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.