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Cutting Edge Executive Benefits

By Jim Van Eperen, VP Executive Benefits and Business Succession, Raffa Financial Services, Inc.

​The competition for top talent in the Washington, DC market seems to remain at a fever pitch. As a result, many of our nonprofit clients, as well as our for-profit corporate clients have sought our advice on how to provide a strong benefit and compensation package. There are too many factors that influence where a star employee chooses to work to discuss them all here. It is safe to assume that employers will offer a challenge, potential for growth, and competitive salary. When great candidates have several good offers from which to choose, most employers agree that strong, cutting edge benefits will help them stand out and ensure they have the quality employees they need. 

The landscape of compensation strategies is changing.  Whether your goal is to find that superstar new-hire who will help your organization thrive or to reward those existing people who have already been a key to your organization’s success, you should consider a variety of factors. 

The most common hurdles include expense, taxation, flexibility and the ability to provide special perks only to a selected few. Can you clear those challenges and provide a benefit that will be appreciated enough that it will serve to attract and/or retain the caliber of people needed? Salary alone will not keep a great employee – especially if a competitor comes along with a higher salary. Most employers are painfully aware that their existing top employees are also the top prospects for competitors.   

What are the challenges?

Today, ERISA and a labyrinth of employment regulations demand that employers provide benefits with virtual uniformity to all employees.  Many employers have told me they want benefits that align with and promote the culture they are trying to create.  I have been told, “It is just not good business to provide the same perks for everyone from your most valuable employee to the newest entry-level hire.”  Unfortunately, many of the regulations have focused so intently on parity that they have created an unintentional environment of discrimination against your most valuable (and highly paid) employees. 

For example, most would agree that a 401K plan, or one of the other qualified retirement plans, often serves as the foundation of a benefits package. I am an advocate of these plans and I know they serve the majority of employees quite well. However, I encourage you to consider how, on their own, they can send a discouraging message to top performers. 

To illustrate, I will review two mythical employees named Bill and Bob, who are each 45 years-old.  Bill is an entry level person without extraordinary skills or experience and has been given a salary of $50,000. Bob, on the other hand, is recognized as a dedicated employee, his skills are widely desired and he has already created great results for your organization. Bob has earned a salary of $250,000. The basic rules within a 401K dictate that these employees can contribute a maximum of $18,000 per year to the plan. If I disregard potential future raises and increased contributions that the 401K rules may someday allow, the percentage of each individual’s income  that can be replaced in retirement (via the 401K plan) is dramatically different. If both employees earn an identical rate of return (seven percent - not guaranteed) from age 45 to age 65, Bill will be able to replace over 100% of his income in retirement. The highly valuable employee (Bob) will only be able to replace 21% of his current income in retirement – even if he contributes the maximum amount allowed by law. 

If that was not bad enough, owners and “highly compensated employees” could even be precluded from making their maximum contribution to a 401K. The average deferral percentage (ADP) test can limit how much money highly compensated employees can contribute to the 401K.  In a recent case, Raffa Financial Services was called when several highly-compensated employees of a family business had the contributions they intended to make to the 401K plan refunded.  Since the contributions were returned, those executives were forced to pay taxes on the monies. The family and key employees affected were very disappointed. They intended to invest in their future but their contribution was rejected by the plan. Many employees can replace their salary using a 401K. Unfortunately, the most valuable employees may be capped at a very low percentage, which is unfair and typically not intended. The 401K is not the only benefit program where this sort of phenomenon can occur. 

There are plenty of studies that have tried to anticipate what percentage of income we will need in retirement. Many people have questions about the viability of Social Security and Medicare and the expected need varies between 70% and 100% of their full-time salary level. The need may vary but it is safe to assume that most employees who earn an income of $250,000 would not be happy about an employer-sponsored retirement plan which would only provide 21% of their salary ($51,654) at retirement. At the risk of piling on, I need to remind you that the distributions from the 401K plan are also fully income taxable.  If we assume a 40% tax, that leaves only $30,992 of retirement income or – just over 10% of their gross salary.

Today, top talent is often aware of the available options. Many want income in retirement to replace 100% of their salary. Smart employees will want at least some of their retirement income to be received tax-free, like a Roth IRA. Many also recognize the need for creative benefits that include more comprehensive permanent life insurance, or even Long Term Care insurance (LTC).  Most people do not want to go to a nursing home but want care in the privacy of their home. LTC can pay those expenses. To ensure these kinds of solutions for your most valuable employees, you should explore a custom benefits package.  

What are some possible solutions?

Fortunately, the daunting circumstances I outlined above are not insurmountable. In fact, there are new strategies that may be able to offer stronger benefits, tax preference, as well as efficiency and flexibility your organization needs. You may even be surprised at how affordable these strategies can be. 

Programs that provide all these appealing characteristics will often initially appear very complex. We are happy to walk you through design and budget options to start the process.  We are also able to ensure you have all the tools and support you need to communicate the features, value and thoughtful consideration you put into establishing these programs for your executives. 

One of the more appealing aspects of these special benefits is that they can be designed for a limited group of your choosing. They even allow different levels of benefit within the group receiving the plan. To accomplish this flexibility, we must use non-qualified plans. 

To help understand and compare qualified (IRA, 401K) vs. non-qualified plans we often explain that there are three times when taxes can become payable on a savings program. First, when you earn money that you will use to contribute, you may need to pay taxes. A 401K allows you to defer those taxes and as a result, they have many rules that must be followed. The second potential way taxes can erode your gains is while the money grows inside an investment. Here it can be subject to income or capital gains tax. Finally, when distributions are taken out as income in retirement, they can be taxed again. 

A 401K allows you to avoid tax when contributions are made and while the money grows, but it is subject to full ordinary income tax when withdrawn in retirement. Qualified Plans can also allow you to avoid two out of the three places where taxes can reduce your savings. The more flexible programs that are used today for executive benefits are typically Non-Qualified Plans. These also allow you and your most valued employees to avoid two out of the three times where taxes can be payable. They simply reverse the order so that you pay tax on contributions going in, the growth is tax deferred, and when the distributions are made, they can come out tax-free too. 

I mentioned earlier that I clearly see the need for 401K plans. I am not looking to discourage the use of those plans as they serve a very valuable function by providing retirement income for the average employee. To design more flexible plans that can be offered only to the employees you select you need to use Non-Qualified plans. The two plans types can be offered together.

Non-Qualified plans can be very simple and informal. They can be as simple as an unfunded promise between employer and employee. They can also be designed with “strings attached” - where the employer has great flexibility to create a long-term vesting schedule. In this way, the special benefit that is provided can be forfeited if the selected employee leaves too soon or leaves inappropriately. The employer has a great deal of latitude when drafting the conditions necessary to receive the benefit. 

Occasionally, employers suggest that they might merely set up a sinking fund and invest in mutual funds to accrue the cash to pay the benefits. Unfortunately, that strategy misses out on tax advantages and other efficiencies. 

Let’s compare our two 45-year-old participants who each contribute the same amount into a program and earn the exact same rate of return on their investments. If one used a taxable investment, like a simple mutual fund, and the other chose a more tax-sensitive non-qualified plan, the results would be dramatically different. The individual using the mutual fund would contribute the same amount and earn the same return, yet they would have roughly half of the net-after-tax retirement income as the other participant. These plans can even be coupled with bank leverage to provide substantially more after-tax retirement income than a mutual fund alone.

If you would like to discuss how your organization might create special benefits for your top people, please feel free to reach out to me for a complimentary consultation at jim@raffafinancial.com.