Industry Experience

Supplemental Retirement Income

A Supplemental Executive Retirement Plan (SERP) is an agreement between an employer and a selected key employee in which the employer agrees to provide a specified benefit at retirement, or upon termination, disability, or death prior to retirement.

SERPs are funded entirely by the employer with no contribution by the employee. In this sense, SERPs are unlike nonqualified deferred compensation plans in which the employee is, at least in theory, deferring compensation that otherwise could be taken currently.  Unfortunately, SERPs are often described as “deferred” compensation agreements. In any case, SERPs are exactly what their name implies, they provide retirement benefits that supplement all other retirement plans such as IRAs, 401(k) plans, or qualified defined benefit pension plans.

The retirement benefits to be provided are generally determined using either a defined benefitor a defined contribution approach. A defined benefit agreement specifies an exact dollaramount to be paid (in a lump sum or otherwise) upon retirement, or upon termination, disability, or death prior to retirement. In recruiting high level executives, this type of SERP is often used to replace retirement benefits that will be forfeited when leaving another company. Rather than a fixed dollar amount, benefits under a defined benefit approach are more likely to be determined using a formula that considers the employee’s years of service and pay (e.g., 70 percent of final five years average pay). When a defined contribution approach is used, individual accounts are established into which either discretionary or results-tied contributions are made based on company performance (e.g., 20 percent of salary if profitability exceeds a pre-determined target). Vesting schedules are often used to provide for a graded benefit should the employee terminate employment prior to retirement.

Payments under the SERP are taxed as ordinary income to the employee in the year received and are deductible to the employer in the year paid. Should the employee die, payments to the surviving beneficiaries are also taxed as ordinary income (i.e., the life insurance death benefit is paid to the employer, not to the employee’s beneficiary).

When life insurance is used to informally fund the employer’s obligations under a SERP, the employer purchases cash value life insurance on the employee’s life (see notice and consent requirements, page 309). The employer owns the policy, pays the premiums, and is the policy beneficiary. If the employee dies prior to retirement, the policy death benefit is payable to the employer. These funds can then be used to provide survivor benefits to the employee’s beneficiary under the terms of the agreement. Upon the employee’s retirement, the employer can use policy cash values to assist in meeting its obligations under the agreement, maintain the policy until the insured’s death, or otherwise sell or dispose of the policy.