Structuring the Plans
Designing the bonus is limited only by the employer's imagination. In general, the simpler the plan design, the more effective the plan is likely to be. Since no government approval is required, the bonus structure may be changed, as needed, to meet the employers objectives. The basic approaches to executive bonus plan design may involve the following:
A formula method
A flat amount/flat percentage method, and
Employers that are trying to further business goals through their bonus plans usually want to tie the amount of bonus to the executive's meeting agreed-upon benchmarks. A sales executive's goals, for example, may include a particular level of sales growth in the coming year, and the bonus could be established at a certain percentage of that growth.
Similar formulas may be developed for executives responsible for production and other functions that can be quantified. The rationale behind the formula approach is that it pays for results. As such, it is not only fair but also one to which both employers and employees respond positively.
Flat Amount/Flat Percentage Method
Although a formula approach is highly desirable, it is not the only acceptable method for designing bonuses. A flat amount method may be used when there are few participants or when the employer wants benefit or contribution equity. Two basic variations in the flat amount method of executive bonus plan design exist:
Defined contribution, and
In a defined contribution 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 in a particular class, e.g. all vice presidents
the same percentage of base compensation for all participants, e.g. 5 percent for all participants , or
the same percentage of base compensation for all participants in a particular class, e.g. 5 percent for all vice presidents.
As in all defined contribution type plans, the value available to the executive at retirement determines the income that the executive may receive.
In a defined benefit approach, an income to be paid at retirement is determined by the employer. For example, the retirement income determined might be:
the same amount for all participants, e.g. $25,000 per year for 10 years;
the same amount for all participants of a certain class, e.g. all vice presidents receive $25,000 per year for 10 years, and all senior vice presidents receive $35,000 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, e.g. 5 percent for all vice presidents, and 7.5 percent for all senior vice presidents.
Under this approach, a calculation is made for each participant to determine the premium level that will provide the promised retirement benefit. Because of the substantial level of complexity that is added, employers generally prefer the defined contribution approach.
Vesting -- as that term is used in qualified plans -- is not applicable to executive bonus plans. Nonetheless, by specifying in the resolution authorizing the plan that the bonus is to be used only for the purchase of permanent life insurance, the employer has the assurance that the bonus will be used for that purpose.
There is a "golden handcuffs" aspect to an insured bonus plan to the extent that the executive will become accustomed to the insurance coverage, will want the retirement benefit, and may carefully consider the value of the benefit when other employment opportunities arise. Also, although somewhat unusual, an employer may restrict the executive's rights to the policy by limiting cash value access only after a period of time specified by the employer.
Funding the Plan
Insured executive bonus plans are funded by a permanent life insurance policy, and any type of policy may be used. However, one type of life insurance plan may be more appropriate than others depending on the formula used.
A plan with a bonus formula under which a bonus is payable only if certain objectives are met probably ought to be funded with universal life insurance because of its premium flexibility. Even though a whole life insurance policy with an attached rider designed to accept premiums in excess of the policy premium can offer some flexibility, it is difficult to approximate universal life insurance flexibility in any other life insurance policy design. Furthermore, the easy access to cash values by withdrawal helps make universal life insurance the preferred policy.
The employer or participant may choose declared-rate universal life insurance, equity-indexed universal life insurance or a variable universal life insurance policy. That choice typically depends on risk tolerance level. If premium flexibility is not a concern and the participant wants substantial guarantees, a whole life insurance policy may be the right choice.
A deferred annuity may also be used as a funding alternative for an executive bonus plan, especially for the uninsurable executive. Despite their lack of a substantial death benefit and FIFO tax treatment, annuities can be issued to any executive, regardless of health and may produce larger cash values than permanent life insurance.