In Penn Mutual’s recent family business survey, 95% of respondents agree that family business owners have a strong sense of responsibility toward their employees. If you’re a small business owner, part of your responsibility is to ensure that your business can continue if you or a key employee dies. If business continuity is important to you, key person insurance (KPI) should be too.
Protect your business
At its core, KPI protects your business from financial loss if you or one of your key employees dies, providing you with the necessary liquidity to keep your business running efficiently, through an income tax-free influx of cash. KPI will also give you the assurance of knowing that your business will have a much higher probability of continued success should an unforeseen death occur.
Identify your key employees
How do you identify your key employees? It’s a subjective exercise at best, but one you need to do. Job title, role in the business and total compensation are factors to consider when determining who they are. But don’t overlook an important salesperson who may have some major accounts that contribute significant revenue to your business. Of course, you are a key employee of your business too. You should answer these three questions to help identify others:
- Who has specialized skills or knowledge that is critical to your business’ operation?
- Has anyone built a loyal client base that generates consistent income for your business that it can’t risk losing?
- Who has driven substantial revenue to the business?
Get the right amount of coverage
After you’ve identified your key employees, it’s important to determine how much coverage your business will need. Remember, you purchase KPI to protect your business, so it’s owned by your business for the benefit of your business.
Answer these questions to evaluate the amount of coverage you’ll need:
- How much would it cost to hire and train a new employee to replace a key employee? How much revenue would the business lose before you hire that new employee?
- How much profitability does your key employee add to the business? How long would it take for a new employee to contribute this amount?
- How much does your key employee earn?
The proceeds from KPI allows you to cover these costs without directly impacting your business’ cash flow, and it can provide for any temporary dip in revenue associated with the loss.
A good way to determine the appropriate amount of coverage for a key employee is using a multiple of their total compensation. Many insurance companies allow coverage up to 10 times total compensation, so if your employee earns $250,000 annually, your business could qualify for $2.5 million in coverage on them.
Other benefits to your business
Protecting your business and ensuring its continuity are important reasons for buying KPI. But there are other ways that KPI can benefit your business.
- Recruiting and Retention
KPI is a great tool for recruiting, rewarding and retaining key employees, by showing them that you care about the business and their important role in it. When structured properly, it can provide supplemental retirement income, deferred compensation and a death benefit to retired key employees.
Because KPI is a non-qualified benefit, you decide who will participate.
Each plan can be tailored to meet the needs of your business and each of your key employees. In addition, as your business grows, the amounts of your KPI can and should grow with it.
Start the process
Unfortunately, some small business owners don’t understand the importance of KPI until it’s too late. Our survey shows that only 21% of respondents have a formal, written succession plan in place, and less than half (49%) have KPI. An alarming 33% don’t consider KPI all that important.
The truth is that the constant demands of running a business can put long-term planning on the back burner. But that doesn’t minimize the need for KPI. The best place to get started is to meet with your trusted financial professional, who can paint the big picture for you and help answer your questions.
The benefit might not be realized until way down the road, but KPI is vital today, to ensure the future success and legacy of your business.
For more details on the survey findings, download the white paper, “Taking care of business (and employees)” (registration required), which takes a deeper dive into our survey and the dynamics of running a family business.
*Penn Mutual’s 2020 Family Business Survey was conducted between July 22 and August 10, 2020. Conducted with Family Business Magazine, the survey was intended to understand the challenges, expectations and behaviors of family-owned businesses and the people who lead them. The 305 respondents included business owners, partners and other high-level family employees.
This post is for informational purposes only and should not be considered as specific financial, legal or tax advice. Depending on your individual circumstances, the strategies discussed in this presentation may not be appropriate for your situation. Always consult your legal or tax professionals for specific information regarding your individual situation.