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Performance-Based SERPs: Adapted for a Changing Landscape

While many U.S. public companies offer a nonqualified deferred compensation plan, only 20 percent of surveyed companies report linking a long-term incentive plan to their NQDC strategy.

Changes in tax laws and Securities and Exchange Commission (SEC) regulations continually force the reevaluation of executive compensation strategies. Rising shareholder expectations for transparency in top-tier pay and benefits also motivate the reassessment of total rewards for the highly compensated.

Although U.S. companies adapt their disclosure practices to the SEC’s evolving rules, future changes are inevitable. Performance-based, defined contribution, supplemental executive retirement plans (SERPs) provide a strategy to help balance regulatory and marketplace concerns while also affording an effective reward and retention solution.

Old School: The Award of Unrestricted Company Stock

Stock ownership was once viewed as the optimal way to align senior executives' performance with shareholders' interests. Over the years, the use of stock options in broad-based compensation systems has declined. The award of unrestricted stock has largely been replaced with restricted stock or performance shares.

Although various studies have confirmed the value of awarding stock to top-tier executives, no empirical data links a company’s performance with the award of broadly distributed, equity-based grants to employees outside the C-suite.

Without data to confirm a causal relationship between equity grants and the performance of employees below the top tier, some companies choose a mix of equity and cash-based alternatives to reward long-term employee performance. This balanced approach may take the form of a nonqualified plan platform that provides for the elective deferral of base salary, short-term incentives (annual bonus), restoration matches, long-term incentive plan payouts, and a performance-based, defined contribution SERP.

The SERP Solution: Supplemental Executive Retirement Plans

A SERP is a nonqualified benefit plan that does not defer an individual’s salary or bonus. While SERPs can be structured as either defined benefit or defined contribution plans, few defined benefit SERPs are being implemented today, as they place all investment risk on the company.

Defined contribution SERPs provide for monthly, quarterly, or yearly contributions to the plan, with the plan participant receiving a phantom account where hypothetical investment returns are credited. The primary goals in implementing a SERP are to:

  • Provide a salary continuation plan upon retirement.
  • Create an additional wealth-accumulation opportunity for the employee.
  • Restore qualified plan benefits that are lost due to government limitations.

Most SERPs are funded entirely by the company. They are not subject to ERISA ("The Employee Retirement Income Security Act of 1974")* vesting and participation requirements; however, proxy disclosure is required. While traditional SERPs lack a direct relationship between the company's performance and the benefit design, performance-based SERPs can resolve that concern.

Designing the Performance-Based SERP

Performance-based SERPs link company- or departmental-based performance metrics to employee rewards. Just as performance shares can be linked to a long-term incentive plan (LTIP), performance-based SERPs can be designed to focus on the performance of a business unit within the company.

Performance-based SERPs appeal to companies because they transfer risk to the plan participant and can be linked to a long-term incentive plan for financial measurements. A defined contribution SERP benefit is only a target, not a promise the company will pay.

SERP contributions will always vary by participant. The plan participant assumes the risks and rewards of the hypothetical investment, which are logged notionally into a SERP account. Factors considered in determining an individual level of contribution are:

  • The participant’s current total compensation and a reasonable estimate of what final pay will be at retirement, assuming an annual salary increase.
  • Traditional retirement age and the number of years of service the participant will have while eligible for supplemental contributions.
  • A reasonable estimate of the growth in the value of SERP account investments over the years before retirement.
  • The attainment of the performance targets, whether wholly or only partially achieved.
  • The company’s plan or compensation committee always determines the award of SERP contributions to a participant’s account. If the committee determines the full target has not been reached, partial awards can be made, or a company may choose an all-or-nothing approach.

    Vesting is also common in designing a defined contribution SERP. Graded vesting could begin ten to fifteen years before the normal retirement age. Vesting can be a way to incrementally reward an employee while at the same time enhancing retention.

    A performance-based SERP offers companies a flexible and market-aligned reward and retention strategy when it is combined with an equity-based, long-term incentive plan. For a deep dive into the design of defined contribution SERPs, read “Performance-Based SERPs: Changing the Landscape” or talk to any OneDigital executive benefits team member.

    Examples used in this article are hypothetical and for illustrative purposes only.

    Any tax advice contained herein is of a general nature. Seek specific advice from your tax professional before pursuing any idea contemplated herein.

    Want to read more about executive benefits strategies? Check out this article: Bank-Owned Life Insurance in Today's Banking Environment.

    FINRA BrokerCheck Summary:

    Sam Robert is affiliated with Valmark Securities, Inc. Securities offered through Valmark Securities, Inc. member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor. 130 Springside Drive, Suite 300, Akron, OH 44333. 800-765-5201. OneDigital is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc.