approaches may be suitable for a particular organization, an employer seeking to further corporate objectives through its benefit plans often wants to connect the bonus amount to predetermined goals achieved by the participant. We noted earlier that a sales executive's goals may specify a percentage of sales growth for the coming year, say 20 percent. If the employer wanted to grow sales from its current $10 million level to $12 million, for example, it would be reasonable for the employer to provide an executive bonus plan formula, which it may change as follows from year to year:
$10 million or less
$10 to $11 million
1/2% of sales in excess of $10 million
$11 -$12 million
$50,000 plus 1% of sales
over $12 million
$60,000 plus 1 1/2% of sales
A similar approach could be designed for the executives responsible for customer service, production and other quantifiable functions. The important element of this formula approach is that it pays for results-not only a fair way of allocating bonus compensation, but one to which employers often respond positively.
Flat Amount Method
A formula approach to bonuses is not the only acceptable method for allocating bonus funds, of course. The flat amount method is commonly used when there are only a few participants or when benefit or contribution equity is desired. There are two basic variations in the flat amount method of executive bonus plan design:
a defined contribution approach; and
a defined benefit approach.
The defined contribution approach is by far the simpler of these two variations. In this approach, a flat amount of bonus is determined for all years and may be:
the same amount for all participants;
the same amount for all participants of a certain class, for example, all vice presidents;
the same percentage of base compensation for all participants; or
the same percentage of base compensation for all participants of a certain class, for example, 5 percent for all vice presidents.
Under this approach, the life insurance policy cash value that the executive has at retirement will determine the extent of income that the executive may receive.
The defined benefit approach is more complicated. In this approach, the employer selects an amount of income to be paid at retirement under the plan. As in the defined contribution approach that we just examined, that retirement income may be:
the same amount for all participants, for example, $50,000 per year for 10 years;
the same amount for all participants of a certain class, for example, all vice presidents receive $50,000 per year for 10 years and all senior vice presidents receive $75,000 per year for 10 years;
the same percentage of final compensation for all participants; or
the same percentage of base compensation for all participants of a certain class, for example, 5 percent for all vice presidents and 7.5 percent for all senior vice presidents.
In the defined benefit approach, a calculation must be made to determine the contribution amount level that will provide the promised retirement benefit. Not surprisingly, since a defined benefit approach adds a substantial level of complexity to the plan, many employers will tend to avoid it.
Since the employer pays the bonus to the executive, and the executive buys the life insurance on his or her own life, vesting (in the sense that the term is used in qualified retirement plans) normally is not applicable to executive bonus plans. However, by specifying in the resolution authorizing the plan that the bonus is to be used for the purchase of personally owned, permanent cash value life insurance, the employer has the assurance that the bonus will be used for that purpose.
The insured bonus plan does provide a variation of the golden handcuffs concept, especially if the benefit amount is large with a correspondingly large life insurance policy funding the benefit. The executive will become accustomed to the insurance coverage, will want the retirement benefit and will consider the value of the benefit when other employment opportunities arise. An employer also may restrict the executive's rights to the policy by allowing him or her access to the cash value only after a specified period of time.
Employers may be interested in defraying some or all of the income tax cost of the bonus to the executive. We noted earlier that a double bonus arrangement may be used and we will expand on that approach when we examine the taxation of an executive bonus plan. Some plans provide for loans from the employer to the executive to cover the additional income tax on the bonus amount.
If loans are made from the employer to the employee, they should be defined clearly as loans with a written loan instrument, specifying a reasonable interest charge and a repayment schedule. If the loans are not characterized properly, the IRS may deem them additional income or, in the case of a shareholder executive participant, dividends.
If the loans are not repaid, they become deductible bad debts for the employer and taxable income to the executive. The plan document may provide for all loans to be forgiven at the executive's death or retirement. In that event, the loans are income tax-deductible by the employer as an additional death or retirement benefit. Loans forgiven are included in the executive's or beneficiary's gross income.
If the life insurance purchased in the executive bonus plan is participating, any and all policy dividends are payable to the executive. The executive may choose any dividend option, including cash as a means of offsetting the end-of-year income tax liability caused by the bonus. For younger executives, the dividend may offset the entire income tax liability, particularly in the later years of the policy.
Funding the Plan
Any form of permanent, cash value life insurance may be used to fund the plan. Depending on the design formula, certain life insurance plans may be more appropriate than other plans. For example, an employer that institutes an executive bonus plan that ties bonuses to performance is likely to find universal life preferable to whole life insurance. Although a whole life policy with a rider designed to accept amounts in excess of the base policy premium can offer some premium flexibility, the flexibility built into a universal life insurance policy is difficult to approximate in any other product. In addition, the ease of accessing policy cash values through withdrawals-a feature that is a part of universal life insurance-helps make it the vehicle of choice.
If policy flexibility is needed, the employer or individual executive may choose a declared-rate universal life insurance policy, an equity-indexed life insurance policy or a variable universal life insurance policy, depending on his or her risk tolerance level. If there is a need for life insurance coupled with cash value guarantees, a whole life insurance policy may be appropriate provided that flexibility is not a primary concern.
Annuity contracts also may be used as a funding alternative for an executive bonus plan. Although annuities lack the advantage of a preretirement death benefit and FIFO tax treatment, they can be issued to any executive regardless of health. Also, annuity contracts may produce greater cash values at any duration when compared with some forms of permanent life insurance. The annuity chosen may be a variable, equity-indexed or declared-rate annuity.