What it means
Qualified plans such as a 401(k) have yearly limits on what an employee can put in, and they must be offered on fair terms to a wide group of staff. A SERP is non-qualified, so it can be offered to a few people and sized to the company's goals.
In exchange, it does not get the same immediate tax breaks. Investopedia says the company and the executive sign an agreement that promises a certain amount of retirement income if conditions are met.
The company funds it from cash flow or through a cash-value life insurance policy. Funds grow tax-deferred, and the executive pays tax on payments as ordinary income when they are received.
The benefit is often defined by a formula, such as a share of final pay like 60%, minus what the executive gets from other company plans. That makes the SERP a top-up that fills the gap.
The company usually records the cost over time, and Investopedia notes it can book an annual expense equal to the present value of future benefit payments and later deduct the payments when they are made. Because the plan is non-qualified, it needs no IRS approval and has light reporting.
Vesting matters, though: if an executive leaves before the benefit is vested, some or all of it can be lost. The IRS describes two vesting types, graded vesting that releases a share each year and cliff vesting that releases everything after a set period.
The main risk is credit risk. SERP assets are generally part of the company's own assets, so if the company becomes insolvent, the executive can rank as an unsecured creditor.
Funds held in a life insurance policy are not shielded from the company's creditors. The IRS audit guide on non-qualified deferred compensation explains that Section 409A sets rules on when deferrals and payouts must be fixed.
Rules differ in other countries, where similar top-up pensions exist under local law. Executives should read their own plan documents and take tax advice.
In practice
Real-world examples.
Example
A fictional executive has a final salary of $400,000 and a SERP promising 60% of final pay, which is $240,000 a year. The regular company pension pays $100,000. The SERP pays the difference, $140,000 a year.
Example
The same $140,000 a year is paid for 20 years, and the company uses a 5% discount rate. The present value is $140,000 x (1 - 1.05 to the power of -20) / 0.05, about $1,744,709. This is the size of the liability the company has to plan for.
Example
The executive leaves after 3 years under graded vesting of 20% a year, so 60% is vested and the benefit falls to $84,000 a year. Under a 4-year cliff schedule the same departure leaves nothing. The vesting rule changes the result by the whole $140,000.
Formula
Calculation
SERP benefit = Target percentage x Final pay - Other pension income. With 0.60 x $400,000 - $100,000 = $240,000 - $100,000 = $140,000 a year.
Present value = Payment x (1 - (1 + r) ^ -n) / r. With a $140,000 annual payment, r = 0.05 and n = 20, the value is about $1,744,709.
Vested benefit = Full benefit x Vested share. With $140,000 x 60% = $84,000 a year.Case study
Seen in the real world.
This case study is fictional and illustrative. Hana, 54, in Tokyo, is a finance director offered a SERP worth $140,000 a year after age 65. She reads the plan and finds a 4-year cliff schedule with a payout over 15 years. She asks how the plan is funded and learns it is an unsecured promise backed by company assets.
She also asks whether the benefit changes if she is let go. She weighs this against an outside job offer. She decides to stay one more year to reach the cliff date, since leaving earlier would cost her the whole benefit. She also keeps saving in her own accounts.
She does not depend on one promise from one company for her retirement. Hana also does the simple sums on the payout. Fifteen years at $140,000 a year adds up to $2,100,000 before any discounting, which is a large promise for one company to carry. She asks the human resources team when the first payment would fall due and what the plan document says about the timing rules, so she can take tax advice before she signs anything.
Watch out
Common mistakes.
- Treating a SERP promise as safe like a bank deposit when it is usually an unsecured claim on the company.
- Leaving before the vesting date without checking how much of the benefit would be lost.
- Ignoring the tax on payouts, which is generally ordinary income when received.
Questions
People also ask.
What is a SERP?
It is a non-qualified plan that gives selected executives extra retirement income beyond regular plans.
Is a SERP protected if the company fails?
Usually not. The benefit is typically an unsecured claim on the company, so the executive may rank with other creditors.
How is a SERP taxed?
Payments are generally taxed as ordinary income when received. Section 409A sets timing rules for deferrals and payouts.
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