Asset/Liability Matching Strategies
Nonqualified plan sponsors may pay benefits from earnings or annual cash flows (Self-Funded). As an alternative, sponsors may invest assets to match the plan liabilities.
The assets remain on the company’s balance sheet. Therefore, any earnings on those assets are taxable to the company when earned or realized in the income statement. Opinions vary as to whether unrealized gains may be recognized.
Three basic informal financing methods used to finance Nonqualified Deferred Compensation Plans:
Self Fund (“Pay As You Go”)
- Employer pays benefits when due out of current business capital and cash flows
- Primary advantage is postponement of negative cash flow
- No provision made for paying benefits
- Employees may not feel secure about benefits
- Employer allocates deferral amounts or corporate contributions to an investment fund informally earmarked for the payment of benefits
- Primary advantage is ability to manage business cash flow
- Taxable income generated by the funds add an additional employer tax cost and can cause the after-tax asset account value to lag the plan liability
- Fund may not be adequate to pay benefits when due
- Death and disability income benefits are not insured
Corporate Owned Life Insurance (COLI)
- Employer purchases a life insurance policy on life of key employees and contributes aggregate deferrals or employer funding to policy in the form of premiums.
- Tax-deferred growth
- Non-taxable access to cash values up to policy basis
- Tax-free reallocation of separate accounts
- Tax-free death proceeds
- Primary disadvantage is that in the early policy years, the asset may lag the liability as the early cost of insurance is amortized