Advanced Planning

Employee Retention Strategies: Employer Funded Deferred Compensation

Employer funded deferred compensation has more moving parts than the two previous strategies in this employee retention series, and it may involve a bit more effort and a few out-of-pocket expenses. However, it is also one of the most effective strategies a business owner can use to keep exceptionally talented employees from looking elsewhere.

Spring is finally here, and we’re already covering our third and final strategy in the employee retention series — employer funded deferred compensation. This is a sophisticated concept that is established with a select group of key employees. The structure allows the business to make discretionary contributions to a deferred account balance on an annual basis to be paid out to the participant at a later date.

It’s ideal for business owners looking for an effective way to incentivize key non-owner employees with a simple implementation process, but who are willing to consider some complexity to enhance retention. Businesses with a minimum budget of $25,000 per employee per year should consider discretionary contributions to a deferred compensation plan. There are many advantages for both the employer and employee.

Benefits for the employer:

  • Employer contributions to fund the plan remain corporate assets under corporate control until benefits are actually paid
  • Annual contribution amounts are completely discretionary to the employer (but should remain relatively consistent over time to make the plan effective)
  • Contributions may be tied to either company performance and profitability or to the employee’s performance
  • There is a sense of strong golden handcuffs” for employee retention effect – the larger the account balance, the more the employee has to lose by leaving
  • Flexibility in plan design, such as use of a vesting schedule and defining benefit payout term
  • Flexibility to offer different plan options to different employees
  • Flexibility to pick and choose specific employees

Benefits for the employee:

  • The employee’s account is fully funded by employer, so there are no out-of-pocket costs incurred
  • The employer’s contributions are not taxable to the employee, nor is any interest earned on the account balance
  • The plan balance is protected from the employee’s creditors
  • If the employee dies or becomes disabled, the plan usually becomes fully vested and payable
  • The employee’s value to the employer is demonstrated through large contribution amounts and plan account balances

This is one of the most effective strategies a business owner can use to keep exceptionally talented employees from looking elsewhere.

How It Works

Step 1: The employer creates a plan document that promises participants a future payout based on annual contributions. Amounts can be tied to company or employee performance. The plan will specify, among other things, a vesting schedule, a benefit start date and a benefit payout schedule.

Step 2: The selected employees agree to a long-term commitment in exchange for a future payout under the plan.

Step 3: Each year, the employer makes annual contributions to each employee’s account, and may also credit the account balance with interest. The employee is provided a plan statement showing new amounts credited and the current plan balance — reinforcing the value of the plan benefit which enhances retention.

Step 4: If the employee is still in good standing as of the triggering date — usually retirement — the employer begins paying out the accrued benefit over the term specified. Each benefit payment is tax deductible compensation for the employer and taxable income for the employee. 

If the employee leaves prior to the triggering date, they forfeit all unvested amounts in their plan account.

Informal Funding Using Life Insurance

Technically, each annual contribution” to an employee’s deferred compensation account is just an accounting entry — the employer is not required to actually set aside cash. However, given the magnitude of the benefit promises being made, prudent employers will plan on informally funding some or all of the future liabilities.

While such informal funding can be done using the business’ investment account, it usually makes sense to direct at least a portion of the informal funding into cash value life insurance policies on the key employees. Here’s why:

  • Earnings inside the policy are tax-deferred
  • Life insurance cash values are a cash equivalent asset on the balance sheet
  • When benefits are due to be paid, the policy can provide tax-free cash
  • The policy provides a tax-free death benefit to the business for key person protection, which can provide cost recovery of post-retirement benefits down the road
  • If desired, a portion of the death benefit can be assigned to the key employee for family protection

It’s More Complex, But It’s Most Effective

Defined contribution deferred compensation has more moving parts than the other two strategies we described in this series, and it may involve a bit more effort and a few out-of-pocket expenses. However, it is also one of the most effective strategies a business owner can use to keep exceptionally talented employees from looking elsewhere.

You can count on Ash to help explain this strategy to your business owner client without the conversation getting overwhelmed by complexity. Fundamentally, it comes down to making a promise today that will get paid in some future tomorrow. The rest is implementation details.

Wrapping Up with Successful Strategies

We’ve covered quite a bit throughout this series, including why employee retention is such a priority for business owners, what makes a good incentive and retention strategy and three effective insurance-based executive benefit strategies. Don’t worry if it feels like you can’t keep them straight right now. Your Ash team of Advanced Market experts is here to help.

Advanced Markets don’t have to be difficult. Advanced means extraordinary. It means you need more – more ideas, more resources and more answers. You don’t stop at good enough and neither do we. Contact your Palladium Group expert at (888) 274‑5462.

Related Blogs in This Series:

3 Effective Key Employee Retention Strategies: A Series Introduction

Strategy #1: Executive Bonus with Added Restrictions (REBA)

Strategy #2: Endorsement Split Dollar Arrangement

*This material is for financial professional and educational use only. Not to be reproduced or shown to clients.