D—Deferred Compensation and Business Life Insurance

In allowing selected management or highly compensated employees to defer income until after retirement, deferred compensation offers multiple tax advantages to both the employer and the participant.

Corporate Obligation. To illustrate, assume we have a key corporate manager who is currently age 45. Under its terms, the plan would provide for retirement payments, at age 65, of $10,000 per year for 10 years. These payments would be tax-deductible to the corporation when made, and, although taxable to the retired employee, presumably he would pay less in taxes due to a reduced retirement income and resulting lower marginal tax bracket.

Typically, such plans also provide for survivor payments if the employee dies prior to retirement. For example, should the employee die at age 55, a typical plan might pay his surviving family $10,000 per year for 10 years. Since these payments would be tax-deductible to the corporation, each $10,000 payment would cost only $7,900 (assuming a 21 percent corporate marginal tax bracket). However, these payments would be taxable income to the family. Life insurance cash values grow on an income tax deferred basis and death benefits are ordinarily received on an income tax free basis – making life insurance a common and tax-effective method of funding deferred compensation obligations.

The plan can also be structured to provide disability benefits to the employee. To assure itself of funds to meet its obligation, the employer could purchase a disability income contract, or it could partially protect itself by adding a waiver of premium rider to any life insurance contract on the employee’s life. Although standards for disability, long-term care, chronic illness, and critical illness differ – today it is common to see plans created with pre-retirement payouts based
on a standard that is consistent with the payout language on a hybrid life insurance policy offering
a lifetime benefits rider. 

Life Insurance. Life insurance on the life of the employee can assure the employer that it will have the funds to meet its obligation. When a company owns life insurance on an employee it is referred to as Corporate Owned Life Insurance (COLI) and Employer-Owned Life Insurance (EOLI). For illustrative purposes, using life insurance for this purpose could require a corporate commitment to spend $4,000 per year during the first 20 years, and $6,600 per year during the 10 years following
the employee’s retirement (all after taxes).6 The cumulative outlay by the corporation would be $80,000 during the 20 years prior to retirement at age 65, and $146,000 by time the employee reaches age 75.

If life insurance with an increasing death benefit is purchased, it will likely produce a gain to corporate surplus when the employee dies, which amount can then be used to make the survivor payments. This gain is the amount by which the death benefit exceeds the cumulative outlay by the corporation (i.e., the sum of the premium payments prior to retirement and the after-tax cost of the retirement payments). For example, if the employee died at age 55, payment of a $120,000 death benefit would produce a gain to corporate surplus of $80,000 ($120,000 – $40,000 = $80,000).