Retaining key employees is one of the most important issues companies face, especially in a “full-employment” environment, and certainly in defense and government contracting. Qualified retirement plans, such as 401(k)s and profit sharing, are usually inadequate to incentivize high-earning, critical staff, and they are subject to strict tax and employment regulations.
Equity-sharing can be an option; however, many business owners, especially those of closely held companies, are loathe to part with equity, or face all the tax and compliance demands, just to retain key people. So, in the lucrative but sensitive, business of defense contracting, the key question is how to retain personnel vital to business growth, even viability; overcome the limits of qualified plans; yet avoid equity dilution and its burdens?
Supplemental Executive Retirement Plans (SERPs), especially those using cash-producing insurance as the funding vehicle, are worth serious evaluation. SERPs can answer the above question while also providing tax efficiency, reduced costs, and increased company flexibility and control over the plans.
IN HIGH STAKES GOVERNMENT CONTRACTING, RETENTION OFTEN MEANS SURVIVAL
The first question a company might ask is: “Just how important are our top people?” Companies in all sectors, with high-performing, high-earning executives, are likely to answer, “Very important,” but on careful evaluation, many good people are in fact replaceable, even if uncomfortably so. Could this person actually make or break the company, for example? Often the answer is “no.”
In the defense industry, however, the answer can be quite different. Consider indispensable security clearances, which are extremely difficult, costly, and time-consuming to replace. Failure to retain those could seriously imperil a defense contractor – those people, and their clearances, are truly indispensable. Even worse, what if such an employee left for a competitor? It’s not a stretch to say that that could crush a defense company.
Additionally, defense contractors are full of employees with special licenses who are not easily replaced. Let’s also consider those who have critical relationships with decision-makers, inside the government. Those key people effectively block out the competition and pave the way to profitable contracts. It’s clear that failing to retain the best, most well-connected employees would inflict serious damage on a defense business, and possibly even threaten its survival.
LIMITATIONS OF QUALIFIED PLANS
Of course, retirement plans are common ways for businesses to attract and retain every type of employee. Most businesses and employees participate in a qualified retirement plan, like a 401(k).
The problem is that, due to contribution limitations and anti-discrimination regulations, qualified plans are usually not enough to meet the needs of key, high-earning people. And, although contributions are tax deductible, distributions are fully taxable as income. Top people understand these limits as well as company owners do. Since the plans don’t provide enough incentive, equity-sharing is a common next step, which can be a good choice, but does have drawbacks for both the company and employee.
EMPLOYEE EQUITY SHARING
Equity sharing can be the right choice in certain circumstances, with certain employees, and many reading this article may already have done so. All strategies involve trade-offs, however, so here are some disadvantages that companies may want to avoid:
Privacy / Transparency Trade-off. Owners will almost certainly have to provide more company details to the employee. State and federal laws allow shareholders access to company financial records, meeting minutes, and on-going reporting, so it’s important to evaluate each employee carefully and be very comfortable with their access to these records.
Tax & Regulatory Complication. Tax planning and compliance for equity compensation is rather complex. Companies could lose certain tax deductions, and different business structures are regulated differently. No matter how well companies structure programs, equity-based compensation is always more complicated than cash. Experienced tax and securities attorneys must evaluate if the equity compensation must be registered under various securities laws, and that it meets necessary anti-fraud provisions.
Owner–Employee Alignment. Successful owners become successful for a multitude of reasons, not the least of which is the inner drive and fortitude to work through great difficulty, no matter what. Many employees, on the other hand, even if very high-performing, simply prefer to be compensated fairly for their valuable contributions. So, employee equity stakes can also create unwarranted pressure to sell because that’s the only way to unlock value to the employee. This is often overlooked. It’s possible to avoid the problem by declaring a dividend, which may or may not satisfy the employee, and adds tax and legal complication.
Mergers and Acquisitions. If company owners do decide to sell, for their own reasons, most buyers are only interested in 100% ownership. The greater the number of shareholders, each with their own situations and agendas, the more complex it can be to reach the required ownership threshold and achieve the desired price.
Phantom Stock. Is actually an agreement, whereby owners issue “hypothetical” rather than actual stock, then agree to pay the cash value of the “shares” upon the occurrence of a future event or fulfillment of certain conditions. This is a popular option, which has benefits, but also pitfalls: 1) without careful and expensive structuring, the plans can come under the strict, Employee Retirement Income and Security Act (ERISA), as 401(k) plans do; 2) The plans must also be designed around IRS Section 409A, to avoid restrictions on certain deferred payments; and, 3) The compensation is subject to ordinary income tax, whereas true stock options receive capital tax gains treatment.
Dilution. Obviously, existing owners dilute their own equity when sharing with employees. Owners often instinctively recognize that the effort, intelligence, risk, and sacrifice required to build a valuable company are enormous, and that they, therefore, have earned the rewards of ownership. Also, there’s always a risk of giving away too much ownership. Many avoid that, but without careful planning, owners can become too motivated with equity incentives.
RETAINING EMPLOYEES, WHILE PRESERVING EQUITY, WITH SUPPLEMENTAL EXECUTIVE RETIREMENT PLANS (SERPs)
Since defense companies invest so much time and money in critical employees, they are loathe to lose those key people, when a next, great opportunity appears. A SERP is a powerful, extra piece of compensation, with attractive long-term growth and tax benefits, that incentivizes people to stay and perform, while also acting as an informal insurance policy for the company.
A SERP is an agreement whereby a company agrees to provide retirement income to key personnel, and his or her family if they die unexpectedly, as long as the employee meets specific conditions. The conditions, which are most often tied to length of service and job performance, are part of the individual negotiation between the company and the key person. A typical plan would provide the employee a retirement benefit equal to 70% of the executive’s highest three year average compensation. If the executive were to die before receiving the benefits, his beneficiaries would receive the them instead.
Best practice says: begin setting aside assets now to pay these potential obligations, so they do not jeopardize the company’s future cash flow. Most companies place permanent, cash value life insurance, on the lives of their key staff to help make future benefits payments and to recover the cost of the plan, regardless of how long the employee lives or works for the company. Based on industry surveys, 75% of the Fortune 1000 companies finance their SERP obligations with COLI programs as do 43 of the top 50 top U.S. banks and thrift institutions1.
The company books an annual expense equal to the present value of the future benefit payments. It purchases a life insurance policy that recovers the costs associated with the agreed, future benefits2. There are other funding options, including: self-funding, which preserves current cash flow, but can stress future cash flow when benefit payments are due; investments, which could be lucrative, but subject the company to market risk, higher risk assets, and earnings taxation; and annuities, which are safer, but do not provide tax deferral when company-owned.
Remember that the allowability of expenses under the Federal Acquisition Regulations (FAR) relating to executive retention and key person protection depends on your company’s specific facts and circumstances; please consult your FAR accounting expert for guidance before implementing any type of compensation plan.
Since no strategy is perfectly advantageous, let’s summarize both the key advantages and trade-offs of SERPs, beginning with the trade-offs:
Immediate deductibility: Companies do not get immediate tax deductions on the SERP contributions. The deductions come when plan benefits are paid out at retirement or death.
Creditor protection: SERP assets, including the life insurance cash-value, are subject to creditors and are not protected in the event of insolvency. Companies can use “rabbi” trusts, an extra layer of protection for executives against all risks, except company bankruptcy.
Health impairments: If an eligible employee is in poor health, life insurance may not be a funding option. Certain benefits, like pre-retirement death benefits, may not be available to that executive or may have to be funded separately from other sources.
Flexibility: the company selects which employees will participate, and the specific benefit to provide to each employee.
Control: the company controls the plan, owns the policy, and carries the cash value as an asset on its balance sheet. Company owners stipulate the employee performance and vesting metrics required for the employee to receive the benefits.
Retention / “Golden handcuffs”: the company imposes a vesting schedule which motivates the key employee to stay and perform.
Tax efficiency: when informally funded with life insurance, the policy’s cash value growth is tax-deferred, and the company can also access that value, tax-free.
Cost recovery: when informally funded with life insurance, the death benefit is income tax-free, and provides plan cost-recovery.
Future tax deductions: the company receives a tax deduction when the income benefits are paid to the employee.
Equity preservation: company owners provide top people with valuable benefits that increase loyalty, but do not require equity dilution.
Simplicity: SERPs are easy to implement because they are not “qualified” by the IRS under the Employee Retirement Income Security Act (ERISA) and therefore are not subject to the strict requirements of qualified plans.
Advantages to Key Executives and Employees
Supplemental retirement income: supplements an executive’s qualified plan with generous, additional retirement income designed to meet specific needs.
Pre-retirement death benefit: employees may receive a pre-retirement death benefit for their beneficiaries.
Protection: the additional retirement income and/or survivor benefit will help ensure the employee’s family is protected.
Tax-deferral: No income taxes are due until retirement benefits are received.
A CASE IN POINT
This study considers a scenario where a business owner is a few years from retirement, and considers the value of employee retention, which SERPs offer, in order to increase business value and attractiveness to buyers. As we’ve tried to show above, retention via non-qualified plans is equally valuable to current day business growth, even viability, long before owners consider a company sale.
Suppose that after 25 years of growing a defense company, the owners are ready to sell and retire. Key employee, Emma, has a high-level security clearance that allows the company to bid on large and profitable government contracts.
A buyer will not offer nearly as much, or anything at all, if Emma leaves, diminishing personal retirements and inheritances substantially.
So before entertaining offers, the company agrees to a non-qualified arrangement with Emma, which requires her to keep her security clearances current and to stay on for ten years after the ownership change.
In exchange, she will receive a $100,000 benefit each year from ages 60 to 85, as well as a $500,000 pre-retirement death benefit for her family. This generous benefit will strongly incentivize her to both stay with the company and to keep performing at a high level.
The company owns and pays the premiums on a permanent policy insuring Emma’s life for “key-person” purposes. The arrangement informally earmarks the policy’s cash value as a source of Emily’s future retirement benefit.
When she retires, the new owners use tax-fee loans and withdrawals from the cash value to pay the $100,000 annual benefit. The distributions are taxable to Emma, but tax-deductible to the company.
If Emma passes away before retiring, the company receives a tax-free death benefit to compensate for lost revenue and to find a replacement. The company agrees to provide a small fraction of the total death benefit, $500,000 in this case, to Emma’s family. That payment can be tax deductible to the employer, and tax-free to Emma’s family, if she recognizes a small amount of additional income tax each year.
If Emma fails to meet the plan stipulations, she does not receive a benefit, and the company does what it pleases with the life insurance policy: keep it, sell it, borrow against it, cancel it, or use the cash value for a different employee. Note that this strategy offers far more flexibility and retention power than a 401(k) or one-time “retention bonus,” plus, the company can recover all its costs over time.
A MULTI-FACETED, WIN-WIN STRATEGY FOR DEFENSE CONTRACTORS
Non-qualified SERPs do seem to be a win-win strategy in many situations. Employees receive benefits that can be far more generous than limited qualified plans, along with protection for their families, while companies retain critical staff, avoid equity dilution and complication, retain control and flexibility, and can recover their costs – accomplishing all of that relatively simply and tax efficiently.
Government/defense businesses, which simply must retain key employees, are therefore able to ensure on-going viability, protect business growth, and insure against painful business disruptions, while positioning themselves for premium bids if/when the time comes to plan for a company sale.
2 Withdrawals and loans from life insurance polices classified as MECs may be subject to income tax, and also a federal tax penalty, if taken prior to age 59½. Policy
withdrawals and loans may cause the policy to lapse, which will result in the loss of death benefit and adverse tax consequences.. See policy illustration for details.