Creating Golden Handcuffs With Premium Finance

Founding member of Vérité Group, LLC, specializing in premium finance, with 40 years of life insurance experience.

The Great Resignation has reached every level of the workplace with even executives and partners walking out on their jobs for the promise of greener pastures. The U.S. Bureau of Labor Statistics reported in 2021 that 47.4 million Americans voluntarily left their jobs. Of these, a March 2022 Pew Research survey found that 63% of respondents who quit left for better pay, and an equal number who quit reported they felt they had no career advancement opportunities.

The impact to a business of employees departing, especially at senior levels, is staggering and not just limited to recruiting, hiring and training new employees. Departing employees take intellectual capital with them as well as other employees—sometimes entire departments!

Increasingly, professional partnership organizations such as law, accounting, medical and consulting firms are turning to a restricted executive bonus arrangement (REBA) to retain and reward non-equity partners and other key employees. By utilizing premium finance, these companies are able to offer generous future benefits while managing costs and remaining within budget.

Arthur’s Dilemma

Earlier this year, Arthur, a senior partner in a Florida law firm, emailed to say his firm had just lost its fourth non-equity partner to another law firm promising a higher payout in fees and the ability to work remotely and not have their work subsidize expensive office real estate. Clients were following these attorneys out the door and contributing to a significant loss in revenue.

While Arthur was able to offer the flexibility to work remotely, he needed a compensation solution beyond just throwing cash at the problem in the form of higher salaries. In fact, Arthur’s dilemma had a “chicken-and-the-egg” aspect to it—Arthur had no objection to increasing compensation if he could be assured the partner or employee would stay.

After I conducted a review of the firm’s compensation practices and laid out several options, Arthur felt the benefit that had the best retention mechanism with a corresponding monetary reward was a REBA. Presented with a budget from Arthur, I showed him a traditional REBA as well one with a premium finance component that would vastly increase a REBA’s future cash benefit.

The Best Of Both Worlds

In a REBA, an employer bonuses the premiums to maximum fund a cash value life insurance policy owned by the employee. In the future, usually after retirement, the employee can take tax-free withdrawals and loans from the policy’s cash value to supplement their income.

A written agreement includes an endorsement that encourages employees to perform adequately in order to earn additional bonuses while staying with the employer until restrictions on the REBA are gone. These restrictions could include cliff vesting or a percentage-by-year vesting.

For example, a traditional REBA design for one non-equity partner, age 46, was to bonus premiums of $100,000 a year for 20 years. Then, in retirement, this attorney was projected to be able to take $252,000 a year from the policy tax-free through age 100. For a cost of $2 million, the participant would receive over $4.5 million in income.

By incorporating premium finance, this REBA was “super charged” so that the participant’s projected annual tax-free income from the policy was $475,000 a year—a total of over $8.5 million. Instead of using the annually budgeted $100,000 for the bonus applied to the policy’s premium, this sum was used to pay the interest on a loan taken out by the firm and collateralized by the life insurance policy. The larger loan amount would then be bonused and paid into the policy, permitting greater cash value growth and a much higher, projected future benefit.

For the same cost, a premium finance approach allowed the law firm to nearly double the future payout, making the REBA an extremely enticing benefit. The law firm will eventually recoup its loan from a share of the policy’s income tax-free death benefit, with any remaining death benefit being paid to the participant’s heirs.

Thank You for Staying

The restrictive endorsement Arthur chose was in line with the generous size of the REBA’s payout. It required this specific participant to remain with the firm for 10 years before being entitled to any portion of the policy’s cash value. After 10 years, the participant would vest in increments of 10% a year, becoming fully vested at retirement age. While the participant is free to quit at any time, he is likely to think twice before walking away from all, or a part of an estimated $475,000 a year in tax-free income.

Calculating Risks

Those considering utilizing premium finance should be aware of the risks that generally fall into three categories.

Personal Risks: These are largely related to someone’s net worth, liquidity and posted collateral. If, for example, net worth fell or the collateral was insufficient or moved so it was improperly held, it may be difficult to obtain future premium loans, or the outstanding loan could be called.

Lending Risks: These are almost always associated with the interest rates for loans but may also come from changes to other terms.

Policy Risks: These involve changes to the performance of the life insurance policy such as a decrease in dividend or crediting rates.

A Win-Win

Arthur and his partners were elated and relieved to offer a REBA arrangement that met their “golden handcuff” and budgetary goals. By financing the premiums of the cash value policies owned by participating key employees and restricting immediate access, the law firm was far less likely to see attorneys and other staff heading for the exits. Instead of incurring financial losses from voluntary resignations, capital could be more efficiently deployed in providing REBA benefits.

Premium financing life insurance can offer incredible advantages and value for the appropriate client, but it does come with several risks. It is important to work with a team of qualified financial, legal and tax experts when implementing this strategy for clients.

Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?