By Boyce F. Lowery, CLU, ChFC
Half a decade ago, it was normal for a young person to graduate from college, get a job, and stay with the same company for their entire career. Not so anymore. In fact, last year an average of 3.5 million people quit their jobs voluntarily every single month. (1) Voluntary employee turnover is most commonly attributed to the opportunity for higher compensation elsewhere, a promotion, work hours, a shorter commute, and/or job-related issues.
This is an unnerving trend for business owners. Especially when it comes to key employees, employee retention is very important for business owners. After all, losing a key employee costs a lot of money in recruitment fees, training expenses, onboarding costs, and lost productivity. In fact, research has found that the cost of replacing an executive can be up to 213% of their annual salary. (2) For this reason, 87% of HR leaders consider improved employee retention to be a primary concern. (3)
Combating Voluntary Turnover
Employers have tried a lot of things to decrease voluntary turnover. They have offered flexible scheduling (even before coronavirus), given promotions, started employee recognition programs, provided more in benefits and provided higher compensation in the form of increased salaries and bonus payments.
While using higher compensation for key employee retention is a popular technique, it has two major problems. If the compensation is in the form of increased salary or a bonus, the key employee has no real incentive to stay if a better offer comes along. There is nothing that binds them to the company since they have already received their reward. When that happens, the employee departs and takes the employer’s money with them. There is a better way.
Another financial incentive that can be used to retain key employees is a non-qualified deferred compensation plan. This can take one of several forms. There are supplemental executive retirement plans, or SERPS, that can be created as either defined benefit plans or defined contribution plans; deferred bonus plans (that can be exempt from Internal Revenue Code (IRC) Section 409A); and other forms of deferred compensation that are beyond the scope of this article.
What Is IRC Section 409A?
No discussion of non-qualified compensation plans is complete without a look at IRC Section 409A. What is it? It is a very complex set of rules covering most non-qualified deferred compensation plans that was conceived with the American Jobs Creation Act on October 22, 2004. The non-qualified plans that it affects include:
- Salary and bonus deferral arrangements
- Annual and long-term bonus and other incentive arrangements
- Severance pay arrangements
- Taxable reimbursement arrangements
- Certain in-kind benefits like autos and club memberships
- Certain equity-based compensation
- Change in control agreements
- Commission arrangements
- Retention arrangements
There are a few exceptions to IRC Section 409A. The most important one for the sake of this article is the short-term deferral exception. It exempts from Section 409A amounts that, in all possible circumstances, will be paid by the 15th day of the third month following the end of the taxable year (of the employee or employer) in which the right to the compensation is vested. Other exceptions will not be discussed in this article.
What Is a Deferred Bonus Plan?
One form of employee compensation that can take advantage of this short-term deferral exception to IRS Section 409A is a deferred bonus plan. It is an agreement to vest a specified bonus at a future date, but only if the employee is still employed on that specified date. The employer stipulates in the agreement the number of years to work for the employee to become vested, and that vesting period can vary by employee, as can the bonus itself. The key is to make the bonus payable no later than the 15th day of the third month following the end of the tax year of the employer or employee in which the employee became vested, in order to be exempt from Section 409A.
What makes this a great retention tool is that 100% of the future bonus is forfeited if the employee terminates employment prior to the vesting date. The employer may also include a change in control of the business and/or death of the employee as a different vesting date if desired.
How to Fund a Deferred Bonus Arrangement
Funding a deferred bonus plan is an important consideration, but it must remain informal and cannot be a part of the agreement itself. One option is to pay the vested bonus out of cash flow at the time payment is due or from cash on hand. Another option is to create a sinking fund of some kind. For a sinking fund, there are bank account options, investment options, and corporate-owned life insurance on the key employee. The vast majority of business owners usually opt for the latter, life insurance, because specialty life insurance products are available for this type of agreement and the policy can also serve as key person insurance as well.
Why Use a Deferred Bonus Plan for Key Employee Retention?
It should be clear by now that a deferred bonus plan is an excellent way to retain key employees that benefits both the employees and employers. First of all, deferred bonus plans are not subject to IRC Section 409A requirements when structured correctly. Second, top hat plans are not subject to the onerous restrictions of ERISA. From the employee’s perspective, it provides a strong financial incentive to stay with the company, as their receipt of the funds is dependent upon it. And, finally, the arrangement is beneficial to employers because if the employee leaves, it costs them nothing. If you want to learn more about how you can retain key employees with a deferred bonus plan and use life insurance to fund it, call us at 888-827-0146.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.