Supplemental Executive Benefit Retirement Plans – What & Why for Your Financial Institution

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(Last Updated On: May 26, 2020)

What does a retirement plan for your leadership team have to do with the success of your financial institution? Funny you should ask. Turns out, they play an important role in retention, recruitment, and taking care of your existing executives.

In this article, you will learn the benefits, terms, qualifications, and recipients of these plans. Make sure you read through to understand the opportunities, as well as potential (costly!) risks if you implement them incorrectly.

What is a Supplemental Executive Retirement Plan?

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A Supplemental Executive Retirement Plan, known as SERP, is a retirement arrangement for select top executives and the C-level team.

Sidenote:

We use the acronym SERP on the Learning Library for another topic as well: Marketing. Shakes fist at sky…ACRONYMS!

For our SEO experts, SERP represents “Search Engine Result Page”. As a fellow marketer, I feel your confusion, frustration, and pain. Not only are we giving you another acronym, it’s literally the same as one you’ve used for years. Sorry!

Imagine how the retirement plan experts feel when you start talking about SEO efforts? “Why do they keep mentioning an executive retirement strategy for our digital marketing?”

Ok, enough ranting about acronyms. Back to SERP, the retirement plan one.

A SERP is a supplement to your standard retirement plan. It offers benefits above and beyond what you have now. As such, it is not a replacement, so if you like what you have now, keep it!

Why Add a SERP?

Putting Coins in Clear Piggy Bank

If you already have a retirement package, why bother with another benefit? Great question. It comes down to competitiveness and reward strategy. 

Your SERP is intended either to secure your executive’s participation on the team until retirement or to reward them for their loyal service. The other Executive Benefits we discuss have similar goals.

Retirement preparedness is a concern of all your employees, including the executive team. This lets you help them all. We’ll get to that, and more, below.

Are SERPs Tax-Qualified?

No. SERPs are not tax-qualified. SERPs are deferred compensation plans, otherwise known as non-qualified plans.

Most likely, your standard retirement plan is qualified. In other words, it meets certain participation, coverage, vesting, and funding requirements set out under the Internal Revenue Code (IRC) Section 401.

Such tax-qualified plans receive tax-favored treatment, such as pre-tax contributions allowed under IRC Section 401(k).

Tax Forms and Computer Mouse

Since SERPs are unfunded, they receive no special tax considerations. However, there’s an upside to this designation. Keep reading.

What are the Advantages of a Non-Qualified Plan?

The primary advantage of a non-qualified deferred compensation plan:

Few IRS compliance requirements or coverage testing

With your standard 401(k), contributions can be limited due to maximum annual contributions or income eligibility thresholds.

Your SERP, as a non-qualified plan, has none of these limits. Thus, it can mean an additional financial incentive to your executive team, encouraging them to stay with your institution.

Specifically, a SERP does not require:

  • Approval by the IRS
  • Complex administration

It also is not subject to:

  • IRC penalties for early distributions prior to age 59 1/2
  • Mandatory distribution rules required at age 70 1/2
  • Vesting and funding rules required for qualified plans

Your SERP lets your institution control the plan while owning the life insurance policy (if used for financing the SERP; we discuss further later in the article). The cash value accumulates tax deferred.

Also enjoy:

  • Deferral of contributions
  • Deferral of the taxes applicable to contributions until distributed at retirement
  • Distribution at retirement is a business expense to the institution
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How does a SERP contract work?

Institution Obligations

Imagine you’re the executive staff receiving a SERP. The institution presents a contract between your two parties. They promise to pay an agreed-upon dollar amount as a supplemental benefit at retirement.

Executive Obligations

Your obligations include performing substantial services with the institution (ie. being an awesome executive!) and meeting certain eligibility provisions (see your contract for details).

Make sure you (whether the executive or program advisor) advise your team on receiving benefits while avoiding negative tax consequences.

Are SERPs funded?

No. Unlike qualified plans, the IRS specifically requires that non-qualified deferred compensation plans like SERPs have no formal funding mechanism.

How does your institution pay the SERP benefit?

Coins Stacked in Front of Clock

Your institution may finance SERP benefits directly out of its treasury. You may also invest in mutual funds, ETFs, or annuities.  A combination of these three investment strategies is also possible.

However, the typical approach is purchasing a life insurance product to finance the benefit.

Assuming your institution goes this route, you will pay the life insurance premiums and own the cash value of the policies. These policies become part of the institution’s assets, subject to the rights of its creditors.

This type of life insurance policy arrangement is known as “split-dollar” insurance. This means that the insured(s) will share the cost of the premiums and the benefits of the life insurance policy, such as the death benefit, the cash value, and other components.

What if you went that first route, where the SERP is financed out of your treasury? That’s an option. In this case, your books will show:

Annual expense amount = Present value of future payment stream for each selected key employee

What are the legal requirements?

The IRS rules relating to non-qualified deferred compensation plans appear in IRC Section 409A. The plans are generally referred to as “top-hat plans.”

Can financial institutions create a top-hat plan?

Top Hat and Cane
You get it. You don’t have to laugh. Or chuckle.

Yes, your financial institution can design a top-hat plan. According to IRC Section 409A, it must not have a formal funding mechanism. This section also mandates you provide written notice to the IRS that your plan exists.

If the top-hat plan permits participation by rank-and-file employees, the top-hat plan will:

  • Forfeit its non-qualified status
  • Trigger tax qualification issues under the provisions of IRC Section 401

This would mean failing to comply with Section 409A, which, in a word, is bad. You may see tax consequences (varies if a credit union or for-profit institution) and a 20% penalty could apply.

Ask your regulatory people to look away now. Because if you end up in this situation, your deferred compensation plan becomes subject to ERISA’s regulatory framework.

So, to summarize: You may create a top-hat plan. It must not be formally funded. If you plan to include all your employees, don’t include the SERP.

Can credit unions provide a SERP for key employees? 

Line of Piggy Banks

Yes. In fact, the IRS prohibits non-key employees from participating in a SERP. To be clear, this means you cannot offer it to your entire employee base (IRC Sections 457(b) or 457(f)).

Top-hat plans must comply with Section 409A (see previous section).

Section 457(b) plans are known as “eligible” deferred compensation plans and incorporate contribution limits specified under IRC Section 402(g).

For “eligible” plans, non-qualified deferred contributions and the earnings on the contributions are both tax-deferred.

Section 457(f)’s SERPs are considered “ineligible” and have no annual contribution limits. However, in exchange for that advantage, an “ineligible” SERP must contain a “substantial risk of forfeiture” clause.

Key points:

  1. The employer promises to pay the employee a benefit equal to a specified dollar amount or a percentage of final compensation.
  2. No salary reduction.
  3. The promise to pay is unfunded and unsecured. An employee is a general, unsecured creditor of the employer.
  4. Typically, the benefit is subject to a vesting schedule. In some cases, there is a 100% forfeiture of benefits if the employee terminates prior to a designated retirement age for reasons other than death, disability, or change in control.
  5. If the employee has no substantial risk of forfeiting the SERP’s benefit that year, it is treated as taxable income. Forfeiture clauses generally include service performance or meet earnings thresholds to avoid the forfeiture.

What are the costs for a SERP?

Analysis Over Chart

You want to keep employee benefit costs under control. That makes sense. Beyond the costs for compensation to your included employees, there are other expenses to implement and operate a SERP.

Here are some of the costs for your non-qualified deferred compensation plan:

  • Actuarial/consulting fees to determine the present value of the payment stream
  • Legal fees to draft the contract
  • Premiums paid for life insurance (not deductible when made)

Consider negotiating the terms of the life insurance policy. This may let you recover some of the costs through the death benefit paid under the policy.

Ongoing, your bottom-line impacts are minimal. In most cases, it’s cost-neutral.

Consult a Trusted Advisor

Trust in Sand

Like other employee benefits, there are complexities you need to consider. For that, it’s best to talk to the experts. No, that’s not us (though we do aim to learn what we can to share honest guidance!).

When building a plan, you want to ensure it is compliant and have confidence you won’t run into any IRS surprises. We work with the professionals at The Sheeter Group. Should you? That’s not for us to say.

Your executive staff wants financial security. The institution is looking for affordable and valuable benefits to retain and attract leadership. A Supplemental Executive Retirement Plan might be part of your effort to achieve both goals.

Executive Benefits & More

We hope this article helped you decide if a SERP is worth pursuing at your financial institution. It’s part of our Executive Benefit section of the Learning Library. Want more insights to help save time, money, and energy? Subscribe to the Learning Library!

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Thanks for being here and we hope to continue assisting your financial institution’s mission.

Joe Winn - CU Geek

Blogger. Speaker. Part-time Jedi.

Focused on helping your bank or credit union grow in the face of emerging challenges.