In our practice, we are often asked to build total compensation and benefit plans that give employers the extra power to attract, reward and retain talented executives and key employees.
One common dilemma for employers is how to reward select executives. A group executive carve-out plan is a smart way to reward key executives beyond what is available through a typical group term life insurance plan.
Group term life insurance is a standard in most employee benefit plans, and typically features a minimum $50,000 death benefit pay-out—woefully short of the financial needs of most top executives and their families. Even if the plan stipulates a six-figure pay-out at death, it is doubtful the money will adequately cover mortgages, college tuition, or other life essentials, when the primary income-earner passes, leaving the family with unpleasant options.
So, let’s say, you’re an employer with a top-notch executive team. And you’ve covered your entire leadership team on a group term-life policy with a six-figure death benefit. The typical policy contract will include provisions that may raise premiums and reduce benefits.
For example, what happens when your executive turns 65? Depending on contract provisions, coverage drops: the death benefit on that group term-life policy reduces by 25 percent; at age 70, it drops by 50 percent; at age 75, it drops by 75 percent. What’s more, the presence of older executives in the risk pool pushes up rates for everyone in the pool.
Worse yet, the executive cannot easily go out and replace the policy with permanent life insurance because premiums will rise substantially, right when income decreases at retirement. By this time, too, the executive can face health hurdles such as passing the medical exam, common to elder years.
Executives can easily lull themselves into a state of false security, thinking their group term-life policy will carry them throughout life, a high-risk assumption. Here’s why:
Limits of Group Term Life
Ordinary group term-life insurance carries a non-discrimination requirement (everyone must be treated equally). If the employee retires or leaves an employer (or high expense to continue it) and imputed income costs for coverage over $50,000.
- Coverage must be provided on a nondiscriminatory basis (If not, employees may face disadvantaged tax treatment and employer’s premium payments may become taxable income to plan participants);
- Coverage is adversely affected, reduced or terminated at retirement (If executive wants to obtain permanent life insurance, premiums increase when income decreases);
- Coverage is lost upon termination (if executive leaves employer, coverage stops);
Consider the Executive Carve-Out Solution
An executive carve-out life insurance plan rewards key, tenured executives, managers or team leads beyond standard group term-life insurance benefits. Those deemed eligible for this special policy can access potentially significant life insurance benefits capable of accumulating cash value over time.
Inside a Carve-Out Plan
When eligible for a group carve-out plan, the executive holds onto his or her $50,000 of ordinary group term-life insurance coverage, then the employer subsumes and supplements the coverage with a higher value universal life (UL) insurance plan. The employer decides which individuals it wants to “carve-out” of the standard term-life policy.
A UL policy upgrades the quality of insurance benefits because 1) it is portable from employer-to-employer; 2) it can create supplemental retirement income through its cash value; 3) employers can be highly selective and offer this policy to only those executives or employees making the greatest contribution to the company because the non-discrimination rule does not apply.
Carve-Out Benefits to Employers
If you’re an employer, or an executive who wants your employer to know the critical advantages of group carve-out plans, please note these plan benefits:
- Reduces potential for a discrimination violation in group term-life insurance
- Adds no additional costs unless death benefit increased or supplement contributions made
- Provides better cost efficiency than group term plan
- Gives freedom to selectively limit participation
- Provides a current employer a tax deduction on all premiums paid
- Encourages executives to participate in plan and stay the course
Carve-Out Benefits to Executives
A select group of top executives stands to benefit from a UL carve-out plan even more than the employer. With a separate plan, they now realize:
- An opportunity to maintain death benefits beyond retirement
- Tax-deferred accumulation of voluntary contributions
- Policy ownership and portability across employers as the policy continues in force
- Ability to use cash values to supplement retirement income
Carve-Out Options for Plan Designs
Employers can choose from three primary designs, each with pros and cons. See chart below.
Executive Bonus Plan
Premiums tax deductible to employer
Taxable income to executive
Executive owns policy
Employer cannot cost recover
Executive accumulates cash value to add to retirement income
Does not incent executive to remain with employer
Death Benefit Only Plan
Employer holds cash value
Employer premium payments not tax-deductible
Employer can deduct benefits payment
Benefit to beneficiaries taxed as income
Strong executive retention tool
Endorsement Split-Dollar Plan
Little to no tax implications if plan tweaked
Premium paid to employer not tax-deductible
Employer can cost recover expense
To buy-out employer policy rights requires substantial cash
Moderate retention effect
Of course, this chart simplifies a complicated topic. Allow the professionals at Henehan review the intricacies of these policies with you to ensure you can make an informed and successful decision.
Managing the Tax Bite
Tax implications are often the deciding factor as to which policy will suit your company. The IRS requires employees to report the value of group term-life insurance coverage in excess of $50,000. The IRS then imputes a value to that “excess coverage.”
These “Table I costs” are based on government rates and shown in the chart to the right may be higher than the actual coverage cost.
Consider that before a carve-out, an eligible key employee could hold $250,000 in group term-life insurance coverage. Of that coverage, the IRS taxes amount above $50,000 as imputed income.
Here, the company would be taxed on $200,000, representing a significant tax consequence. However, after the carve-out, the employee holds $50,000 in group-term coverage, capped at that level to avoid sustaining the imputed income and any tax penalties.
Since the employer pays the group UL carve-out premium, it also pays the policy costs levied on a per-policy or per-thousand-dollar basis. That’s why the executive’s voluntary contributions (in excess of the minimum premium) result in better returns than the policy’s interest crediting rate may offer.
If the executive makes additional voluntary premium contributions of $6,000 each year for the 20-year period, the cash value at age 65 increases to $282,000, or $274,500 in added funds. In other words, the $6,000 voluntary contribution made each year accumulates to almost $275,000, an approximate 7.3 percent annual return.
The table below assumes your executive saves $6,000 annually in a 36 percent marginal income tax bracket. The difference swells to an additional $73,108 at the end of 20 years at a 7.55 percent assumed interest rate. See chart below.
When we consider growth in the policy’s cash value as entirely tax-deferred until withdrawn, the 7.3 percent return may be much higher considering the executive’s marginal income tax bracket. Due to the FIFO tax treatment afforded any policy withdrawals (not a modified endowment contract) the executive’s voluntary premium deposits become a smart tax-efficient investment strategy.
So, an employer-funded UL carve-out policy provides necessary additional coverage, which grows in cash value over time. Both employer and executive benefit from tax savings and administration with the beauty of added retirement income for the executive—an excellent way to hold onto your best talent. And for the highly compensated executive, any form of tax deferral is worth pursuing.
To your life well-lived,
Joseph E. Henehan, president and chief executive officer
The Henehan Company