Deferred Compensation Plan Fundamentals

The design of a deferred compensation plan -- whether true deferred compensation or salary continuation -- is intended to accomplish two important functions:

To provide a benefit to the participant at some time in the future, and
To avoid income taxation on that future benefit until it is actually received

The Promise to Pay a Benefit

The basis of the payment of a benefit under a deferred compensation plan is the agreement between the employer and the key executive under which the employer agrees to pay a benefit upon the fulfillment of certain conditions.  Those conditions normally include the executive's agreement to remain in the service of the employer and may or may not involve an agreement not to compete with the employer for some specified period.

The deferred compensation agreement may promise to pay a specific benefit -- sometimes referred to as a defined benefit model -- couched in terms of dollars or as a certain percentage of final salary (or average of the final three years' salary or any other mutually-agreeable arrangement).  Such a provision might be stated as follows:

Retirement Benefit

From and after the Employee's retirement from the Corporation's service at age 65, or such younger age as may be approved by the Corporation, the Corporation shall thereafter pay the Employee the sum of $50,000 yearly for a period of 10 years, payable in equal monthly installments, commencing with the first day of the first month following his retirement.
This defined benefit model of the deferred compensation agreement's promise to pay is characteristic of salary continuation plans and may also be used, although far less frequently, in true deferred compensation plans under which the executive actually delays receipt of income.

In the majority of true deferred compensation plan agreements, the promise to pay is stated in terms of the defined contribution model.  Specifically, the employer agrees to pay a benefit that is determined based on the amount deferred plus any additions.  The provision used in a true deferred compensation plan agreement might read as shown below:

Retirement Benefit

The Corporation agrees that, from and after the Employee's retirement from the service of the Corporation upon reaching age 65 or upon reaching his Early Retirement Date, the Corporation shall pay thereafter as a retirement benefit to the Employee the Employee's entire Accrued Benefit, payable in equal monthly installments for a period of 120 months, commencing with the first day of the first month following his retirement.

Typically in these true deferred compensation plan agreements, the employer agrees to make contributions of additional amounts.  These additional amounts are payable only if the executive remains in the service of the employer until age 65 or a previously agreed -- upon early retirement date.  If the executive terminates his or her services prior to the dates stated in the agreement, only the amounts deferred by the executive are payable to him or her; the employer's additions are forfeited.  In a true deferred compensation plan agreement, the language providing these additions may state the following:

Additions to Amounts Deferred

The Corporation hereby agrees that it will credit deferred amounts in the Employee's Retirement Account with additions thereon from and after the dates deferred amounts are credited to the Retirement Account.  Additions to deferred amounts shall accrue beginning on the date the Retirement Account first has a positive balance and shall continue until the date that benefits commence.  Additions will be calculated at the rate of 8 percent per annum, compounded annually.

In a true deferred compensation plan agreement, the additions may be calculated in any way that is agreeable to the executive and the corporation.  One method that will tie the executive's eventual benefit to the performance of the employer is to credit additional amounts based on the company's earnings.

Separating the Promised Benefits from the Employer's Assets

Normally, one of the important elements of deferred compensation is the delay in taxation of the deferred funds.  To understand the requirements that must be met to ensure that the executive is not taxed currently on compensation that he or she will not receive until some time in the future, we need to consider the difference between a funded plan and an unfunded plan.  

A funded plan is a deferred compensation plan to which specific assets are allocated to ensure that the promised benefit will be paid. We will examine rabbi trusts and secular trusts later in this section, and as we will see, the secular trust's exempting the asset supporting the benefit from the general assets of the company attachable by creditors is sufficient to cause the benefit to be immediately taxable to the executive.  Although there are certainly cases in which the assurance of the benefit is of greater moment than its tax deferral, avoidance of current income taxation is usually central to the plan.

An unfunded plan is a deferred compensation plan whose benefits are supported by the general assets of the employer, rather than by a specific asset that has been segregated from those general assets.  As such, these assets are attachable by the employer's creditors.  In the bulk of cases, unfunded deferred compensation plans employ an informal funding approach under which a specific asset is acquired by the employer to support the benefits provided by the plan.  Although this informal funding may use virtually any type of investment to support the benefit -- mutual funds, life insurance, etc. -- many organizations opt for life insurance as the informal funding vehicle because of its tax treatment and the opportunity it provides for the employer to recover some or all of the costs of providing the promised deferred compensation benefits.

Informal Funding Through Life Insurance

We noted just above that informal funding simply means that an asset has been purchased by the employer to help it to meet its obligation to provide the promised benefits.  That informal funding may be provided through the purchase of mutual funds, the creation of a sinking fund, the purchase of life insurance or by acquiring any other asset that will help enable the employer to provide the benefits that were promised.  Regardless of the informal funding vehicle, for tax purposes, an informally funded plan is considered unfunded because the identified asset is attachable by the employer's creditors.

Life insurance generally provides the most cost-effective method of informally funding a deferred compensation plan, as long as the executive participant is insurable.  The life insurance policy used in the informal funding of a deferred compensation plan is a permanent life insurance policy that is owned by the employer who is also its premium payer and beneficiary.  The executive participant in the plan has no rights at all in the policy.  

We noted that the typical deferred compensation plan generally provides benefits:

At the participant's retirement from the employer's service
During the participant's disability prior to retirement, and
To survivors upon the participant's death before retirement

During the period before the key executive's retirement, the employer normally makes regular premium payments for the life insurance policy that has been purchased to support the promised benefits.  The policy's cash values grow on a tax-deferred basis, and the death benefits are immediately available to provide any pre-retirement survivor benefits.  The survivor benefits could, of course, become payable almost immediately after the deferred compensation agreement is entered into.
The pre-retirement survivor benefits normally provided by deferred compensation plans may constitute a substantial financial obligation for the employer and one that it might be reluctant to assume without the protection of life insurance coverage.  When the participant retires, the cash values -- which may be based on interest crediting or the performance of a separate account -- can be accessed by the employer to provide the retirement payments.  At the executive's eventual death, the life insurance policy's death benefits -- possibly diminished by withdrawals and policy loans -- are payable to the employer on a tax-free basis to enable it to recover the costs for both the benefits and the life insurance.  

The life insurance policy selected by the employer as the informal funding vehicle should be a permanent policy for several reasons:

Permanent life insurance policies build cash values that can be accessed to help the employer pay retirement benefits
The cash value growth avoids current income taxation, and
The permanent nature of the policy means that death benefits will be available to the employer to enable it to recover costs even if the executive lives for many years after retirement

Although whole life insurance policies may enable the employer to meet its obligations under the deferred compensation plan, many employers prefer to use universal life insurance policies.  These policies permit the policyowner to withdraw funds from the policy's cash value as well as take loans from it.  In contrast, access to cash values in whole life insurance policies is generally limited to policy loans, unless the policyowner is willing to substantially reduce the policy's face amount through a partial surrender.  (Dividends, of course, may be another source of cash in a whole life policy.)  

The universal life insurance policy chosen as the informal funding vehicle in a deferred compensation plan may be one whose cash value growth is affected by:

The insurer's declared crediting interest rate
The change in an equity index, such as the S&P 500,or
The performance of a separate account funded by securities

The choice of policy type should generally reflect the policyowner's risk tolerance level and desire for policy guarantees.

Regardless of the type of universal life insurance policy chosen, universal life insurance gives the policyowner not only access to cash values but also important premium flexibility.  It is the unusual business whose cash flow doesn't vary from time to time.  Because of that cash flow variability, the ability to make large premium payments when cash flow is high, smaller premium payments when it is low and no premium payments when cash flow is interrupted can be the critical component in making the sale.

Although an employer may be able to fulfill its obligations under a deferred compensation plan without purchasing any particular asset, such as a life insurance policy, the employer that buys a life insurance policy to support its obligations actually satisfies several objectives.  It guarantees that funds will be available to meet its pre-retirement death benefit liability, that funds will be available to help provide retirement benefits and that it can recover its costs.  The purchase of a life insurance policy on the participant's life also tends to provide a sense of security to the executive who is more assured of his employer's ability to meet its commitments under the plan.