A New Look at an Old Friend

About 10 years ago, they were all the rage for companies that had defined benefit (DB) plans. Lots of DB plans were still in surplus, or at least thought they were, and lots of companies still had ongoing DB plans. Something happened in the interim (OK, a few somethings happened), but that's not the point here. Roughly 10 years ago, lots of companies were looking for an ideal way to fund their DB Supplemental Executive Retirement Plans (SERPs), In my opinion, the most effective way to fund these nonqualified (NQ) benefits was through a qualified plan (QP). This strategy has gone by many names, but the most prevalent in the industry has been the QSERP.

On the surface, the QSERP is simple. An executive has a NQ accrued benefit which is usually composed of a gross benefit offset by a QP accrued benefit. The resultant net benefit is what the executive would get from the SERP. In a QSERP, the QP is amended to increase the QP benefit to include some or all of the SERP benefit, thus (because of the offset feature) decreasing the net SERP benefit by an equal amount.

What does this do for the executive? Here are some of the benefits.

• It generally secures the benefit. Of course, if the plan sponsor goes bankrupt, such security is subject to PBGC limits on guaranteeable benefits.
• It takes the benefit out from under the purview of Code Section 409A.
• While the benefit is still in the plan, it does not fall prey to the doctrine of constructive receipt under Code Section 83.
• If the benefit is payable in a lump sum, it can be rolled over into an IRA further deferring taxation.
• The executive can wait until just before his benefit commencement date to make an election as to the timing and form of benefit distribution.
• The benefit is exempt from FICA taxes.
• The benefit is protected in the event of a change-in-control.

And, for the plan sponsor, here are some of the benefits.

• To the extent that the benefit is funded immediately, the sponsor gets an immediate tax deduction.
• Since the plan is qualified under Code Section 401(a), the trust will be exempt from taxes under Code Section 501(a), meaning that the plan assets grow tax-free.
• Payment of the benefit comes from a trust that holds all of the plan assets, not from the corporate coffers, or a far smaller rabbi trust.
• Qualified plans have better optics than do SERPs.

How about for the shareholder? How does a QSERP affect them?

• In every case that I can think of, implementation of a QSERP has been either income-neutral or income-positive.
• The company is less likely to have sudden cash flow requirements.
• From a risk standpoint, it is far easier to use risk management techniques in a qualified plan than in a SERP.

So, why can companies put in these QSERPs? Generally, from a technical standpoint, it goes to two things in the Internal Revenue Code: 1) the nondiscrimination rules of Code Section 401(a)(4) are highly objective; and 2) the combined limits under Code Section 415(e) were repealed.

Yes, that's highly technical stuff. But, suffice to say that it works. For years, I had the extreme pleasure <cough, cough> of teaching nondiscrimination testing to generally younger and aspiring actuaries. One of the things about the testing that I drilled into their heads was this: if you don't pass, you're not trying hard enough. 

Sometimes benefits actually are discriminatory, and there is nothing that any of us can do to change that. But, I have seen some benefit formulas over time that are extremely discriminatory to the naked eye. So, what do we do? We take the employee data and put it in a big pot. We add in the benefit provisions. We stir a bit with the nondiscrimination rules (remember, they are objective; either you pass or you fail.) and out comes a nondiscriminatory plan.

We're late in 2011 now. The funding rules have changed. There are fewer large defined benefit plans, and of those that remain, many are in one state of freeze or another. 10 years ago, there was no 409A. There was no Dodd-Frank, 

There is still lots of merit to this approach. Consider it. Talk to us.