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Income Replacement Solutions For Highly Compensated Employees

Updated: Jun 2, 2022

It has always been critically important for employers to offer attractive benefits packages that help recruit, reward, and retain the individuals who are instrumental in making their companies grow and thrive.

But today, as competition for key employee talent increases, the need for a benefits package that is truly meaningful and individualized may be more critical than ever. In addition, with executive compensation under scrutiny by shareholders and stakeholders, it’s vital that any specialized benefits provided to a company’s management team are viewed as equitable too. And of course, they need to be cost-effective for the business as well.

Bridging the gap that benefit limits create for higher earners

Most of the traditional benefits offered to employees—apart from health insurance—have to do with income continuation. As a result, the amount of retirement, disability, and death benefits employees are eligible to receive from these programs is derived from a percentage of income.

This means that high income earners often don’t get equitable treatment because their benefits are limited, either by a cap on the amount of income used to calculate the benefits or by monthly, annual, or lifetime benefit maximums. It also means that an organization’s more highly compensated employees may be inadequately insured.

In a typical group employee benefits package, for example, a Long-Term Disability (LTD) insurance benefit of 60% of salary with an insured earnings cap of $200,000 is designed to provide adequate income replacement for anyone who is ill or disabled. But for employees who make more than the annual cap, the maximum income benefit of $120,000 (60% x $200,000) may provide only a small percentage of what they actually need to maintain their lifestyles. When compensation includes more forms of income than salary alone, this misalignment can be exacerbated further.

The graphic below shows just how dramatic the benefit inequity can be for the highly compensated employees in this hypothetical example.

The Case [1]

The Group LTD plan insures 60% of salary to a maximum monthly benefit of $10,000. Earnings above $200,000 are not protected by the current LTD program.

The Concern

Thirteen key employees have salary above $200,000 which is not insured by the group LTD plan. Additionally, all bonus income is not insured.

If an employee was to have a disability, it could be difficult to maintain their financial responsibilities and could have a dramatic impact on future earnings and retirement goals.

Getting more highly compensated employees on par with the rest of the workforce will almost certainly require augmenting the employer’s broad-based plans with customized solutions. These “restorative” benefits can create fairness in situations where it has been taken away.

The challenge for the employer is how to provide top executives with a more equitable approach to income benefits that can:

  • bridge the gap created by the limitations of the company’s broadly based benefits plans,

  • minimize the tax impact of the benefit solutions for the employer and the employees, and

  • work within the confines of the firm’s budget.

Providing customized benefits that are meaningful to your top employees and cost-effective for your firm


Supplemental Long-term Disability Income (LTD) coverage

Employers who want to provide equitable benefits can work with their disability insurance or benefits provider to offer highly compensated employees the opportunity to purchase additional individual long-term disability coverage at preferred rates on a voluntary basis.

A company-sponsored option provides important advantages for the employee that are not available if the employee seeks the same coverage outside the firm. These advantages may include:

  • a higher level of replacement income in case of illness or injury,

  • guaranteed issue (if executive is actively-at-work, no health questions asked),

  • premiums discounted lower than those available on their own, and

  • additional discounting for female buyers as a result of unisex pricing.

When looking to bring LTD benefits more in line with the percentage that their basic group plan provides, employers have two ways to pay for those benefits. Each one has different tax outcomes.

Option 1: The employer can pay for each key employee’s individual LTD coverage. In this case:

  • the employer takes a tax deduction for the cost of the insurance premiums as part of the company’s total benefit package,

  • the employee receives a non-taxable benefit, but

  • any disability benefits received for a claim will be taxable to the employee.

Option 2: The employer can report the premium as income to the key employee. In this situation,

  • the employee must pay taxes on the premium as income, but

  • benefits received for a claim are not taxed.


Split-Dollar arrangement or Salary Continuation plan

When there is a need to provide more equitable life insurance coverage for highly compensated employees beyond $50,000 for group life plans, employers can choose to use a Split-Dollar arrangement or a Salary Continuation Plan.

If the employer chooses to create an endorsement Split-Dollar (or “Economic Benefit”) arrangement, the company pays for and owns a permanent insurance policy on the employee, and then endorses the rights to the policy proceeds to the insured employee’s beneficiaries. This can be cost effective for the employer who can then write off the cost of the insurance and take loans from the policy’s cash value to fund business needs. It also provides the employee with what is, essentially, a “free” benefit.

But there is a drawback for the insured employee with this arrangement: They must pay income taxes on the “economic benefit” they receive from the Split-Dollar insurance arrangement each year (on any amounts in excess of $50,000). And those taxes can be substantial as the employees grow older and the benefit increases.

For this reason, employers often prefer to implement Salary Continuation plans that are funded with company-owned permanent life insurance. These plans are particularly desirable for employers with older, long-term employees who might otherwise become burdened by the income taxes they must pay on a Split-Dollar plan’s economic benefit.

With a Salary Continuation plan, the employer promises to pay the employee’s salary to his or her family for a certain period of time if the employee dies. The employer then purchases life insurance on the employee for a multiple of his or her salary (plus a cushion for income taxes), payable to the employer as beneficiary.

As owner of the life insurance policy, the employer:

  • treats the premiums as a non-deductible business expense, but

  • has access to any future cash value via loans or partial withdrawals, and

  • receives the policy’s death benefits tax-free.

If the employee dies prematurely, the employer uses the insurance policy proceeds to continue to pay a salary benefit to the family for a specified period of time. But even if the policy benefits are never used – which is more often the case – the employee pays nothing for the extra coverage and owes no taxes on the value of the benefit.

Salary Continuation Plan [1]

This can make a tremendous difference to highly compensated employees in high income tax states who often end up paying more in taxes on the imputed insurance benefit each year than their Split-Dollar life insurance policy is actually worth.

The cash value that accumulates in the corporate owned life insurance policy that funds a Salary Continuation plan also can be used to augment the employee’s disability or retirement income needs.


Restrictive Endorsement Bonus Arrangement (REBA)

A Restrictive Endorsement Bonus Arrangement (REBA) offers highly compensated employees another source of income, but with some “strings attached,” making it an effective retention strategy for the employer.

With this arrangement (which is one of many variations of the IRS’ “Section 162” executive bonus plans), the employer supports a key employee’s purchase of life insurance by paying bonuses to the employee. The employee then uses that bonus money to pay the premiums for supplemental life insurance coverage.

Employers like 162 bonus plans because they:

  • are relatively easy to set up and maintain,

  • are less subject to complex tax rules, and

  • allow them to take a deduction for the bonus payments.

Employees appreciate them because it means they get all of the benefits of a permanent life insurance policy without having to make premium payments from their cash flow. Those benefits include:

  • the ability to accumulate substantial tax-deferred assets for future retirement income or estate liquidity,

  • tax-free access to the policy’s cash value via loans or partial withdrawals, and

  • protection for their families via tax-free death benefits if they die prematurely.

Section 162 Executive Bonus Plan with a Restrictive Endorsement Bonus Arrangement [1]

1) The employer establishes a life insurance policy on behalf of the employee. The employee owns the policy and names his/her beneficiaries. The employer receives a tax deduction for the bonus (provided in step 2).

2) The employer pays a bonus to the employee as either:

  • A bonus sufficient to pay the life insurance premiums (Single Bonus), or

  • A bonus sufficient to pay both the life insurance premiums and cover the employee’s taxes on the bonus (Double Bonus).

  • The bonus can be subject to a REBA, which limits the employee’s access to the policy’s cash value until he/she qualifies for it to be released.

3) The employee pays:

  • The premium on the insurance policy, and

  • The taxes on the bonus value.

The REBA variation of a 162 bonus plan adds restrictions to the benefit that are meant to encourage employees to remain with the company.

For example, the employer may require employees to repay their bonuses if they leave the company before a certain date or restrict access to their cash values until they’ve been with the company for a specified number of years.

For an employee who is being courted by another company, having these benefit restrictions can be a factor in the decision to stay or leave. It also may be a consideration for companies wishing to hire away a key employee, because they may need to include the cost of the bonus payback in their offer package.


Additional considerations for employers

As you explore ways to provide more equitable benefits to highly compensated executives, remember that:

  • The insurance providers for the benefits you select may require minimum participation levels by the eligible employees, so paying attention to potential adoption rates by key employees is critical.

  • Effective communications to the employees you are targeting are vital to assure that they participate in the benefits offered (if there are minimum levels) and appreciate the value you are providing.

  • You also may get pushback from stakeholders in your company who view the added benefits for highly compensated employees as “extraordinary” or “inequitable.” They also may be worried about the effect of reporting this as compensation on financial statements.

To address any reservations, you may need to work with your benefits provider to demonstrate that:

  • You are not giving key employee more benefits, but the same benefits with the same ratios as all employees, but in a more equitable way.

  • The impact on the bottom line will be more reasonable if you are financing the new benefits using the leverage that life insurance creates.

Finally, it’s important to remember that, while you may be able to finance the delivery of these benefits in ways that significantly reduce their cost and/or tax impact, you will still need to plan for startup costs and ongoing expenses for communication, administration, and maintenance.

Still, the value of adding meaningful benefits for your most talented employees almost always outweighs any additional costs, especially when those benefits can have a powerful and positive effect on your company’s success. Learn more about our Executive Disability insurance services for businesses.

[1] All examples provided are for illustrative purposes only and are not intended to serve as investment advice since strategy is dependent upon your individual facts and circumstances.

Neither M Financial nor TRC Financial are authorized to give tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.

An insurance contract’s financial guarantees are subject to the claims-paying ability of the issuing insurance company.

Cash value accumulation is determined by the policy contract, is not always guaranteed, and is subject to withdrawals.

Cash values and death benefits may vary based on the policy you purchased. Please consult your full policy illustration at the time of purchase.


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