Nonqualified Deferred Compensation

Why Consider COLI?

As an Alternative to Other Investment Choices to Informally Fund a Nonqualified Deferred Compensation Plan

Why COLI?

For companies that offer Nonqualified Deferred Compensation (NQDC) plans for their valued executives, many sponsors choose to informally fund these plans with corporate-owned life insurance (COLI) to hedge their deferred compensation liability, reduce associated income statement volatility and provide greater assurance to participants that the funds will be available when promised.

 

Why informally fund nonqualified liabilities with COLI? 

Investment in COLI is a common approach to funding NQDC plans. Over the short-term, COLI programs can generally be structured to closely track unfunded balance sheet liabilities. Over the long-term, COLI programs can help increase benefit security and help reduce overall plan costs, potentially delivering more value to participants.

 

  • COLI can help reduce taxes on invested assets, potentially increasing after-tax returns and enhancing shareholder value.

 

  • COLI generally offers income tax advantages over other investments including:

 

o   Tax-deferred growth of cash value.1

 

o   Tax-free reallocation within the policy.1

 

o   Tax-free receipt of death proceeds.2

 

o   Policy withdrawals are generally first treated as a nontaxable recovery of basis.2,3

 

o   Policy loans are generally not treated as taxable.2,4

 

  • COLI can provide enhanced cash flow flexibility through the employer's access to the cash value via policy loans and policy withdrawals.3,4

 

  • COLI receives favorable accounting and profit and loss treatment relative to taxable investments.

 

  • Competitive COLI products provide a wide array of investment choices, including alternative investment classes designed for a more sophisticated investor.

 

The tax benefits associated with COLI including tax-advantaged inside buildup and tax-free death benefits make it highly attractive for many companies.1,2

 

How does COLI work?

COLI is a term to describe a life insurance product that is tailored to institutional buyers. Companies purchase policies on the lives of their executives. These COLI policies can serve as a powerful informal funding vehicle for NQDC plan liabilities. While each plan design has unique features, the methodology to evaluate various COLI products is generally the same. COLI is a financial product, and its benefits and potential risks should be measured as such.

 

When a company acquires life insurance on their executives – namely, the eligible participants in a NQDC plan – the company pays the premium and owns the policy. The company becomes the beneficiary of the insurance benefit. Typically, while the employees are the insured under the COLI policies, the employees do not receive direct insurance benefits, or pay the premiums. This coverage is issued on a Guaranteed Issue (GI) underwriting basis (i.e., no medical exams), and doesn't replace or interfere with any other insurance provided by the company, nor does it generally impact the executive’s ability to obtain insurance. COLI policies produce financial statement income for a company if the cash surrender value exceeds the cumulative premiums paid.

Summary

In choosing which vehicle (or combination of vehicles) to use to fund deferred compensation benefits, sponsors will want to consider a variety of factors. Determining the optimal financing vehicle(s) and strategy will need to incorporate such factors as:

  • Current and future tax status.
 
  • Cash considerations and constraints.
 
  • Sensitivity to profit and loss exposure.
 
  • Expectation of market conditions.
 
  • Benefit security.

 

NQDC plans can play an important role in attracting and retaining the talent crucial to the success of your business. By leveraging the depth of experience and expertise from across Morgan Stanley, we can help deliver a deferred compensation package well-suited to the needs of both your participants and your bottom line.

 

Talk to a Morgan Stanley Financial Advisor about evaluating your current NQDC plan or considerations to offer a new plan.

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Footnotes:

1 If the COLI policy is structured properly, the cash-value build-up within the policy (“Inside Build-up”) generally grows free of current income taxation. For a variable COLI policy, the cash value can generally be invested in certain subaccounts available under the policy and the Inside Build-up attributable to such subaccounts, including dividends, interest and other realized gains, generally grow free of current income taxation. Please consult your tax advisor for additional information.

2 If the COLI policy is properly structured (and not considered a Modified Endowment Contract ("MEC")), then (a) withdrawals are generally first treated as a nontaxable recovery of the employer's cost basis in the policy and only subject to income tax to the extent the withdrawal exceeds the cost basis of the policy, (b) policy loans are generally not treated as a distribution and, therefore, not subject to income taxation as a withdrawal from the policy, and (c) death benefit proceeds paid on the death of the insured are generally not subject income tax, provided certain requirements are met (e.g., written consent from insured, etc.). Distributions during the first 15 contract years may result in the application of special rules that cause an additional amount to be includable in income. The favorable tax treatment described in this footnote does not apply to MECs. If the COLI policy is treated as a MEC, policy withdrawals and loans will be treated as taxable to the extent the policy's cash value exceeds the basis in the policy ("income first" rule) and will generally be subject to a 10% penalty tax. Please consult your tax advisor for additional information.

3 Policy withdrawals will reduce the cash value and may reduce the death benefit (or other benefits provided by the policy). Failure to maintain sufficient cash value may cause the COLI policy to lapse. A policyholder's ability to take policy withdrawals may be subject to certain limitations or requirements under the COLI contract.

4 Policy loans may have an adverse impact on the cash value and/or death benefit (or other benefits provided by the policy). If the COLI policy lapses, terminates or is exchanged while there is an outstanding loan, there may be federal and/or state income tax consequences. A policyholder's ability to take policy loans may be subject to limitations or requirements under the COLI contract.

5 Life insurance provides liquidity upon death of the insured. Policy loans and/or withdrawals may be available, but can reduce benefits received upon death.

 

Variable life insurance is sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable life insurance product and the underlying investments, which should be considered carefully before investing. Prospectuses for both the variable life insurance product and the underlying investments are available from your Financial Advisor. Please read the prospectus carefully before you invest.

Variable life insurance products are long term programs and may not be suitable for all investors. The acquisition of variable life insurance entails fees and charges and is subject to fluctuating values of the underlying investment options. Variable life insurance entails risks, including the possible loss of principal. The death benefit coverage of variable life insurance is based on the claims-paying ability of the insurance company.

Insurance products are offered through Morgan Stanley Smith Barney LLC in conjunction with its licensed insurance agency subsidiaries.

Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice. You should consult your own tax and legal advisors (a) before establishing a nonqualified deferred compensation plan, and (b) regarding any potential legal, tax, and related consequences of any investments or other transactions made with respect to a nonqualified deferred compensation plan.

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