Executive benefits are often viewed as “extra compensation”; that is, payment over and above salary, bonus, and equity. Consequently, boards, shareholders, and the media alike are scrutinizing executive benefit plans more than ever before./p>
That’s why it’s important to form an objective basis and process for determining which of the many possible benefits make good business sense, and to know how they may help or hurt an organization’s ability to attract, retain, reward or motivate those key employees who can make a difference.
When we think of executive benefits, we often only think about deferred compensation and supplemental executive retirement plans. Of course, these benefits help the executive with tax planning and wealth accumulation and retirement
But there is often a valuable benefit that is overlooked. Life insurance.
All employees value the life insurance benefits provided by their employers. However, highly compensated people tend not to receive equal treatment. First, most group life insurance programs are structured as a multiple of the employee’s salary, say 3 times. But most senior executives receive the majority of their compensation from variable pay which includes cash bonuses and long-term incentive plans which include stock options and restricted shares. What’s more, most group life insurance plans also cap the benefit amount, usually around $500,000. So our typical executive not only gets a reduced benefit based on salary only, he is capped, too.
According to a study done by MetLife, “Watch the Gap!”, earning a high income does not preclude concern about personal financial risks. Forty-two percent of highly compensated employees say they are very concerned about the financial effects of a loss of income in the event of a disability and/or premature death. However, despite these concerns, more than one-third (38%) of highly compensated employees who were surveyed reported that they did not have sufficient life insurance and disability insurance at all.
Employers are well positioned to help—especially as 51% of executives in the study reported they were looking to their employers for more help in achieving financial security through employee benefits.
TAXES AND CAPS
When employers provide group term-life insurance in excess of $50,000 for employees, the benefit is considered by the Internal Revenue Service (IRS) taxable as income. Section 79 of the Internal Revenue Code (IRC) requires employers to calculate taxable income for employees that receive more than $50,000 in term life coverage, which must be reported on the employee’s W-2 form.
What this means: Employees covered by an employer with a benefit of more than $50,000 must pay taxes for the “value” of the excess benefits. For example, if our sample executive has $500,000 of group term-life insurance coverage paid for by the employer, the employer needs to determine the value of the benefit to the employee.
In this example, the excess coverage is $450,000 ($500,000 minus $50,000). The “value” of this coverage less any after-tax payment the employee contributes toward the coverage, is the value of the excess benefits that must be included in the taxable compensation for the employee each year. Take a moment to reread that sentence.
The amount of taxable income on coverage in excess of $50,000 is known as “imputed income.” In order to calculate the imputed income for an employee, Section 79 Table 1 Rates for group term-life insurance must be used. Table 1 is a uniform premium table published by the IRS that is used to determine how much imputed income applies to each employee.
The cost of the excess coverage is based on the Table 1 rate, not the rate the employer or employee pays for the coverage to the insurance carrier. Table 1 rates are age-banded step rates, and the age of the employee as of the last day of the taxable year must be used in calculations.
Cost Per $1,000 of Protection for 1 Month
25 through 29
|30 through 34||.08|
|35 through 39||.09|
|40 through 44||.10|
|45 through 49||.15|
|50 through 54||.23|
|55 through 59
60 through 64
65 through 69
70 and older
The basic formula for the imputed income calculation for our sample executive is as follows: (Total group term coverage – $50,000) / 1,000) x Table 1 rate for employee’s age.
– Age 45 $810
– Age 55 $2,300
– Age 60 $3,564
– Age 65 $6,858
In this example, we assumed the executive’s benefit remains static over the year, but it is not uncommon for the amount of coverage to change (due to adjustments in pay or changes in his position (with a cap). And with most group life plans, the benefits are reduced, usually by one-half at older ages. Therefore, our sample executive would be reduced to $250,000 of coverage.
The employer who provided this benefit paid between 15 cents and, on the high side 30 cents, per month per thousand, yet the executive included much more in their taxable income. Does that make any sense?
HIGH COST OF CONVERSION
To add insult to injury, if the executive wants to convert his group life insurance to a term policy, the cost is prohibited. Many executives, due to their high-net worth, require life insurance protection into retirement to pay estate taxes and provide liquidity to their estate or to cover final expenses. In a typical group policy, the annual premium for conversion at age 55 is $31.18 per thousand, at age 60 $40.25, and at age 65 $52.85. Remember, at the older ages, the group benefit may have been reduced to one-half—that’s all the executives can convert without evidence of insurability.
Individual 10-Year Term Policy – The first solution is to cap the executives at $50,000 and provide them with an individual term life policy that is portable, convertible at reasonable rates and issued without evidence of insurability. EBS offers a customized solution with rates well below the imputed income paid by the executive. The employer would simply pay the premiums, include them as income to the executive, and take a corporate tax deduction.
Split Dollar Life Insurance – A Split Dollar plan helps to address the executive and company’s primary concerns by providing executives with current life insurance protection (or increasing to a multiple of total earnings). This holds the potential for future cash value appreciation while giving the company the flexibility to select participants and recover costs at the termination of the agreement due to death, retirement or separation from service of the participant.
Split dollar plans hold benefits for both the employer and the insured executive. They can help employees provide for their survivors’ welfare and help an employer develop a group of loyal key executives. Both of these objectives can be accomplished at virtually no long-term cost to the employer.
The value of a split dollar plan for a specific employer depends on its needs and objectives. Some of the generally more important employer benefits are:
- The executive becomes more closely involved with the employer
- The plan helps to impart a feeling of executive value
- The plan is simple to administer and involves no long-term employer cost
- Control in a traditional split dollar plan resides with the employer
- The policy’s cash value becomes an employer asset
- The executive has a lower cost of life insurance
- The plan could provide post retirement life insurance benefits.
Since the employer’s contributions to the split dollar plan depend on the executive’s remaining with the corporation, the plan can cause the key executive to identify more closely with the employer. In addition, a key executive that is considering a change of employers may see the loss of a split dollar benefit as an incentive to remain in the current situation. For more information, read this full report on split dollar life insurance.
Death Benefit Only Plans (DBO) – Like split dollar plans, DBO plans may make sense for employers looking to attract and retain key employees. Unlike group term insurance or split dollar plans, executives should not be subject to income tax on the value of the current life insurance protection.
The employer generally cannot take a current deduction for the life insurance premiums but should receive the death benefits without an income tax. The death benefit payments to the surviving beneficiaries should be tax deductible to the corporation.
In the case of DBO plans, the executive does not pay any economic benefit tax or have any imputed income, because the ultimate benefit is taxed at individual ordinary income tax rates. Many companies pre-fund these obligations and gross up the benefit to the beneficiary for tax purposes.
If your company is using COLI to fund other benefit obligations, there may be excess coverage that can be used to provide this benefit. EBS through it’s Optimization Process ™ might be able to find those savings to produce such a benefit.
High turnover is expensive
It’s estimated that the cost to replace and hire new staff is 60 percent of the employee’s annual salary, states a 2008 Society of Human Resources Management Foundation report. But total costs of replacement—including training and loss of productivity—can range from 90 percent to 200 percent of an employee’s annual salary, according to a 2006 PricewaterhouseCoopers report.
We venture to say that no corporation in the country can afford to lose competent executives. As the economy improves, quit rates will increase as executives look for better opportunities. That’s why it is a worthwhile exercise to revisit your benefits package to make sure it’s maximizing retention potential.
See you on the upside,
- Chris Wyrtzen
- 617.904.9444 ext. 111
- Bill MacDonald