Table of Contents: 2 Rediscovery of the Secular Trust
Written By: Robert D. Birdsell Marc Castor Managing Directors RCG|Benefits Group - Milwaukee
Doing the Basics Brilliantly as Fixed Rate NQDC Plans Return Yields Approach 6 – 12 Percent—Some with No Cost to Shareholders
Written By: William L. MacDonald Chairman, President & CEO RCG|Executive Compensation & Benefits Group
15 A Tax Exclusion is a Terrible Thing to Waste
Why It’s Time to Revisit the COLI Best Practices Act
Written By: Mark Walton, CFP® Senior Vice President RCG|Benefits Group
18 Executive Retirement Tax Alert
Download the Deferral-Timer SM for Rigorous Pretax vs. After Tax Investment Analysis
Written By: Chris Wyrtzen Managing Director RCG|Benefits Group - Boston
utives and other highly compensated professionals have enjoyed the benefits derived from “non-qualified” benefit plans for several decades. They sought out every imaginable way to defer tax on current income, delaying their income to a point where they would be presumably in a lower tax bracket. Now, however, these loyal citizens have been thrown a curve ball the likes of which they neither expected (nor, in their minds, deserved). In reality, there were three curve balls; the first was concealed in the new law dealing with deferred compensation, called §409A, which severely restricts both deferrals and distributions from deferred compensation plans, the second involved the erroneous assumption of receiving the deferrals in a lower tax bracket, and the third strike was the purging of the few safeguards formerly available in non-qualified deferred compensation plans. And of course, although not a direct result of current legislation or the prospect of higher taxes, the lack of security still exists in all non-qualified plans. This article will address the issues outlined above and offer some optimism for all highly compensated individuals who are interested in planning for their own financial wellbeing as well as the security of their families. The quandary created by §409A and the prospect of higher taxes in the future, however, has substantially affected the planning tools previously employed by most corporations offering non-qualified plans. The dilemma involves how to simultaneously address:
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Rediscovery of the Secular Trust • Benefit security • Current taxation • The restrictions resulting from the new 409A legislation • Future legislation and tax policy as it relates to retirement income
Rabbi Trust vs. Secular Trust Until now, the conventional approach to benefit security most typically involved the use of a Rabbi Trust to provide reasonable security for the increasing levels of deferrals held by corporations, both in terms of voluntary deferred income plans and the supplemental plans which have been prevalent for many years. And, although the use of Rabbi Trust have provided some level of security for the participants, such as change of heart and change of control, this device does little to address the issue of insolvency and bankruptcy. Nor does the Rabbi Trust provide protection against the prospect of higher taxes in the future. The probability of higher income taxes in the future is one of the primary reasons the use of deferred compensation plans has diminished in usage in the last 2 or 3 years. The question then becomes, if Rabbi Trusts can no longer be relied on to provide a reasonable level of security, are there other devices available to take their place? At RCG we believe the answer is absolutely! An ideal arrangement would ensure payment to the participant if the company is either unwilling or financially unable to pay. As pointed out above, the uncertainty of future tax rates adds additional risk to the executive. In the balance of this article, an old idea is rediscovered (or perhaps is just made contemporary). The concept is the “Secular Trust”, and what is innovative about this concept is how these arrangements are now being funded. The Secular Trust are so named to distinguish them from the Rabbi Trust and the major distinction between the two is the absolute security it offers the participant since the employer’s creditors “cannot” reach the money held in a Secular Trust. According to recent surveys, over 7% of the Fortune 1000 companies now use Secular Trusts and this number is likely to show significant growth in the years to come. Companies that currently use Secular Trusts include: Abbott Labs Advanced Micro Devices AMR Corp Chicopee Bancorp, Inc. First of Long Island Corp. Gentiva Health Services, Inc. Magyar Bancorp, Inc. Motorola, Inc. MutualFirst Financial, Inc.
Owens Illinois Inc. Pathfinder Bancorp, Inc. Resource America, Inc. Sherwin Williams TRW Automotive Holdings UAL Corporation United Community Bancorp Vector Group LTD Walgreen Co.
Application of Secular Trusts Secular Trusts have been adopted to provide security for: • Excess Benefit Plans • Voluntary Deferred Compensation Plans www.retirementcapital.com
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Rediscovery of the Secular Trust • Supplemental Executive Retirement Plans The important features and details of a Secular Trust include: • It is designed as an irrevocable trust • All benefits are ultimately vested • The benefit becomes taxable to the participant when it vests • The benefit is tax deductible to the company immediately • The benefits are 100% secured There are two types of Secular Trusts • An Employee Grantor Secular Trust • An Employer Secular Trust There are several IRS rulings on Secular Trusts; in 1991 and 1992 the IRS ruled that an Employer sponsored Secular Trust would result in double taxation, once to the participant and once to the trust. It is imperative, therefore, that only the “employee grantor” trust be used to avoid the problem of the double taxation. An Employee Grantor Secular Trust is a trust established by the employees for themselves; however, the employer still funds the trust and receives an immediate tax deduction. The employer contributions to the trust are technically first offered to the participant, who in turn authorizes payment to the trust. This modification results in the trust being established as an employee grantor trust which avoids double taxation.
How They Differ The major differences between the Secular Trust and the Rabbi Trust can be summed up as follows: Rabbi Trust
Based on distribution election
No- Can be funded at triggering event
May be funded at inception
Depends on trust terms
Depends on trust terms
Protected except for insolvency
Protected all times
Contributions Currently Deductible to Employer
Contributions Currently Taxable to Executive
Taxable to Executive at Distribution
No – The executive already paid tax at time of contributions. If not subject to a withdrawal power then subject to IRC Section 72
Employer Deduction at Distribution
No – Employer received tax deduction when first contributed to trust
Generally exempt from most requirements
Exempt from most requirements if it is an employee created plan with no employer contributions
Yes-but more palatable because funds are secured(1)
Forfeitability Availability to Executive Requirement to Fund Employer Control Over Funds Creditor Protection
ERISA Golden Handcuffs
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Rediscovery of the Secular Trust The advantages of the Secular Trust method of securing and funding executive benefits over other alternatives can be best summarized by examining the advantages from both the perspective of the participant and the sponsoring company. From the participant’s point of view, it provides 100% security, protection against the prospect of higher income taxes in the future, and access to funds, if required and no burdensome §409A issues to deal with. And from the sponsoring company’s perspective, the plan is totally transparent, with no accrued liability on its balance sheet, an immediate tax deduction, and low administrative expense. With the impressive advantages for both the participant and the company, why doesn’t everyone adopt a Secular Trust? Perhaps it is the economics? It would seem reasonable that a pre-tax saving methodology would have a distinct advantage over an after-tax alternative. After all if you have 100% of your money working at a compound rate, rather than just 60% (assuming a combined tax rate of 40%), it should provide an insurmountable advantage. The difference is not as significant as a person may at first suspect; please see the chart below which assumes a deferral of $50,000 per year for 15 years under a traditional deferred compensation plan and an after tax Secular Trust alternative at $30,000. The difference is approximately 16% in favor of the deferred compensation option as illustrated in the chart below: Table A: Traditional Pre-Tax Deferral Plan
7% Investment Earnings
Tax on Realized Gains
Amount Distributed 40% Tax Net Distribution
1,344,403 (537,761) 806,642
20% Capital Gains Tax
Financial Differences Given the obvious advantages of the Secular Trust has over other funding options, if the economics of this new strategy can be improved, at little or no additional cost to the sponsoring company, it may provide an important and refreshing new option for companies interested in improving the security of their non-qualified programs. Assuming a company currently offers a voluntary non-qualified deferred compensation plan, the cost of providing that benefit can be measured by acknowledging the associated cost of the three expense components comprising a deferred compensation plan which are: first, the supplemental contributions the company makes to the plan, if any; second, the out of pocket cost associated with the administration; and third (and often overlooked) the cost of the corporate delayed tax deduction on the deferrals. It is the last item, i.e. the delayed tax deduction, that may offer the greatest opportunity for a company to of the participant.
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Rediscovery of the Secular Trust It is beyond the scope of this article to engage in an in depth analysis of this cost reallocation, but a simple inspection should provide insight into the concept. Assuming the company sponsoring the deferred compensation plan has informally funded the a deferred compensation plan through the use of mutual funds or COLI, there in fact is a cost of providing a deferred compensation plan. For example, assuming the cost of capital for the sponsoring company offering the non-qualified deferred compensation is 6% after tax, the annual financial cost incurred by the sponsor of a deferred compensation plan is 6% times the lost tax deduction. Further, if the corporate tax rate (federal & state) is 40%, then for every $50,000 of deferrals the net cost to the firm is $1,200 ($20,000 times 6%). Keep in mind this cost compounds as long as there is an outstanding deferred compensation balance outstanding. In other words, the cost to the sponsoring company to maintain a non-qualified deferred compensation plan based on the above assumptions is $1,200 the first year, $2,400 the second, and by the 10th year $12,000. Earlier in this article, it was determined that the non-qualified deferred compensation plan had an economic advantage over the Secular Trust alternative by approximately 16%. Now we discover this method of evaluation is not contrasting similar benefit programs. In the Secular Trust, the company expense is recognized and extinguished each year with no lingering costs; however, under a traditional deferred compensation arrangement; there is a continuing and ongoing financial cost in the form of a lost tax deduction. Another way to view this concept would be to equate a deferred compensation plan to a tax free loan to the participant, since the company is crediting 100% of the executive’s deferrals with either an assumed interest rate or phantom equity accounts. In the example outlined above, where the annual deferral is assumed to be $50,000, the indirect loan, therefore, is $20,000 (the amount the company pays in current tax) and these amount increases each year a new deferral is elected. Only when the deferrals are paid to the executive does the company realize the benefit of the tax deduction. In the meantime, it has absorbed the financial cost of providing the benefit, which has generally been accepted as part of the cost of doing business in a competitive environment. As observed above, when comparing the corporate cost of a non-qualified deferred compensation plan with a Secular Trust arrangement, adjustments for the financial differences between the two options should be taken into consideration. To provide equity between the two options, a company could make a supplemental contribution to the Secular Trust in an amount equal to the financial cost of supporting a deferred compensation plan. Embracing this model would neutralize the disparity between the two options. The perceived advantage of the non-qualified plan vs. the Secular Trust alternative is eliminated; in fact, the advantage now is with the Secular Trust as is demonstrated in the schedule below, the company now reallocates their cost of sponsoring a deferred compensation plan to the participant in a Secular Trust. The cost reallocation is $1200 (pre-tax and $720 after tax) in year one, $2400 ($1440 after tax) in year two and increases by $1200 ($720 after tax) each year thereafter until retirement or termination, this amount is illustrated in the schedule below, and the company contribution is included in the column entitled “after-tax deferral”:
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Rediscovery of the Secular Trust Table B Traditional Pre-Tax Deferral Plan
7% Investment Earnings
Tax on Realized Gains
Amount Distributed 40% Tax Net Distribution
1,344,403 (537,761) 806,642
20% Capital Gains Tax
Ordinary Income @ 40%, Capital Gains @ 20% Blended Tax Rate @ 28%
Planning Opportunities A vesting component for supplemental company contributions could be added to the Secular Trust option which would improve the overall acceptance of the concept involving adding a supplemental company contribution. This feature could reduce the company cost of contribution resulting from forfeitures of company contributions. The company contribution, although nothing more than a reallocation of an existing expense, can be incorporated in the mix of cash and long-term incentive devices available to the sponsoring company. Finally, as established above, the cost of a non-qualified deferred compensation plan can be measured as a function of the cost of capital associated with the delayed tax deduction resulting from the deferral and that cost is not limited to any specific time frame (i.e. 5 years 10 years, 20 years etc) but rather is dependent on the service period of the participant, the longer the period the higher the cost. When a company adopts a Secular Trust alternative with a supplemental contribution many design options emerge. For example, the company can limit the number of years it will make a supplemental contribution to the program. In addition to limiting the time period it will make a contribution, the company may also introduce performance enhancements to the company contribution. For instance, if the alternate cost is established on a basis similar to what was described earlier, i.e. $1,200 year one $2,400 year two etc. then this level could be established as the maximum level the company is willing to contribute to the program. In other words, a minimum/maximum level could be established thereby using the opportunity to create some incentive/rewards components to what otherwise could be deemed a tedious and simply an opportune benefit program.
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Rediscovery of the Secular Trust
Assets Available for Funding The final issues to be reviewed in this article will involve the type of assets that may be most appropriate to be held in a Secular Trust, these asset categories include: • Mutual funds • Tax free bonds • Annuities • COLI/BOLI (corporate owned life insurance/bank owned life insurance) As with most asset evaluations, there are advantages and disadvantages with each alternative. Therefore, a brief review of each asset will be presented which will allow our readers to begin the selection process and select the option that is best for their particular circumstances.
Mutual Funds Mutual funds are used in funding circumstances generally where taxes are not an issue such as “not-forprofit” organizations. Also, mutual funds may be one of the simpler funding arrangements. However, in circumstances where taxes are an issue, mutual funds may not be as desired as other options, or would be used in conjunction with one of the other assets available to the company. The Secular Trust, as stated earlier does not pay taxes, but the owner or beneficiary of the assets will be required to pay the taxes as they become due. As a consequence, the immediate taxation of gains may prove to be undesirable. This asset would qualify for the “In Kind Distribution” type of asst.
Tax Free Bonds Tax free bonds may be a desirable option since there are no taxes due and these assets would qualify as assets that can be distributed to the participant as an “In Kind Distributions”. One negative of this asset category involves the lack of flexibility these assets contain inasmuch as there is no equity component. Tax free bonds may be used a desirable supplement, but probably not the only asset in the Trust.
Annuities Annuities offer several advantages including tax deferred accumulation and the possibility of investing in a wide range of investments, known as sub-accounts that function similarly to mutual funds but without the associated current income tax. The disadvantages, however, involves how annuities are taxed. First, if any withdrawals occur before 59½ a tax penalty will occur. If the owner choices not to annuitize the policy, but wishes to withdraw money from the contract, he/she will be taxed under the LIFO tax methodology-- that is, last in first out at ordinary income rates. If an annuity is elected, only a portion of his/her basis will come out tax free. As with the mutual funds and tax free bonds, annuities also qualify for “In Kind Distributions”.
COLI/BOLI COLI/BOLI policies have at least until now, only been available to corporate sponsors and used to fund various corporate liabilities. Now however, RCG has established a relationships with two providers of COLI who now allow individual ownership of such contracts. The difference in the pricing and the features of a
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Rediscovery of the Secular Trust COLI/BOLI type of insurance contract are significant since corporations expect and receive various benefits not available to the individual retail life insurance policies, including, no surrender charges, guaranteed issue, enhanced cash value, lower administrative expenses and lower COIâ€™s (cost of insurance). Perhaps the most innovative feature, however, is a special tax-restoration provision which allows the owner of the contract to restore the taxes paid on the premium. This provision allows the owner to borrow money directly from the insurance company up to 40% of premiums contributed at an interest rate set at LIBOR plus 1.5%. The owner of the contract can then invest the proceeds in any investment option available in the contract. Assuming the earnings exceed the cost of the loan, the owner will have an enhanced return. In addition to the tax free growth inside the policy, and unlike an annuity, a properly structured COLI program can deliver tax free income at retirement and ultimately a tax free death benefit to the beneficiaries of the executive. The supplemental life insurance benefit alone is a valuable and attractive benefit which is provided when selecting this asset option. Combining the tax-restoration feature with a company contribution equal to its cost of maintaining a deferred compensation program, can result in creating a powerful and competitive benefit program. This loan is referred to as the ALR (alternative loan rider). When this asset option is selected, the additional benefit of leverage can be added to the overall improvement in the performance of the Secular Trust vs. the traditional deferred compensation as seen in the chart below: Age: Net Crediting Rate: ALR Interest Rate:
50 7.0% 4.0%
Sample Executive Age 50 Retirement Age:
40% With ALR
Cash ALR Total Premium Premium Premium 30,720 20,480 51,200 31,440 20,960 52,400 32,160 21,440 53,600 32,880 21,920 54,800 33,600 22,400 56,000
Net Death Benefit 1,659,964 1,637,328 1,613,303 1,587,805 1,560,798
Distribution 0 0 0 0 0
0 0 0 0 0 0
772,430 740,248 705,355 667,777 627,119 583,879
1,904,343 1,867,573 1,825,046 1,777,212 1,722,917 1,685,235
80,267 80,267 80,267 80,267 80,267 80,267
Year 1 2 3 4 5
Age 50 51 52 53 54
16 17 18 19 20 21
65 66 67 68 69 70
0 0 0 0 0 0
0 0 0 0 0 0
Cash Surrender Value 33,432 69,443 108,896 144,836 180,709
After-tax Participant Contributions After-tax Company Contributions
Non-Taxable Retirement Benefits After Tax IRR on Retirement Benefits
Income Tax Free Death Benefit Age 85 After Tax IRR including Death Benefit
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Rediscovery of the Secular Trust Notes: This summary must be accompanied by insurance company compliance illustration. This hypothetical illustration is based on the assumptions presented and shows how the performance of underlying accounts could affect a policy’s cash value and death benefits and should not be used to predict or project investment results. Loans and withdrawals reduce available cash value and reduce the death benefit or cause the policy to lapse. Actual returns may vary. Variable Universal Life Insurance is available by prospectus only.
Summary The purpose of this article has been to review a well established executive benefit concept from a fresh and innovative perspective. Specifically, how the application of the Secular Trust can be applied as both an effective security device for non-qualified benefits for participants, while at the same time, allowing corporations to condense or eliminate unfavorable accounting and financial implications of non-qualified programs. The benefits to the participants include 100% security of the assets, control over the assets, protection against the prospect of higher income taxes in the future, a supplemental death benefit (assuming the COLI option is selected) and portability. Furthermore, when the a sponsoring company establishes a contribution tied to reallocating existing expenses associate with the deferred compensation program, the company is able to introduce an incentive/rewards opportunities that were not heretofore incorporated in the deferred compensation program. For the sponsoring company, it is able to eliminate burdensome accounting and tax issues relating to complying with §409A and the consequences of non-compliance as well as reducing the administrative burden. From a cost perspective, when a company adopts a cost neutral option, i.e. providing a supplemental company contribution which establishes parity between the non-qualified deferred compensation and the Secular Trust, the net financial cost to the firm is the same or less when taken into consideration the savings from forfeitures. However, with the introduction of the Secular Trust, the benefits are secured, the administrative issues reduced dramatically, and the cost to the firm is equal to or less than under the traditional system.
Securities Offered Through Retirement Capital Group Securities, Inc., a Registered Broker /Dealer, Member FINRA/SIPC. Retirement Capital Group Securities, Inc. is a wholly-owned subsidiary of Retirement Capital Group, Inc. Variable life insurance is offered by prospectus only. Guarantees and death benefits are subject to the claims-paying ability of the underlying insurance company. Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/material(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. The information contained in this article should not be construed as tax, legal, or financial advice. This article does not constitute a solicitation. Robert D. Birdsell, Registered Representative - Wisconsin Insurance License #89755
10 • Vol. 8 No. 1
here are times when doing the basics brilliantly delivers an equally polished payback. Such is the case with top executives who are clearly benefiting from no nonsense deferred compensation plans with fixed rates of return. Many companies today offer these plans precisely because they yield predictable rates of return, and they are simple to understand and manage.
Take a moment to review the 2010 proxy statements of leading companies (Chart I), and youâ€™ll soon discover that top executives at some companies are earning returns on deferred compensation accounts as high as 12 percent. Nonqualified Deferred Compensation (NQDC) plans are quite prevalent among the Fortune 1000, with 85 percent providing such a plan according to the 2009 Clark Consulting Executive Benefitsâ€”A Survey of Current Trends (Chart II). This same study further calculates 11 percent of companies offer a fixed rate of return. www.retirementcapital.com
Vol. 8 No. 1 â€˘ 11
Fixed Rate Nonqualified Plans Return
Adding Competitive Investment Options, Including High Fixed Rate Investment Companies with Fixed Rate Plans Comcast
Bank of New York Mellon 6.6% Edison International
Illinois Tool Works
6.3% - 8.4%
Source. Public proxy filings.
Source: Clark Consultingâ€™s 2009 Executive Benefits - A Survey of Current Trends
A Common Purpose NQDC arrangements make it possible for highly paid employees to save for retirement without the burden of government limitations. The Internal Revenue Service (IRS) limits the amount employees can contribute to a 401(k) plan ($16,500 in 2010). Companies that truly place a premium on executive talent set up
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Fixed Rate Nonqualified Plans Return these supplemental plans to strengthen their ability to recruit, reward and retain highly compensated employees. Top performers will naturally seek competitive benefits packages that accelerate their ability to set aside more money for retirement. These plans are designed purposely as “nonqualified” compared to “qualified” employer-sponsored 401(k) plans. Nonqualified simply means that the plan is not subject to the requirements of qualified plans, which are regulated by the Employee Retirement Income Security Act, known as ERISA. This freedom from regulation confers significant benefits on the NQDC plan participant. Deferred compensation arrangements, as in NQDC plans, generally provide investment elections that mimic mutual funds available in the employee 401(k) plan. However, investments in NQDC plans are not protected by ERISA, like 401(k) plans. As a result, participant account balances are subject to the claims of the company’s creditors. With historic volatility in the stock market this last decade, the S&P 500 rate of return has produced a paltry equivalent to 1 percent. Little wonder, then, why many organizations have decided to return to fixed crediting rates to supplement or replace the notional mutual fund type of return.
A Look Back Back in the 1970s and 80s, many organizations adopted fix rates of returns for deferred compensation arrangements, offering participants a rate tied to either the 10-Year Treasury Rate or the Moody’s Corporate Bond rate. Then, the interest rate climate was superheated; it was not uncommon to come across plans that offered Moody’s plus 5-8 percent rates which produced a fixed return equal to 20-22 percent. Those attractive numbers were possible prior to the Tax Reform Act of 1986, and due to unique life insurance funding strategies that produced these returns. What’s more, the numbers were achieved with no cost to the shareholders. Of course, that concept has since been legislated out. For a fortunate few, some plans were grandfathered and still exist. In fact, we still hear from many smiling executives who continue to enjoy fixed rates of return north of 10 percent.
Cost Neutrality Even so, given the number of funding alternatives today, you can still support a fixed rate of return around 6 to 7 percent. The key is how the company funds or hedges the liability for the high-fixed return. Let’s start with some basic math: If a full taxpaying company can deduct the benefits it pays to nonqualified participants, then a 6 percent return would cost a 40 percent bracket corporate tax payer 3.6 percent after tax (Chart III). To hedge that liability, the sponsoring company must earn 3.6 percent after tax or be tax free.
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Fixed Rate Nonqualified Plans Return Many organizations, as mention earlier, do earn a 6 to 7 percent return by wrapping fixed rate of return assets in a corporate-owned life insurance (COLI) policy, which is owned by the company. Major insurance companies offer current fixed rates in COLI policies with a guarantee of 3 percent. Other insurers allow you to purchase bond portfolios and stable value funds with more attractive returns.
Chart III Gross Crediting Rate
Net Crediting Rate
* Based on a 40% corporate tax rate
Capture the Gain RCG has developed a strategy whereby a company can leverage its fixed-rate investment, and borrow internally from the policy to leverage the return. As an example, if the participant deferred $100,000, and the company deposits those funds into a COLI policy with an investment fund earning 5 percent, the company can borrow at LIBOR plus 1 percent (as of March 2010, 1.75%) and capture the additional gain. Of course, there are various methods to support a cost neutral rate of return, and a sponsoring organization is advised to conduct due diligence by carefully examining all alternatives.
Net Takeaway In the world of investments, we always look for the highest clarity diamonds in the rough. Only today, we must view opportunities through the optics of a jewelerâ€™s loop. Stock market volatility, aggravated by flat equity growth in stock options and restricted stock plans, impels restless companies to get back to basics. The more cost-effective alternative investments await the patient. Thus, we urge you to consider a leverage strategy to capture the most brilliant aspects of fixed-rate investments.
Securities are offered by Retirement Capital Group Securities, Member FINRA / SiPC. Retirement Capital Group Securities, Inc. is a wholly owned subsidiary of Retirement Capital Group, Inc. Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/ material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/material(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. This report contains proprietary and confidential information belonging to RCG (www.retirementcapital.com). Acceptance of this report constitutes acknowledgement of the confidential nature of the information contained within. William L. MacDonald, Registered Representative - California Insurance License #0556980
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Pension Protection Act of 2006 swept through the industry with notable force. Rolled up within this sweeping piece of legislative reform were many smaller acts with equal power to tax corporate America. This brief commentary serves as a reminder to pay close attention to one such act, IRC Section 101(j), where the devil lies waiting in the administrative details.
Internal Revenue Code Section 101(j), known as the COLI Best Practices Act, applies to corporate-owned life insurance policies issued after August 17, 2006. In effect, it removes the income tax exclusion of IRC Section 101(a)(1), making death benefit proceeds taxable, unless certain guidelines are painstakingly followed. As long as no trigger event occurs, and all guidelines are met, tax-free death benefits on policies taken out on key executives continue to confer to employers. To review, companies purchase COLI on the lives of key employees to fund and offset the cost of executive benefits, or to protect against the loss of business owners and executives essential to running the company. Historically, COLI has been a stable financing vehicle, ideally suited to financing long-term benefit plans. COLI is structured on actuarial projections with the result that the pattern of death benefits paid closely mirror company’s benefit payments. Policy cash values and earnings are allowed to grow and offset the accrued cost of the future employee benefit liabilities on the company’s balance sheet. Importantly, COLI soldiers on as one of the few tax-advantaged assets remaining to high corporate taxpayers with strong cash flow and a favorable, long-term financial outlook. www.retirementcapital.com
Vol. 8 No. 1 • 15
A Tax Exclusion is a Terrible Thing to Waste Let’s revisit the basics of the COLI Best Practices Act to help us guard against any tax trigger events.
General Contract Provisions COLI is a life insurance policy owned by a person engaged in a trade or business. A policy that is owned by a business owner or a qualified plan (or VEBA) of an employer is not an employer-owned contract for IRC Section 101(j) purposes. Some examples of employer-owned life insurance are: • Key person insurance • Policies held by the employer to fund a nonqualified deferred compensation plan or SERP • Policies held to fund a stock redemption buy-sell agreement • Plicies held by the employer subject to a split-dollar arrangement Exceptions: Recent Employees The insured employee was employed by the employer during the 12-month period preceding death. Directors and Highly Compensated Employees At time of contract issue, the insured employee was either a director; or a 5 percent or greater owner of the business at any time during the proceeding year; or received compensation in excess of $105,000, adjusted in the future for inflation, in the proceeding year; or was one of the five highest-paid officers; or was among the highest-paid 35 percent of all employees. Death Benefits Paid to Insured’s Heirs Death benefits are considered such: • To the extent paid to a member of the insured’s immediate family • To the insured’s designated beneficiary under the policy • To a trust for the benefit of a family member or a beneficiary or to the estate of the insured • Or used to purchase an interest in the employer from any of the proceeding persons If these areas are not met to IRS satisfaction, the eligible death benefit amount an employer is allowed to exclude from gross income is then equal only to the sum of premiums and other amounts paid for the contract.
Notice and Consent Requirements Notice and consent requirements can be the Achilles heel of 101(j). If unintentionally overlooked, failure to notify employees properly carries costly taxable consequences. For example, in all cases, the employee must be: 1. Notified in writing that the employer intends to insure the employee’s life, and the maximum face amount for which the employee could be insured at the time the contract was issued; 2. Provided written consent to be insured under the contract during and after active employment; 3. Informed in writing that the employer will be the beneficiary of any death benefits.
Recordkeeping and Form 8925 Although it seems like ancient history given the last several eventful years, on January 15, 2008, the IRS released the final version of Form 8925, Report of Employer-Owned Life Insurance Contracts. This form must be used by policyholders under
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A Tax Exclusion is a Terrible Thing to Waste the COLI Best Practices Act, then completed and attached with the policyholder’s tax return for each tax year ending after November 13, 2007 for which the policyholder holds “employer-owned life insurance contracts”, subject to the requirements of Section 101(j). Form 8925 stipulates that the policyholder must provide: • Number of employees the policyholder has on staff at the end of the tax year; • Number of those employees insured under the employer-owned life insurance contracts at the end tax year (issued after August 17, 2006); • Total amount of employer-owned life insurance in force at the end of the tax year for those insured; • A statement that the policyholder has a valid consent for each insured employee in accordance with Section 101 (j) and, if not, the total number of insured employees lacking a consent form. You can download Form 8925 with instructions at the IRS website at http://www.irs.gov/pub/irs-pdf/f8925.pdf. The income tax exclusion on the death proceeds would be a terrible thing to waste.
Best Practices Best Practices also apply to forward-thinking advisory firms whose primary role is to enhance and protect client assets. As best practice management, RCG|Benefits Group, working closely with your tax and legal advisors, positions a four-point administrative safety net under any and all life insurance policies you may own. Expressly, we continuously: • Review and audit existing employer-owned life insurance plans for compliance to COLI Best Practices • Monitor clients to ensure notice/consent requirements are carried out on insured employees • Evaluate cost efficiencies of the existing policies to uncover improvement where possible • Provide all required disclosure and consent forms and complete information for IRC Form 8925
If you are not sure where the devil could be lurking in your COLI assets, consider the celestial advantages of working with a team who knows all its favorite hiding places.
Mark Walton, Registered Representative. Securities and Investment Advisory Services offered through NFP Securities, Inc. a Broker/ Dealer, Member FINRA/SIPC and a Federally Registered Investment Advisor. NFP Securities, Inc. is not affiliated with RCG|Benefits Group. California State Insurance Agent License #0654782 This article is not intended as a definitive statement regarding the law, but rather to alert our clients and other readers regarding our understanding of its impact on nonqualified deferred compensation and/or COLI. This material does not constitute tax, legal, or accounting advice and neither RCG|Benefits Group nor any of its employees or consultants, or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisers.
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mid the uncertainties rolling across the financial landscape, there is one force that can rattle the calmest of executives. Taxes. Conventional wisdom tells us that U.S. tax rates are headed up in the near futureâ€”a logical assumption given the seemingly empty coffers of the U.S. budget and the intense drive to fund more and more programs. Congress and the President are presented with a prime opportunity: Take no action at all, and the tax cuts implemented by President Bush in 2003 will expire in 2010, leading to higher rates in 2011. Which means that the top income tax rate is likely to increase from 35 percent to 39.6 percent, and the capital gains tax rate from 15 percent to 20 percent. Understandably, executives are shaking their heads and searching for answers: Does it make financial sense to defer income under a company-sponsored deferred compensation plan (DCP)? If there is a financial advantage to deferring, is it sufficient enough to offset the risk of corporate default and the potential loss of the entire deferred compensation account? Amounts deferred by executives under a corporate-sponsored DCP are unsecured promises to pay, superseded by the claims of a corporationâ€™s creditors in the event of bankruptcy. High profile corporate failures from Lehmann Brothers and
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Executive Retirement Tax Alert
Bear Stearns to Washington Mutual Bank bring the second question painfully home. What is a top-performing executive to do? The answer is near. RCG|Benefits Group has developed a user-friendly financial model for executives to analyze pretax deferral opportunities versus paying current income tax on specific compensation and investing in an after-tax vehicle such as a mutual fund. Think of it as a mini-life raft for retirement funds during this time when everything we thought we knew, we don’t.
Do Your Homework The Deferral-TimeSM is a simple financial model built in Excel by RCG|Benefits Group and available for download at www. retirementcapital.com/excelmodel. You can model two investment vehicles side-by-side to analyze and compare the financial result. Typically, one alternative might be a pretax investment in a corporatesponsored DCP, and the second an after tax investment in a mutual fund, thus giving you a clear view to pretax versus after tax implications. The model also offers the capability to analyze two mutual fund alternatives—one in a low turnover indexed equity fund; one in an actively managed equity fund. User-friendly, the Deferral-Timer is also financially rigorous in its ability to accurately reflect investment alternatives, and flexible enough to analyze a variety of scenarios. Now, you can answer these questions with confidence:
Given identical pretax contributions, how much would an executive accumulate in a DCP compared to an after tax mutual fund account? If a DCP does yield a superior financial result, yet there is a broader array of after-tax investments available outside the plan, how much higher rate of return outside the plan is needed to generate the same financial result? If tax rates rise in the future, does it make more sense to save on an after tax basis?
Use Variables in Formulas Microsoft Excel is a powerful tool for financial modeling. To tap into this power, set up variables for assumed values such as tax and growth rates. A variable is a cell or group of cells assigned a name using Excel’s Name Manager. Once a cell has been named, use it in the formulas to make data easier to understand. Please note, variables for Tax Impact.xls are contained in three spreadsheets along with analyses-specific worksheets in the downloadable workbook. Briefly, these spreadsheets offer General Variables, Variables linked to Contributions, and Variables based on Accumulations and Distributions.
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Executive Retirement Tax Alert
A Few Words on Tax Rates Ordinary income and capital gain tax rates are key variables in any analysis model pretax/after tax investments. In the U.S., ordinary income is taxed on a progressive tax rate schedule that increases with taxable income. Four filing brackets apply: Married filing jointly; married filing separately; single; and head of household. The tax rates for 2009 are as follows: Marginal Tax Rate 10.0% 15.0% 25.0% 28.0% 33.0% 35.0%
Married Filing Jointly Tax Brackets Over But Not Over 0 16,700 16,700 67,900 67,900 137,050 137,050 208,850 208,850 372,950 372,950 -
Marginal Tax Rate 10.0% 15.0% 25.0% 28.0% 33.0% 35.0%
Single Tax Brackets Over But Not Over 0 8,350 8,350 33,950 33,950 82,250 82,250 171,550 171,550 372,950 372,950 -
Married Filing Separtely Marginal Tax Brackets Tax Rate Over But Not Over 10.0% 0 8,350 15.0% 8,350 33,950 25.0% 33,950 68,525 28.0% 68,525 104,425 33.0% 104,425 186,475 35.0% 186,475 -
Marginal Tax Rate 10.0% 15.0% 25.0% 28.0% 33.0% 35.0%
Head of Household Tax Brackets Over But Not Over 0 11,950 11,950 45,500 45,500 117,450 117,450 190,200 190,200 372,950 372,950 -
The taxable income amounts listed above are calculated as a taxpayerâ€™s income from all sources, less certain exclusions, deductions, and personal exemptions. Breakpoints on tax brackets occur where tax on income increases; they are also indexed with inflation. When analyzing the impact of pre- versus after-tax deferrals, use the marginal tax rate as the appropriate rate. For highly compensated executives, it is frequently assumed that the highest marginal tax rate is the applicable rate. For 2009, that rate is 35.0 percent. The key question is whether the appropriate marginal tax rate will remain the same in the future. Will it go down due to lower income during retirement or due to a mandated decrease in tax rates? Or will it go up due to an increase in taxable income or an increase in tax rates? The table below provides a history of the highest U.S. marginal tax rates. For now, tax rates will likely remain the same in 2010. However, as the Bush tax cuts expire in 2010, the highest marginal tax rate will be restored to 39.6 percent in 2011. Year 1913-1915 1916 1917 1918 1919-1921 1922 1923 1924 1925-1931
History of US Tax Rates: Highest Marginal Tax Rate Tax Rate Year Tax Rate Year 7.0% 1932-1935 63.0% 1965-1981 15.0% 1936-1940 79.0% 1982-1986 67.0% 1941 81.0% 1987 77.0% 1942-1943 88.0% 1988-1990 73.0% 1944-1945 94.0% 1991-1992 58.0% 1946-1951 91.0% 1993-2001 50.0% 1952-1953 92.0% 2002 54.0% 1954-1963 91.0% 2003-2009 25.0% 1964 77.0%
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Tax Rate 70.0% 50.0% 38.5% 28.0% 31.0% 39.6% 38.6% 35.0%
Executive Retirement Tax Alert
Hypothetical Executive Analysis In developing the Deferral-Timer, we experimented with a wide range of variables for a typical executive who faces a deferral choice between ABC Company’s DCP, and a personal after-tax mutual fund account. At age 65, based on all of our executive’s inputted assumptions, the model shows that he can 1) generate $67,516 per year after taxes from the DCP, for a total of $1,012,744 over 15 years; or, 2) generate roughly $57,000 per year after taxes from the mutual fund, for a total of $770,918. With a little patience and the Deferral-Timer, our executive concluded that his DCP generates $241,000 more in retirement income, 31 percent more than the after-tax investment in mutual funds, and delivers a strong case for enrolling in the DCP. In comparing his two alternatives further, we learned:
Contribution Phase: Contributions to the DCP are not taxed, so our executive has $500,000 of net contributions working for him after 20 years compared to only $300,000 in his after-tax mutual fund. Accumulation Phase: With these additional funds at work in the DCP, and with investment earnings growing tax-deferred, the DCP generates $596,629 of investment earnings, creating a balance of $1,096,629 at retirement. The after tax mutual fund generates only $274,424 of after-tax earnings, with a balance at retirement of $574,424, about 50 percent less. Distribution Phase: The DCP is further bolstered with tax-deferred earnings during the distribution phase. But there is a sizeable downside; the entire account balance, including investment earnings, is taxed at the then current ordinary income tax rates. The 40 percent rate our executive assumed for all years depletes a substantial portion of the DCP distributions. Even so, he still shows about 30 percent more retirement income from the DCP.
Explore the What-Ifs In our hypothetical, the executive realized the tax advantages of DCP participation. But what if ABC Company goes bankrupt? What if he lost his entire account balance? Is the additional 30 percent return is sufficient to compensate him for the additional risk? Eventually, our executive determines that a 5.90 percent return in the DCP yields a similar result as a 7.50 percent in an after-tax investment. In other words, a 20 percent lower return allows him to generate the same financial result. Does the lower return with a less risky asset allocation still compensate him for the added DCP risk? At this point, he’s ready for an in depth discussion with his own financial advisor.
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Executive Retirement Tax Alert
If you downloaded the Excel workbook, you have begun to gain an appreciation of how well Excel builds a financial model, and how effectively the Deferral-Timer delivers the datapoints for a smart analysis. Use variables, and what-if questions flow easily. Change assumptions, and know the larger impact in the future of your decisions today.
Take a Global View Generally, if an executive takes a global view on his asset allocation, the portion of his portfolio allocated to investments with the highest percentage of appreciation (realized annually), should reside within the DCP. Fixed income funds and actively managed mutual funds are also included. Indexed equity funds turnover less often, and can be held in after-tax accounts, where high, built-in fund deferral characteristics allow them to benefit from low capital gain tax rates. You can use the Deferral-Timer to test this concept. For modeling purposes, we also caution you to carefully examine the actual investment lineup offered in the DCP to verify the fund competitiveness from a return and an expense perspective. After-tax investing offers a universe of investment options; a DCP offers limited investment choices. If the choices are subpar, and there is added risk of becoming an unsecured creditor, then the tax advantages of a DCP are diminished. Equally important, corporate sponsors are encouraged to carefully analyze the investment offerings in the DCP for effectiveness.
Diversify to Tax Buckets Finally, investment advisors have long focused on the value of diversification in investment allocation. Given the uncertainty of tax rates, we urge you to extend the diversification concept to “tax buckets”, as well. Pretax saving is a powerful tool, but withdrawals from these plans are subject to ordinary income tax rates at the time of the distribution. Prudent behavior calls for an option to withdraw retirement income from a pretax account or from an after-tax account possibly subject to more favorable capital gain rates. A third option is a tax-free bucket from such vehicles as Roth IRAs or Roth 401(k)s, or the Professional Security Plan offered by RCG|Benefits Group. Heraclitus, Greece’s “weeping philosopher,” lamented in 500 BC that “Nothing is permanent but change.” If alive today, he might well weep that nothing is permanent but taxes. If you remember no other points from this commentary, remember these: 1) Always explore deferral what ifs with sound financial modeling, and 2) accept that diversification of tax buckets provides the flexibility to meet a wealth of changing circumstances. Variable life insurance is offered by prospectus only. Guarantees and death benefits are subject to the claims-paying ability of the underlying insurance company. Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/material(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. The information contained in this article should not be construed as tax, legal, or financial advice. This article does not constitute a solicitation.
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RCG|Executive Compensation & Benefits Group 12340 El Camino Real, Suite 400 San Diego, CA 92130 Phone: (858) 677-5900 Toll Free: (866) 724-4877 Fax: (858) 677-5915 E-mail: firstname.lastname@example.org www.retirementcapital.com
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Vol. 8 No. 1 â€˘ 23
RCG|Executive Compensation & Benefits Group Headquarters: 12340 El Camino Real, Suite 400 San Diego, CA 92130 Phone: (858) 677.5900 Fax: (858) 677.5915 email@example.com www.retirementcapital.com
Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/material(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. This report contains proprietary and confidential information belonging to RCG (www.retirementcapital. com). Acceptance of this report constitutes acknowledgement of the confidential nature of the information contained within. Securities Offered Through Retirement Capital Group Securities, Inc., a Registered Broker/Dealer, Member FINRA/SIPC. Retirement Capital Group Securities, Inc. is a wholly owned subsidiary of Retirement Capital Group, Inc. William L. MacDonald, Registered Representative | California License #0556980