I work with corporate clients on a daily basis regarding executive benefit plans and overall brainstorming on ways to best meet their short-term and long-term needs. One of the most discussed areas in the past few years has undoubtedly centered on deferred compensation (“DC”) plans, particularly those informally funded with life insurance.
What is a deferred compensation plan?
A DC plan is an elective or non-elective plan, agreement, or arrangement between an employer and an employee – or service recipient and service provider – to pay the service provider compensation in the future.
DC plans can provide for employee-only elective contributions, employer-only elective contributions, or both employee and employer contributions. DC plans are “nonqualified”, which means that there is a significant amount of flexibility in establishing their terms, as long as certain legal requirements are met.
In simplified terms, DC plans provide my corporate clients with a way to offer additional benefits to help attract and retain key employees and facilitate business succession. I’ve worked with, drafted, and implemented these types of plans for well over 10 years, and am extremely familiar with all types of informal funding mechanisms, as well as the advantages (and disadvantages) of each mechanism.
What is premium financing?
Premium financing (“PF”) involves the lending of funds to a person, company, or trust to pay an insurance premium. Premium-financed loans are often provided by a third party, typically a bank, at favorable loan rates.
In essence, by implementing a premium financing strategy, my client will not be making the premium payments directly but will instead enlist a lending institution to make premium payments on its behalf. My client will simply be required to pay the interest on an annual basis.
Is this too good to be true? The straight answer is NO.
One of the biggest challenges I find is getting my client to take the time to truly understand the premium finance process and related components.
Is the PF strategy complex? Yes. But once my client can grasp and truly appreciate the strategy and underlying process, the significant benefits are readily apparent.
Through a PF strategy, my client company obtains life insurance on its key executives, but only pays the interest on the annual premiums. This gives my client the ability to maintain key assets that might otherwise be needed to pay the full annual premium amounts. Thus, the company benefits by maintaining key person life insurance on its executives, and by retaining important assets investment and/or wealth-generating purposes. For a comprehensive article on PF and related strategies, see: https://www.fraserstryker.com/premium-finance-strategies-and-outlook-for-2022/.
At what financial level does premium financing make sense?
There is no set financial requirement for PF; however, $5 million is my generally recommended starting point to explore whether the PF strategy makes sense for a particular client. This can mean a $5 million face amount of the life insurance policy or a $5 million net worth. The specific facts and circumstances of each case need to be examined before determining whether PF is right for a given client or company.
The key requirement is that the company needs to be able to pledge collateral and be able to demonstrate to the lending institution that it has the ability to pay the interest on the annual premiums.
What is the target business size for deferred compensation plans?
Small to medium-sized closely held businesses are the largest target market for these types of deferred compensation combined with premium financed life insurance. There is a very large market for closely held businesses with significant assets, who want to purchase life insurance for key executives, yet at the same time allow their corporate assets to continue to appreciate.
Still, many larger companies are also implementing DC plans combined with PF. This allows such companies – who have considerable assets – to provide an additional benefit for key executives that includes an insurance benefit in the event of death. And as previously mentioned, the company only pays the interest on the annual premium(s) so its other assets can continue to appreciate.
Currently, I have clients ranging from one owner/employee to 400 employees with DC plans in place. The ability to customize such plans makes them ideal for clients of all sizes and in many industries.
Is the market for deferred compensation plans growing?
Absolutely. The market for DC plans has continued to grow exponentially since 2020. Many employees/individuals have realized that they need more than just a salary and want additional employee benefits. DC plans are a strategic way for businesses to attract and retain employees in this market.
DC plans can be informally funded in many ways, However, using life insurance, and specifically, premium financed life insurance, to informally fund a DC plan has considerable tax and asset-preservation advantages.
How can financial, investment, and estate planning advisors introduce the concept of using premium financed life insurance to informally fund deferred compensation plans to clients?
This largely depends on how the advisor prefers to communicate with his or her clients but involving a legal expert as part of the communication process is often ideal so that the attorney can explain the advantages and disadvantages, as well as the ways to mitigate any potential risks.
I often assist advisors with the explanation process to help alleviate any concerns and answer any questions from a legal or compliance standpoint. There is no risk-free scenario, but there are many win-win scenarios that significantly benefit the employer and employee(s) in a very low-risk/high-reward model.
How can we communicate the value of deferred compensation combined with key person life insurance for our employees? How does that process work?
The benefits of DC plans are huge – especially in today’s economic environment. Employees, and particularly key executives, want more than just a salary and basic benefits. Companies can communicate the value of informally funding DC plans through key person life insurance on their own through educational materials or can have an attorney advise regarding the same. Either way, the compensation and tax advantages are significant and can lead to stellar results both in the short- and long-term.
Does this deferred compensation planning naturally lead into buy/sell or other succession planning?
Absolutely. While the overall DC/PF model depends on the specific goals of the company, the implementation of a customized DC plan is key for my clients who want to retain key employees and facilitate their buy/sell agreements and business succession plans. For numerous reasons, informal funding through premium financed life insurance is a very successful strategy for clients with significant assets and considerable asset appreciation potential.
Do you see deferred compensation plans that are funded with COLI or retail products?
Yes. DC plans can be informally funded by whatever type of insurance product that makes the most sense for the client and their executives/insureds. By consulting with an employee benefits attorney and life insurance advisor, the company can implement a plan to meet its business needs.
Informally funding DC plans through life insurance – and particularly premium financed life insurance – can be very beneficial for companies who want to offer executive benefits while still maximizing asset appreciation. DC plans are an excellent mechanism to facilitate business succession, attract and retain employees, and provide additional employee benefits for key executives.
It is important to work with an attorney who specializes in executive benefits, specifically related to deferred compensation and life insurance, as well as an insurance expert. This will help ensure that the company works with solid advisors to develop the best overall strategy to achieve its short-term and long-term goals in a legally-compliant manner.
Author: Emily Langdon
This article has been prepared for general information purposes and (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal advice from a qualified attorney. Always seek professional counsel prior to taking action.