How to Retain Key Employees Without a 401k Match

You can retain key employees without a 401k match by offering a benefit that only the people you choose receive. The usual tools are an executive bonus, a restricted version of that bonus called a REBA, a supplemental retirement plan, or phantom stock. A 401k match goes to everyone who qualifies. These arrangements can go to the two or three people you cannot afford to lose.

Why a 401k Match Is the Wrong Tool for Keeping a Few People

Say you own a business with 40 employees and three of them keep it running. A sales director, a plant manager, and a controller. You'd like to give them a reason to stay for ten more years. A bigger 401k match feels like the obvious move.

The trouble is how qualified plans work. A 401k has to cover a broad group of employees, and it generally has to pass testing that checks whether owners and highly paid people are getting a better deal than everyone else. Safe harbor designs avoid some of that testing, but they do it by requiring a set employer contribution for eligible employees. You can read how the rules are described by the IRS.

So the math goes like this. Raise the match to win over three people, and the cost can rise across the whole payroll. And a match alone may not keep anyone in the building, since many plans vest it on a short schedule and an employee who leaves takes the vested money along.

Qualified plans are good at what they do. They just aren't built for picking favorites on purpose.

Golden Handcuffs for Small Business: Four Selective Options

Nonqualified arrangements don't have to cover everyone, which is the whole point here. Each one below can be offered to the people you choose and tied to a vesting schedule you write. They are not interchangeable, so here is what each one does.

1. The Section 162 executive bonus

The company pays an executive a bonus, and the executive uses it to pay the premium on a permanent life insurance policy the executive owns. The bonus is taxable to the executive and is generally deductible to the company when total pay is reasonable. On its own it does not hold anyone in place, because the policy belongs to the executive from day one. Our guide to the Section 162 executive bonus plan covers the mechanics.

2. The restricted version, a REBA

A REBA adds a restriction form filed with the carrier. Any exercise of ownership rights other than a beneficiary change then needs both the executive's and the company's signature, so no loans, withdrawals, or surrenders on the executive's own. The restriction is where the handcuff comes from. It is a quasi-vesting arrangement, which means that if the executive leaves early the money does not go back to the company. The company just never has to release access. Our post on the restrictive endorsement bonus arrangement walks through it.

3. A SERP or nonqualified deferred compensation plan

Here the company promises a future benefit and the executive earns it by staying. The company can set money aside informally, often with a life insurance policy it owns and controls, but the executive has no claim on that policy. The promise is unsecured, and the executive stands behind the company's general creditors. The benefit is generally taxed to the executive when paid, and the company takes its deduction then. Because the company owns the policy, the premiums are not deductible. Payout triggers have to be fixed in the written agreement to fit Section 409A. See nonqualified deferred compensation funded by life insurance for the full picture.

4. Phantom stock

Phantom stock gives a key person hypothetical shares that measure a promised cash payment. It rewards growth in the company's value without giving up any actual equity. It is a form of deferred compensation, so the same 409A and written agreement rules apply. Some companies fund it informally with a company-owned policy. For an owner who wants a manager to think like an owner without becoming one, it can be a good fit.

Matching the Tool to the Person

Start with what you want the person to feel. Different structures answer different worries.

• You want them to own something now, with a lock on it. A REBA fits. The policy is theirs, and the restriction keeps access tied to the schedule.
• You want to keep the asset and the control. A SERP fits. The company owns the policy and pays out when the executive has earned it.
• You want them thinking about company value. Phantom stock fits, since the benefit rises with the company's growth.
• You want the simplest possible gesture. A straight executive bonus is the lightest. It is also the weakest at retention.

Many companies layer two of these. A common pattern is an ordinary 401k for everyone, plus one selective arrangement for the handful of people who carry the business.

Who These Arrangements Are Built For

Executive bonus arrangements are meant for non-owner executives. If you are a pass-through owner, a bonus paid to yourself is a wash at best. For an S corporation owner it can leave you worse off, because it turns income that could have been K-1 profit into W-2 wages that carry payroll taxes. If the real question is your own retirement, a cash balance or defined benefit plan is often the right place to look, and we are glad to talk it through.

There is one more rule to know. When a company owns life insurance on an employee, as it does in a SERP or a phantom stock plan funded with a policy, federal law requires written notice to the employee and consent before the policy is issued. The company also files Form 8925 each year. Missing this can make part of the death benefit taxable. The IRS Form 8925 page explains the filing. The employee-owned approaches, a bonus and a REBA, avoid this step because the executive owns the policy.

What to Settle Before You Start

Retention plans fail when they are vague. Decide these before anything is signed:

1. Who is in. Pick based on role and replacement risk, and write down why.
2. The vesting schedule. Long enough to matter. Short enough that the person believes they can reach it.
3. What happens on death, disability, or a sale of the company. These events should be spelled out, not left to guesswork.
4. The policy design. If the goal is cash value an executive can draw on later, a whole life insurance contract has to be built that way from the application.

Our standard approach holds for every business case. Your attorney drafts the agreements, your CPA confirms the tax treatment for your entity, and Cornerstone designs and places the insurance. You can see how this fits with the rest of an owner's plan on our business owner strategies page. If you'd like to talk through which structure fits the people you are trying to keep, schedule a conversation with our team.