What Are SERP Plan Limits and How Do They Affect Executives?

Supplemental Executive Retirement Plans (SERPs) offer retirement benefits beyond traditional 401(k) plans, helping companies attract and retain top executives. However, these plans come with limits that affect how much an executive ultimately receives. Understanding these restrictions is essential for both employers designing SERPs and executives planning their financial futures.

Several factors influence a SERP’s effectiveness, including compensation caps, funding structures, vesting schedules, and tax implications. Each of these elements determines the plan’s overall value and accessibility.

Eligibility Criteria

SERPs are typically reserved for senior executives, but eligibility is based on more than just job title. Companies consider tenure, performance, and contributions to long-term business success. Executives responsible for revenue growth, operational efficiency, or strategic initiatives are more likely to be included.

Industry norms also play a role. In finance, healthcare, and technology—where executive compensation is highly structured—SERPs help companies stay competitive. Businesses in industries with high turnover or talent shortages use these plans selectively to retain leadership.

Regulatory factors further shape eligibility. Under the Employee Retirement Income Security Act (ERISA), SERPs are classified as “top-hat” plans, exempt from many ERISA funding and reporting requirements. To maintain this status, participation must be limited to a select group of management or highly compensated employees. While ERISA does not define a “select group,” case law and Department of Labor guidance suggest it should be a small percentage of the workforce, typically those earning well above the IRS-defined highly compensated employee threshold ($150,000 for 2024).

Compensation Caps

SERPs are not subject to IRS contribution limits like qualified retirement plans, but companies often impose internal caps to manage financial risk. These limits may be a percentage of final average salary or a fixed dollar amount. For example, a company might structure a SERP to provide 60% of an executive’s highest three-year average salary upon retirement, but only up to a set ceiling.

Some organizations use tiered caps, offering higher-ranking executives a greater percentage of earnings than mid-level leadership. This keeps benefits competitive while controlling costs.

Deferred compensation rules under Section 409A of the Internal Revenue Code also impact SERP design. If a plan fails to comply—such as through improper deferral elections or distributions—executives could face immediate taxation on vested amounts, plus a 20% penalty and interest. To avoid this, companies structure SERPs with clear deferral elections and distribution triggers that align with regulatory guidelines.

Funding Requirements

Unlike traditional pension plans, which are pre-funded, SERPs are usually unfunded or informally funded. Companies often pay benefits from general corporate funds as executives retire, providing flexibility but introducing financial risk. Future obligations depend on the company’s profitability and liquidity.

To offset this risk, many companies use corporate-owned life insurance (COLI). The company purchases life insurance policies on executives, with itself as the beneficiary. The tax-deferred growth of the policy’s cash value helps cover SERP costs, while death benefits provide liquidity. However, COLI requires careful management to ensure policies remain adequately funded.

Some companies establish rabbi trusts to give executives greater assurance that benefits will be paid. While assets in a rabbi trust are still subject to creditors’ claims if the company goes bankrupt, they cannot be used for other corporate purposes. These trusts must comply with IRS rules to avoid unintended tax consequences, particularly under Section 409A.

Vesting Parameters

Vesting schedules determine when an executive gains irrevocable rights to SERP benefits. Unlike traditional retirement plans, which follow standardized ERISA vesting rules, SERPs allow employers more flexibility. Companies often use graded or cliff vesting. A graded schedule might vest 20% of benefits annually over five years, while a cliff schedule could require ten years of service before an executive is entitled to any payout.

Some SERPs include performance-based vesting, tying benefits to financial targets such as EBITDA growth, return on equity (ROE), or stock price appreciation. A plan might require an executive to meet a three-year average ROE of 12% before vesting. This approach aligns executive incentives with shareholder interests, ensuring benefits are linked to business performance rather than tenure alone.

Distribution Schedules

SERP distributions follow predetermined schedules, unlike 401(k) plans, which allow flexible withdrawals after retirement. Companies may structure payouts as lump sums, periodic installments, or a combination of both.

Lump sum distributions provide immediate access to benefits but can create a significant tax burden in a single year. Companies sometimes prefer this approach to settle obligations quickly and reduce long-term liabilities.

Installment payments spread the tax impact over multiple years, offering executives a more predictable income stream. A common structure involves equal annual payments over ten or fifteen years, reducing exposure to higher marginal tax rates. Hybrid models may include an initial lump sum followed by installments, balancing liquidity needs with tax efficiency.

Tax Treatment

Since SERPs are nonqualified deferred compensation plans, they do not receive the same tax advantages as qualified retirement accounts. Contributions are not tax-deductible for the company until benefits are paid, and executives do not owe taxes on accrued amounts until distributions begin.

Distributions are taxed as ordinary income rather than capital gains, which can result in higher tax rates. A large lump sum could push an executive into the highest federal tax bracket—37% for incomes above $609,350 in 2024. State taxes may further increase the burden, particularly in high-tax states like California and New York.

To minimize tax exposure, executives often work with advisors to structure distributions strategically, spreading payments over multiple years to stay within lower tax brackets.