Corporate-owned life insurance (COLI) is one option companies may use to informally fund liabilities associated with a Nonqualified Deferred Compensation (NQDC) plan. The company purchases and owns life insurance policies on eligible executives, pays the premiums and is generally the beneficiary. The policies do not formally secure participant benefits, but their cash value may help companies manage plan-related liabilities, cash flow and income statement volatility. COLI also carries costs, risks and tax considerations that companies should evaluate alongside other potential funding approaches.
Why use COLI to informally fund an NQDC plan?
A company may use COLI to help offset NQDC plan liabilities and manage related cash flow and income statement volatility. Over the short term, a COLI program may be structured to track unfunded balance sheet liabilities. Over the long term, policy cash value may help the company manage plan costs and benefit payments. COLI assets remain general assets of the company, are subject to the claims of its creditors and do not formally secure participant benefits.
- COLI can help reduce taxes on invested assets, potentially increasing after-tax returns and enhancing shareholder value.
- COLI may offer certain income tax advantages compared with taxable 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 life insurance a company purchases and owns on the lives of eligible employees, typically executives. The company pays the premiums and is generally the beneficiary, while policy cash value may be used as an informal funding vehicle for NQDC plan liabilities. Each plan and policy should be evaluated based on its features, costs and risks.
When a company acquires life insurance on its executives – namely, the eligible participants in an 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.
The following comparisons illustrate selected differences between taxable investments and variable COLI, including how certain costs and tax considerations may affect returns.
