Employees with specialised experience, knowledge and skills are fundamental to the success and profitability of a business. To retain the services of a valued employee, the employer can provide him with an increase in his earnings, which will vest in him after a specified period of time (such as 5 or 10 years), as a lump sum and free of any tax. This lump sum, funded by an endowment policy, acts as an incentive to retain the valued employee's services.
Why is it important from the business’s perspective to have a preferred compensation plan in place?
- It is becoming increasingly difficult in South Africa to attract and retain qualified employees, and even more so those who are not only qualified, but also have experience. Competitors are prepared to pay a premium to lure these employees into their employ. It is no longer possible to try to incentivise employees to remain with an employer by placing restrictions on their access to their pension fund benefits on withdrawal (vesting scales are no longer permitted), so employers have to find some other incentives to encourage them to stay with them and not to move to another employer for a salary increase.
- If the business is one of those who invest in their employees by training them and assisting them in becoming experts in their work, then not only do they run the risk of losing the employee’s services to a competitor, but also the financial loss on the return on their investment, being the price they paid in upskilling them, when they do move to another employer.
- Any incentive plan put in place needs to be over a reasonable time period. In the current job market employees move from one employer to another on average seven times in their life, but some would argue that this statistic is too conservative. It is therefore unlikely that the promise of a reward, many years into the future, will lock the modern employee into service.
- Ideally, the plan put in place for a specific employee, which aims to incentivise that person to remain with the business for a stipulated period of time, ideally should make provision that should that person leave before the end of that time, the business will be able to recover any amounts paid, as the end goal was ultimately not achieved.
The structure of the preferred compensation plan:
The employer and the employee enter into a service agreement in terms of which the employer will grant the employee a salary increase which will be used to contribute to an endowment policy.
The employee will take out the endowment policy, which will immediately be ceded in security to the employer, who will facilitate payment of the premiums on behalf of the employee.
At the end of the period stipulated in the service agreement the employer will cancel the collateral cession and the employee is free to access the cash, to keep the policy going or to take advances from the policy on an as and when basis.
The Income Tax consequences:
The salary increase, which is specifically granted in order to fund the endowment, is tax deductible in terms of section 11(a) of the Income Tax Act in the hands of the employer.
The increased salary is taxable in the employee’s hands. This means that the employer must factor the tax paid by the employee into the equation in determining the amount to be invested in the endowment, so that the employee is no worse off in terms of his/her take home pay once the preferred compensation plan has been put in place.
Four fund approach:
In terms of the Income Tax Act growth on investments by individuals in endowment policies, will be taxed in terms of the so called four fund approach. At this point in time, all interest and net rental income will be taxed at 30%, while capital gains will be taxed at an effective 7.5%. (This could result in a tax saving for the investor if his/her marginal rate of tax is higher than 30%.) The tax levied will depend upon the type of assets class invested in. This taxation process takes place at the insurer and places no tax responsibility on the investor. The proceeds paid out by the insurer therefore are not subject to tax in the investors hands.
Estate duty consequences:
The proceeds of the life insurance policy will be deemed property in the estate of the deceased and may attract estate duty.
Steps to be taken to implement a Preferred Compensation Plan:
- Establish the amount that the business is prepared to put aside, either on a recurring basis, or as a single premium, as a “bonus” to retain the services of the employee, and whether this amount is before or after tax.
- Effect the endowment policy which will be used as the vehicle to fund this plan
- It will be necessary to complete a risk profile analysis on the employee to determine his/her appetite for risk and so to establish which funds or portfolios should be invested in.
- A service agreement must be entered into between the employer and the employee. It is critical that the service agreement is entered into, as both the signed agreement and life insurance is necessary in order to have a binding and effective preferred compensation plan
- All the necessary documents to obtain the life insurance with the relevant life office must be completed
Valued employees are the lifeblood of a business and directly contribute to its success. To retain their services and dedication in the business, it is essential to provide them with an incentive to remain in employment. A Preferred Compensation Plan provides such an incentive.