Mid-year budget planning is ramping up. Business owners are assessing organizational budgets that will inform the second half of the year through next year. They may have a clear vision of what will drive growth targets and expenses in the coming months, but there is one stealth cost that could have a dramatic immediate and lingering long-term impact on a mid-market company’s profitability.

Loss of top talent, whether key executives or those with specialized technical skills, can delay or destabilize a business owner’s long-term growth and succession plans. That is why we think it is essential to think about retention of top talent in a new way.

This shift in thinking is particularly apt when one considers that industry estimates indicate the cost of replacing a key executive at 150% to 300% of annual compensation. And that may be conservative. Some estimates edge up as high as 200% to 400%. It is no wonder that a prominent talent solutions provider, LHH, reported recently that 26% of executives interviewed in a recent report rated retaining top talent as the top internal priority, increasing from ninth position in the prior year (LHH).

There are direct costs when a key executive leaves an organization. Executive search fees can run from 25% to 35% of the position’s first-year compensation, and the cost of training a replacement can run as high as $80,000 for elite training programs (Corporate Vision). 

Other costs are less evident but every bit as corrosive. 

For instance, relationships, and the trust required to build them, are valuable assets. Although not line items on the corporate balance sheet, they take time and human capital to build. While a company’s principal revenue generator is nurturing existing business and building new sources of income, those relationships and the trust required to maintain them are seemingly intangible assets. When that contact departs, they become very tangible. If there is not a smooth transition to a colleague, team or the newly hired replacement, revenue may be lost or delayed driven by pipeline attrition, a slowdown in deal velocity, and renewal risk. This, in turn, has the potential to impact capital debt financing as bank covenants may be tied to revenue or profitability benchmarks.

Even if an organization is able to maintain existing contracts, the relationships that have been established may change because of the new dynamics created with a new executive. The level of risk introduced by the possibility of a slow drift and distancing of established relationships may push an organization’s risk threshold beyond what is deemed acceptable by its enterprise risk management system. 

That risk threshold is further stressed by the “cultural tax” that follows a key person’s departure. The internal disruption caused by a key person’s departure may slow down productivity as work is realigned. The lack of structural processes to help ensure that decisions are made in a timely manner may impact key business relationships. A transition may also accelerate turnover in the departed executive’s department as team members react to the new uncertainty. If the executive was long-tenured, institutional knowledge may be lost. Even more concerning is the potential loss of innovation.

So, what’s the solution?

The best solution for retaining critical talent may well be a generous but fair compensation package that discourages a departure and the volatility that accompanies it. Call it “golden handcuffs” or just good business sense; by reducing business volatility created when a valued executive departs, corporate risk is brought in line with organizational risk budgets, and the subsequent stability delivers a return on investment that more than justifies the investment in an executive’s compensation.

The follow-up question becomes “What’s the best way to implement compensation?”

Standard salary increase: Compensating a valued executive through substantial salary increases presents both the employer and the key executive with outcomes that may not solve the needs of either. The key person is receiving highly tax-inefficient W-2 compensation that is vulnerable to inflation. This tax friction diminishes long-term wealth buildup. The employer is offering a benefit that isn’t sticky: It doesn’t ensure that the valued executive will remain committed to the organization.

Non-qualified Deferred Compensation (NQDC): NQDC compensation such as Supplemental Executive Retirement Plans (SERPs) offer control and flexibility to both employers and the executives they are seeking to retain. 

Employers are able to target specific individuals rather than all employees, a requirement of qualified plans, and are not guided by the approval and reporting strictures of the IRS. They can also establish vesting and performance requirements. These “golden handcuffs” help ensure greater stability, reducing an organization’s risk premium which, in turn, supports greater return on investment (ROI).

Once an executive meets the SERP’s prerequisites, greater control is afforded. In retirement, they may be able to take either a lump sum or an annuity, reflecting need and their tax situation. If the agreement is funded with a cash value life insurance policy, a death benefit may be available to support an executive’s family should death occur. There is also the added confidence of knowing that if life insurance is used, proceeds will pass to beneficiaries while an estate is in probate. So, in a very real way, the estate liquidity created helps reduce the executive’s financial risk profile.

Split-dollar: Split-dollar arrangements offer many of the same benefits to employers who want to retain valued employees and an added benefit of recovery of costs. If a collateral assignment method is selected, the executive is bound by the loan that must be repaid for the premiums paid by the employer. If, however, it is an endorsement policy, then the employer owns the policy and establishes a vesting schedule which determines an executive’s access to the cash value or death benefit rights. Performance goals may also be required. The focus on the rights to an insurance policy rather than a legally binding right to compensation removes the split-dollar strategy from the strictures of IRC §409A, the guidance for NQDC.

Life insurance can be an efficient way to fund SERPs and Split-Dollar plans. There is a high degree of capital efficiency when a cash value life insurance policy is used, allowing for tax-deferred growth and tax-free wealth transfer upon death. When used with an Irrevocable Life Insurance Trust (ILIT), there are additional benefits such as reducing an executive’s taxable estate, and creating controls over distribution, and safeguarding an asset from creditors.

This year’s budget planning is an opportunity for mid-market organizations to move beyond profit and loss projections and to take definitive steps to identify and help mitigate potential executive flight using tax-efficient retention strategies that will incentivize executives to remain with an organization. Part of mid-year planning should include a retention audit that examines the risk to a company’s profitability. It can help assess if an organization’s risk quotient is within the established corporate risk budget.

Clarity precedes action. Our team would be happy to assist you. Schedule your complimentary consultation by clicking the link below.