Understanding Insurance in Non-Qualified Plan Investment Options

When companies design Non-Qualified (Non-Qual) plans, they seek effective ways to fund the obligations that arise from these deferred compensation agreements. One popular strategy involves using insurance products, specifically Corporate-Owned Life Insurance (COLI), to informally finance these plans. But what exactly does insurance mean in this context, and why is it such a valuable tool for employers?

The Role of COLI in Non-Qual Plans

Corporate-Owned Life Insurance is a life insurance policy taken out by a company on the lives of its key employees or executives, with the company named as the beneficiary [1]. These policies are primarily used as a financial instrument to help businesses manage the future liabilities associated with Non-Qualified plans. Unlike qualified plans, which have strict funding and contribution limits set by ERISA, Non-Qual plans offer greater flexibility, but they also carry a significant financial burden [2]. COLI policies offer a way to accumulate cash value within the policy that grows tax-deferred, providing a pool of assets the company can access when it needs to fulfill its commitments under the Non-Qual plan [3].

"COLI can help reduce taxes on invested assets, potentially increasing after-tax returns and enhancing shareholder value." [2]

How COLI Works

The mechanics of COLI are fairly straightforward. The company purchases life insurance policies on the lives of its executives, paying the premiums out of its general assets. Over time, the cash value of these policies builds up within the policy, thanks to the tax-deferred growth of the investments inside the policy [4]. This cash value can be tapped into by the company if needed, either through loans or withdrawals, to cover the costs associated with the Non-Qual plan [2].

When the insured employee passes away, the company receives the death benefit, which is typically tax-free [1]. This death benefit can then be used to pay out the benefits promised under the Non-Qual plan or to reimburse the company for the cost of providing those benefits. Essentially, COLI serves as a financial backstop, providing liquidity when it is most needed and reducing the impact on the company's cash flow [4].

Benefits and Considerations

The appeal of using COLI in Non-Qualified plans lies in its tax advantages and flexibility. Since the growth of the cash value within the policy is tax-deferred, companies can accumulate significant assets over time without being subject to immediate taxation [3]. Moreover, when structured properly, the death benefit paid to the company is tax-free, providing a substantial return on the initial premiums paid [1].

"COLI generally offers income tax advantages over other investments including: Tax-deferred growth of cash value, Tax-free reallocation within the policy, Tax-free receipt of death proceeds." [2]

However, there are considerations to keep in mind. COLI policies can be expensive, particularly when insuring older executives or those with health issues. Additionally, while the company benefits from tax-deferred growth, it must also account for the impact of holding these policies on its balance sheet, as well as the costs associated with maintaining them over the long term [5].

Strategic Use in Fiduciary Planning

For companies looking to manage their fiduciary responsibilities effectively, COLI offers a strategic solution. By aligning the long-term liabilities of Non-Qual plans with the tax-advantaged growth of life insurance, companies can create a more secure financial foundation for fulfilling their obligations [4]. However, it's essential for fiduciaries to carefully consider the costs, benefits, and potential risks associated with using insurance in this manner. A well-thought-out strategy that incorporates COLI can enhance the company's ability to meet its commitments, while also leveraging the financial advantages of tax deferral and death benefits [5].

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References:

 [1] MBS Financial. (2020, June 11). Understanding Corporate Owned Life Insurance (COLI). Retrieved from https://mbsfin.com/understanding-coli/ 

 [2] Morgan Stanley at Work. (n.d.). Corporate-Owned Life Insurance COLI. Retrieved from https://www.morganstanley.com/atwork/articles/corporate-owned-life-insurance-coli 

 [3] New York Life. (n.d.). Non-qualified Deferred Compensation Plans. Retrieved from https://www.newyorklife.com/articles/non-qualified-deferred-compensation-plan 

 [4] Principal. (n.d.). Corporate-Owned Life Insurance (for Nonqualified Deferred Compensation). Retrieved from https://advisors.principal.com/wps/portal/advisor/products/life-insurance/coli-deferred-compensation 

 [5] BoliColi.com. (n.d.). Corporate-Owned Life Insurance (COLI)?. Retrieved from https://www.bolicoli.com/coli/