Page 319 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 305

another set of retirement age or years of service, we would add 18 more combinations. With
the addition of a set in both age and years of service, we would add 42 more models. Thus, it
is easy to see the care needed in designing the matrix. It must have enough data to test the
desired tilt in the plan but not so much as to be subject to analysis paralysis.
How Is It Paid Out? The normal form of payout is an annuity. Typically, these are
monthly payments for a defined-benefit plan (versus a single lump-sum payment from a
defined-contribution plan). Many defined-benefit plans permit conversion to a lump sum
based on actuarial considerations.
Plan Payout

Payments from the plan are either in the form of an annuity for life (or a prescribed number
of years) or in a lump sum. Typically, defined-benefit-plan benefits are in the form of an
annuity, whereas defined-contribution-plan benefits are paid in a lump sum. However, the
reverse is also possible.
As for lump sums, it is important to know that while all lump-sum distributions are
lump-sum payouts, not all lump-sum payouts are lump-sum distributions. Since lump-sum
distributions receive favorable tax treatment (namely, they qualify for a tax-free rollover into
an Individual Retirement Account [IRA] or other defined-contribution plan), it is important
to know what constitutes a “lump-sum distribution.” It is defined as the payment within one
taxable year of the full amount the employee is eligible to receive, paid under one of the
following conditions: (1) the employee is at least age 59 1/2, (2) the employee retires or
otherwise separates from employment, or (3) the employee dies. Thus, an active employee
may qualify only at age 59 1/2.
An additional complication arises if the employee is in several qualified plans and wishes
to receive a lump-sum distribution from one and installment payments from another. This
can be accomplished only if they are different types of plans (e.g., one is a defined-benefit and
the other a defined-contribution plan). Plans that are similar will be treated as one plan for
the purpose of tax distribution of payout (e.g., a profit-sharing plan and a money-purchase
pension plan would probably be treated as a single plan, and it would not be possible to
receive annuity payments from one and a lump-sum payment from the other). Even if they
are different types of plans, it is preferable to receive payment in separate taxable years.
Employers may lump sum a terminated employee’s defined benefit without the person’s
consent only if it is below an amount set by law. The 1997 Taxpayer Relief Act set the amount
at $5,000 or less.
Another point to keep in mind is that the use of unisex tables will probably penalize a male
employee wishing to buy a single life annuity (say at age 65) from a defined-contribution plan
and reward him for taking a lump sum under a defined-benefit plan. To illustrate: The cost of
a $1,000 single life annuity might be $9,300 at 65 for a male, but a unisex table could charge
$9,700. Thus, with an account balance of $9,300 in the defined-contribution plan, the male
executive will not be able to buy the $1,000 annuity but only a lesser amount, using the uni-
sex table. Conversely, taking a lump sum from the defined-benefit plan would mean receiving
$9,300 under a male discount schedule versus $9,700 under a unisex schedule. The reverse
would, of course, be true for a female.
Executives may find a lump-sum distribution very attractive if they either (1) need
income to start up a new venture, or (2) can afford to put it aside in an IRA and live on other
income. Another alternative to the IRA is an annuity purchased from an insurance company.