What Is a Supplement Executive Retirement Plan and How Do You Get One?

A Retirement Plan for Attracting and Retaining Upper Executives

From The Balance.com October 2019 By Tim Parker

Companies know that attracting and retaining key executives is a difficult task. To solve this problem, a company might offer a different retirement plan as part of certain employees’ benefits packages.

Every employee has value, but some employees are harder to replace than others. An entry-level employee working in a company’s manufacturing plant who leaves probably isn’t going to impact the company as much as the CEO, CFO, or other high-level executive’s departure. Ideally, a company board would have measures in place to deal with executive departures.

One of these measures is a Supplement Executive Retirement Plan (SERP), which is designed to be a more lucrative retirement option for retaining top talent.

The Supplement Executive Retirement Plan

Qualified retirement plans refer to plans such as a 401(k) that qualify a company for tax breaks. Qualified plans also require testing to ensure that all contributors are contributing fairly (more on this later). A nonqualified plan does not follow the testing that is required for fairness like a 401(k), is tax-deferred, and does not have contribution limits.

A SERP is a non-qualified plan, allowing it to function outside the rules of IRS regulated qualified plans. Unlike qualified plans like a 401(k) or pension plan, employers don’t have to offer the SERP to all employees.

SERPs don't follow IRS tax laws such as penalties for withdrawing from them before age 59 ½. There are no required minimum distributions at age 70 ½ either. Think of a SERP like a private pension plan for selected key executives.

Reasons to Offer SERPs

Companies don’t want to hire key executives who will only stick around until the next opportunity presents itself. Not only is there a lot invested in a top-level employee, often they are brought in to implement a multi-year restructuring plan.

Or, over time the executive might prove to be highly valuable—enough to make them an offer that would keep them at the company for a number of years.

A SERP is an extra piece of compensation designed as an incentive to attract an executive to stay for a long period of time—an added benefit for the executive while also acting as an informal insurance policy for the company.

An Alternative to Standard Company Plans

High-level executives are normally considered to be “highly compensated” by IRS rules. A highly compensated employee (HCE) is one that makes at least $120,000 per year or owned at least 5% of the company during the current or previous year. The IRS has non-discrimination rules designed to keep the highest-paid employees from enjoying all the benefits of a company 401(k).

While regular employees can contribute up to a set amount in their 401(k), highly compensated employees can see their limits significantly cut. This is due to IRS regulations requiring that HCEs not have an advantage over other employees (the ability to max out their 401(k)s). HCEs cannot contribute more than 2% higher than the average employee contribution.

Because of this, employers sometimes offer a SERP to provide an easier way to save for retirement and live at a standard similar to the one they enjoyed while working.

How a SERP Works

Because a SERP isn’t offered to all employees, you’re not likely to find a pre-defined package in the employee handbook. A typical arrangement would be for the employer to provide compensation equal to 70% of the executive’s highest 3-year average compensation. The details of the plans vary widely between companies.

That doesn’t mean the SERP alone will provide the entire 70%. The company may look at contributions to the company 401(k) plan, social security income, and other sources to reach the 70% number.

Each agreement is individualized based on bargained-upon performance metrics and vesting conditions. Often, the employee is required to stay with the company until retirement to receive the full package.

The most common SERPS are in the form of a cash value life insurance policy. Here’s an example: Assume that the employer and employee agree on a SERP that will pay the employee $65,000 per year for 10 years from ages 61-70.

The employer would purchase a life insurance policy owned by a company large enough to finance the agreement while leaving some surplus for the company. Since the company pays the premiums, it has access to its cash value.

Because the company structured the policy to leave a substantial amount of cash value in place after paying the 10 years of benefits, the policy continues to accumulate value even after the employee is separated from the company.

When the employee passes away, the company receives the life insurance benefits tax-free. This allows the company to recover the cost of the SERP and receive a tax deduction.

This is the most common type of SERP. Another common arrangement is a defined contribution plan where the employer makes periodic contributions to an employee account, much like a pension. The money is invested on the employee’s behalf until retirement, death, or disability triggers the payment.

Tax Treatment of a SERP

Recipients will pay ordinary income tax on the funds as they’re received. However, much like traditional retirement plans, the employee shouldn’t have to pay any upfront taxes. This arrangement allows the funds to grow without taxes negatively impacting the balance.

Another tax advantage of a SERP is that once an employee enters retirement, their income level normally drops, putting them in a lower tax bracket than when they were actively employed. This might lower the tax liability on the SERP payment.

Risks to the Employee

The primary risk of a SERP is that it is subject to the claims of the company’s creditors. Unlike a 401(k) where the money is safe even if the company ceases to exist, a SERP is not safe unless certain planning is done to protect those assets.

Also, the SERP must have conditions that make it subject to forfeiture. Forfeiture for the purpose of a SERP is the clause(s) that dictates circumstances in which the executive will not receive the SERP, forfeiting the benefit. Examples of circumstances could be felony convictions or engaging with the competition.

In other words, it’s not a guaranteed payout. If the employee leaves the company early or doesn’t meet the performance goals agreed upon, they won’t receive the benefits. If there is no risk of forfeiture, the IRS may label the benefit to be “funded” and immediately tax the employee.

SERPs Are Rare

In your early years, when you’re climbing the corporate ladder, you’re not likely to be at a high enough level in a company to be offered a SERP. Even if you make it to an executive level, you may not be offered a SERP unless you have made yourself indispensable to the company.

As you gain experience in a high-level executive position, a SERP could become part of your negotiating package with a new employer or a renegotiation of your compensation package at your current employer.