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QSERPs: A Quirky ExecutivePerk Gains Interest
According to a study by TowersWatson, many small- and middle-sized businesses are missing out on enablingInternal Revenue Code provisions that would permit them to offer enhancedbenefits to just a few key executives. The backbone of this benefit structureis an existing Qualified Plan, such as a profit sharing or active or frozendefined benefit Plan, combined with a Qualified Supplemental ExecutiveRetirement Plan (QSERP). By incorporating design and compliance-targetedcontributions and benefits, these businesses can go beyond traditional limitsof a qualified retirement plan.
Now, more and more plan sponsorsare exploring QSERPs as a means of providing enhanced retirement benefits toexecutives. Below we present some QSERP basics, simple illustrations, highlights,and a few concerns.
QSERPs: What Are They?
QSERPs are enhanced executivebenefits, similar to those provided by executive top hat or excess benefitplans, except that QSERPs are provided through a qualified retirement plan. Forthat reason, these benefits have several advantages over traditional executivebenefit arrangements:
- Employer contributions can be prefunded on a tax-favored basis
- The Executive incurs no tax liability (not even FICA) until benefits are actually distributed
- When benefits are distributed, tax-saving options, such as IRA rollovers, may be available
- Benefits provided via a qualified plan are much more secure than those offered via typical unfunded arrangements
Finally, QSERPs provided throughoverfunded defined benefit plans are funded from existing excess assets, soemployers don't need to make additional contributions.
While this paints a rosy picture,there are a few drawbacks to providing extra benefits via qualified retirementplans. First, the benefits are subject to Internal Revenue Code (IRC) §415benefit limits, which will materially restrict desired benefit levels for manyexecutives. Second, the benefits are subject to special nondiscriminationtests, to ensure that they're not disproportionate to benefits provided torank-and-file employees. Although this second point is referred to as adrawback, it is actually these nondiscrimination tests that give rise to QSERPsin the first place!
In the 1992, the IRS published verydetailed regulations to determine whether qualified retirement plansdiscriminated against non-highly compensated employees. These rules spelled outmechanical processes comparing the benefits of highly compensated employees,expressed as a percentage of pay, with benefits for non-highly compensatedemployees. But having a mechanical test leaves open the question: If thecurrent plan passed the test, would it also have passed if highly compensatedemployees had even larger benefits? In most cases, the answer is"yes," and it is this extra benefit margin that enables employers toadopt QSERPs.
The nondiscrimination tests allowplan sponsors to recognize Social Security benefits (which tend to favor non-highlycompensated employees). Since the nondiscrimination rules tend to favor definedcontribution deposits to younger employees, employers whose retirement programsinclude a significant defined contribution component (other than ESOPs ormatching contributions) may have a considerable benefit margin from which tofund a QSERP. Finally, the tests have several different optional calculationapproaches, some of which can produce significant margins between the maximumallowable benefits for highly compensated employees and those currently beingoffered.
Some Sample QSERPs
QSERPs may take several forms. Asimple QSERP added to a typical defined benefit plan could be a schedule ofnames or job titles appended onto the plan document, stating that the listedindividuals get the indicated additional benefit. For example, the CEO couldget an additional $40,000 per year at retirement, and the CFO an additional$20,000 per year. If the organization sponsored a nonqualified executive plan,the employer typically would reduce these nonqualified benefits by any QSERP benefits—thuslimiting the corporate liability for these nonqualified obligations.
To illustrate a definedcontribution QSERP, consider a law firm, which might deposit an extra $4,000for all partners earning the maximum annual compensation (currently $255,000).Using this approach, it might be possible for each partner to reach his $56,500(including catch-up contributions for executives over 50 years old) definedcontribution maximum without increasing staff benefits at all.
Employers can set up separatedefined contribution plans for each QSERP participant, potentially providingall participants with some investment direction for their QSERP account. Theonly serious drawback for defined contribution QSERPs is the current maximumcontribution limit—$56,500 less the contributions to other defined contributionplans.
Since QSERP programs clearly aredesigned to reward executives, it is important to be cautious in their designand administration. Key considerations include:
- Make sure the nondiscrimination tests leave enough margin to tolerate some year-to-year demographic variations.
- Before actually starting a QSERP, adopt the plan and submit it for IRS approval. Having a favorable IRS determination letter in hand is great insurance against any future rule changes. (Many plan sponsors will need to apply for these letters anyway, because of recent changes to the law. So, now is a good time to consider a QSERP.)
- Do not exceed the IRC §415 limits and make certain that your QSERP provides sufficient benefit enhancement to justify its administrative expense.
Despite the above cautions,QSERPs clearly offer a tremendous opportunity for some employers to prefund keyexecutive retirement benefits, on a basis that is tax effective for both theemployee and the employer—a true win-win situation.
How Austin Capital can Help
Contact Charles Leggette or John Alvarez at 214.624.1000 and we’llhave a confidential discussion about how this may benefit you or your client.