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Supplemental Executive Retirement Plan – Mistakes to Avoid

Supplemental Executive Retirement Plan – Mistakes to Avoid

Supplemental Executive Retirement Plan – Mistakes to Avoid

A Supplemental Executive Retirement Plan (SERP) can be a powerful tool for executive compensation, but costly mistakes can undermine its benefits and long-term effectiveness.

Understanding Supplemental Executive Retirement Plans

A Supplemental Executive Retirement Plan (SERP) is a non-qualified retirement plan that allows employers to provide additional retirement benefits to key executives. These plans are often used to attract, reward, and retain top talent by offering benefits beyond the limitations of qualified plans like 401(k)s. Since SERPs are typically funded by the employer and tailored to the executive, they are a strategic part of total compensation packages.

Unlike traditional retirement plans, SERPs are not subject to the same contribution limits and nondiscrimination rules. This makes them flexible but also exposes them to legal, financial, and tax-related pitfalls if not carefully structured.

Common Mistakes to Avoid with SERPs

Failing to Conduct Thorough Plan Design

One of the most common SERP mistakes is poor plan design. Each organization has unique goals, and copying a generic template can result in misaligned incentives or inadequate retirement benefits.

What to do instead:

  • Customize the SERP based on the company’s objectives and the executive’s needs.

  • Consider factors such as the executive’s tenure, current compensation, and desired retirement age.

  • Work with financial and legal advisors to develop a tailored plan structure.

Overlooking Tax Implications

SERPs are subject to specific tax rules under Internal Revenue Code Section 409A. Noncompliance can result in immediate taxation of plan benefits, penalties, and interest for the executive.

What to do instead:

  • Ensure that the timing of deferrals and distributions aligns with IRS guidelines.

  • Avoid impermissible changes to payment schedules.

  • Use a qualified tax advisor to review the SERP for Section 409A compliance.

Not Establishing a Clear Vesting Schedule

Some companies create SERPs without a well-defined vesting schedule. This can lead to confusion and disputes if an executive departs early or is terminated.

What to do instead:

  • Clearly outline vesting terms in the SERP agreement.

  • Use performance-based or time-based vesting to align with retention goals.

  • Document what happens in cases of early retirement, disability, or termination for cause.

Underfunding the Plan

A SERP that is not adequately funded puts both the executive and the company at risk. If the company cannot meet its financial obligations, promised benefits may go unpaid.

What to do instead:

  • Use informal funding methods like corporate-owned life insurance (COLI) to ensure benefits are covered.

  • Perform regular funding reviews and stress tests.

  • Establish a rabbi trust to informally secure plan assets without triggering current taxation.

Ignoring Communication and Documentation

Lack of communication about SERP terms can lead to misunderstandings and future litigation. Executives need a clear understanding of their benefits and any associated risks.

What to do instead:

  • Provide clear written documentation of the plan’s terms and conditions.

  • Hold regular briefings with executives to review the plan.

  • Maintain comprehensive records and update them when changes are made.

Relying Solely on SERPs for Retirement

Some executives make the mistake of depending entirely on their SERP for retirement income. This approach can be risky due to the unsecured nature of these plans.

What to do instead:

  • Diversify retirement planning with other vehicles such as IRAs, 401(k)s, and personal investments.

  • Encourage financial literacy and independent retirement savings strategies.

  • Treat the SERP as one component of a broader retirement plan.

Not Preparing for Executive Turnover

SERPs often tie retirement benefits to continued service, but companies may face turnover due to resignation, firing, or personal reasons. If the plan doesn’t account for these scenarios, it can create financial or legal issues.

What to do instead:

  • Include clear provisions for different termination scenarios.

  • Determine how forfeiture, partial payouts, or acceleration of benefits are handled.

  • Build flexibility into the plan to accommodate organizational change.

Overlooking Plan Portability

Most SERPs are non-transferable and cannot move with an executive if they change employers. This can reduce the perceived value of the plan.

What to do instead:

  • Make the plan attractive by offering accelerated vesting upon certain events (like change of control).

  • Combine SERPs with portable benefits such as deferred compensation plans.

  • Clearly communicate portability limitations so executives can plan accordingly.

Misjudging the Long-Term Cost

Failing to assess the long-term financial impact of a SERP can lead to underfunding and budget stress. These plans may appear affordable early on but grow costly over time.

What to do instead:

  • Project long-term liabilities and compare them to funding strategies.

  • Conduct annual actuarial reviews to adjust assumptions and contributions.

  • Ensure the board and stakeholders understand the full financial implications.

Disregarding Regulatory Changes

Tax laws and regulatory standards evolve, and companies that don’t adjust their SERP plans accordingly may find themselves in violation.

What to do instead:

  • Assign a compliance officer or external advisor to monitor changes in ERISA, IRC, and employment law.

  • Schedule periodic reviews to update the plan.

  • Ensure documentation is amended promptly to reflect new regulations.

Best Practices for Managing SERPs Effectively

Conduct Annual Reviews

SERPs should be reviewed at least annually to ensure they remain aligned with organizational goals, executive needs, and regulatory standards.

Involve Key Stakeholders

HR, legal, finance, and executive leadership should all be involved in the SERP’s lifecycle, from design to review.

Monitor Funding Vehicles

If you use tools like COLI, evaluate performance, fees, and long-term projections regularly to ensure they’re meeting funding expectations.

Provide Executive Education

Executives should understand how their SERP fits into their overall retirement and tax planning. Provide access to financial advisors and ongoing education.

Conclusion

A well-structured and properly managed SERP can be a powerful retention and retirement tool. However, overlooking key details—from tax compliance and plan funding to communication and exit scenarios—can create serious risks for both the executive and the company. By avoiding these common mistakes and following best practices, employers can ensure their SERPs fulfill their purpose effectively and sustainably.