Industry News, Articles and Events Blog

Whole Life or Indexed Universal Life for Split-Dollar Loan?

1/14/2021

by Scott Richardson, JD, Founder & CEO of IZALE

click for more from IZALE on Split Dollar loans

Split-dollar loan (SDL) remains a popular form of executive benefit, driven by more favorable financial impact on the CU vs. other benefit forms as well as the potential for income-tax-free benefits for the executive.

Split-dollar loan uses a life insurance policy owned by the executive and paid for by the CU. The CU’s payments are treated as a loan under IRS regulations (hence the name), and if the CU is to be repaid premiums plus interest at the IRS-determined Applicable Federal Rate (AFR), there is favorable tax treatment.

Simply put, SDL captures the spread between policy performance (which varies) and the AFR (which is fixed for each CU advance). While actual spread matters the projected spread has far more influence on expected benefits. Therefore, the projection rate you use is crucial to designing and monitoring SDL. Insurance illustration rules limit the maximum projection rate, however, prudent design demands a planning rate below that maximum.

One of the key decisions in designing SDL is what type of policy to use – whole life (WL) or indexed universal life (IUL). We use both types, helping clients match the executive’s profile to the appropriate product.

Whole Life is the oldest form of life insurance. It has strong guarantees with an annual dividend rate set by the carrier that doesn’t change much from year to year. With a 25+ year general decline in fixed income rates, it’s no surprise that dividend rates have changed. The table below shows the number of decreases from 2002-2021. The maximum projection rate in WL is the current dividend rate. We recommend a WL planning rate 0.5%-0.75% below the carrier’s 2021 dividend scale.

Indexed Universal Life has a crediting rate based on the change in an external index, most commonly the 1-year change in the S&P500™. An author of a recent article wrote that IULs are “expected to lose money about half the time.” This is a stunning lack of understanding of how IUL works since cash values are never exposed to the index and there is a guaranteed minimum or “floor” rate. The table below is based on 25 years of 1-year measuring periods

The maximum projection rate in IUL is a function of the IUL cap rate, and like WL dividend rates IUL cap rates have declined. While you can still actually get a 9% crediting rate for any measuring period, the projection rate is lower. We recommend an IUL planning rate that is 0.5%-0.75% below the maximum, and are currently using 5%-5.25%.

So which is the “right” product? While neither WL nor IUL is inherently better the key for us is the first distribution date. If you have less than 10 years before the first scheduled distribution, we generally favor WL as it provides greater confidence in meeting the projection. Beyond that, the upside of IUL may be more desirable. Whichever you choose, stress the initial planning rate by running two lower alternatives to see the impact on the targeted distribution.

There are other features of WL and IUL that are key to a sound SDL plan. Call IZALE Financial Group for a free consultation.

Originally published in the DCUC December 2020 Alert Magazine.

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Balance Sheet Management: How to Pull Ahead of Your Peers

11/12/2020

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by Todd Taylor and Omar Hinojosa, Taylor Advisors

How important is Net Interest Margin (NIM) to your institution? Community financial institutions are heavily dependent on net interest income (NII). With the majority of earnings coming from NIM, implementing a disciplined approach around “NII management” will make the difference between underperforming and outperforming institutions. To request a comparison of how your institution ranks vs national and in-state peers, click here.

As financial institutions across the nation are dealing with challenges from COVID-19, anticipating next steps to protecting or to improving profitability will become increasingly difficult. Why: Margins are under pressure! Cash positions are growing with record deposit inflows; loan pricing has become ultra-competitive; and many institutions are seeing accelerated cash flows from investment portfolios. In times of uncertainty, it can be challenging to develop and execute a strategy to defend profitability.

In addition to profit management, it is important to remember that stress testing your institution’s balance sheet is no longer an academic exercise! Beyond the risk-management applications, stressing the resiliency of capital and durability of liquidity should give your institution the confidence necessary to execute on strategies to improve performance and to stay ahead of your peers. It is of heightened importance to maintain focus on the four major balance sheet positions we discuss below.

Capital Assessment/Position

Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses, and providing resources for seizing opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown. As we navigate this period of uncertainty over the next 12 to 24 months, capital will be tested. Rapid changes occurring within the economy are not entirely cyclical in nature; rather, structural shifts will develop as consumer behavior evolves and business operations adjust to a ‘next normal’. Knowing the ‘breaking points’ for your capital base in terms of growth, credit deterioration, and a combination of these factors will serve your institution well for the Board and regulators.

Liquidity Assessment/Position

At Taylor Advisors, we have a saying, “Asset quality deterioration leads to capital erosion which leads to liquidity evaporation”. With institutions reporting record deposit growth and cash balances swelling, understanding how access to a variety of funding sources can change given asset quality deterioration or capital pressure is critical to evaluating the adequacy of your comprehensive liquidity position. Furthermore, stress testing your profile for a variety of scenarios (including falling below “well capitalized”) should help to give further confidence to execute strategies to protect the margin.

Interest Rate Risk Assessment/Position

In today’s ultra-low rate environment, pressure on earning asset yields is compounded by funding costs already nearing historically low levels. Excess cash is expensive and significant asset-sensitivity represents an opportunity cost as the Fed and the market forecast a low rate environment for the foreseeable future. Focus on adjusting your asset mix, not only to improve your earnings today, but to sustain it with higher, stable earning asset yields over time. Additionally, revisit critical model assumptions including loan reinvestment rate floors to ensure that your assumptions are reflective of actual pricing and rates down deposit beta assumptions as they may be too high for certain deposit categories.

Investment Assessment/Position

Strategies for investment portfolios and cash usually make a meaningful contribution to your institution’s overall interest income. Below are some key considerations to help guide the investment process in today’s challenging environment:

Cost of carrying excess cash just increased – Most institutions are now earning just 0.10% or less on their overnight funds. There are alternatives available in the market to increase income on short-term liquidity. Cash is not always KING!
Consider pre-investing – Many institutions have been very busy with PPP loans, and investments have taken a back seat. However, we anticipate this program having a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market.

Taylor Advisors’ Take:

Looking beyond 2020, liquidity and capital are taking center stage in most ALCO discussions. Moving away from regulatory appeasement and towards pro-active planning and decision-making will be of paramount importance. This can start with upgrading your tools and policies, improving your ability to interpret and communicate the results, and helping implement actionable strategies.

Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. Why? You must know where you are to know where you want to go. Start by studying your latest Q3 data! Dissect your NIM and understand why your earning asset yields are above or below peer. Balance sheet management is about driving unique strategies and tailored risk management practices to outperform…anything less will lead to sub-optimal results.

Todd is the Founder and President of Taylor Advisors, a Certified Public Accountant and a Chartered Financial Analyst charter holder. Todd has spoken at numerous state and national conferences on balance sheet management, bank investments, and risk management.

To learn more, contact Todd at email or visit their website.

A Senior Consultant at Taylor Advisors, Omar Hinojosa holds the Chartered Financial Analyst (CFA) designation and is a member of the Louisville CFA society. Omar works with institutions across the Midwest, Southeast and Southwest regions and has been a speaker at various financial institution programs in these regions.

To learn more, contact Omar at his email or visit their website.

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Recent Settlement Highlights Risks Associated with Top Hat Plans

8/20/2020

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by Jim Earle and Christopher Stock original publication for the WR Marketplace A Washington Report from AALU/GAMA

MARKET TREND: A recent $79 million settlement in the case of Berry v. Wells Fargo serves as a reminder of the unsettled nature surrounding the definition of “top hat” plans under ERISA.

SYNOPSIS: In Berry, Mr. Berry (the named plaintiff) and a class of former and current financial advisors filed a lawsuit against Wells Fargo and certain other defendants alleging that the financial advisors did not receive money owed to them under the “Wells Fargo Advisors, LLC Performance Award Contribution & Deferral Plan” (the “Plan”) due to an allegedly illegal forfeiture provision. Berry argued that the Plan was a “pension plan” under ERISA but did not qualify as a top hat plan, and as a result Wells Fargo breached ERISA by failing to satisfy certain minimum vesting and funding requirements under ERISA. Wells Fargo, on the other hand, contended that the Plan did in fact qualify as a top hat plan and therefore was exempt from those ERISA requirements. Notwithstanding the parties’ arguments, Wells Fargo and Berry ultimately settled the lawsuit for $79 million, including $20 million in attorneys’ fees.

TAKEAWAYS: Employers with nonqualified deferred compensation plans (“NQDC plans”) should carefully review their plans to determine if the employees eligible to participate in the plan are limited to a top hat group of employees. But because ERISA does not provide a bright-line test for defining the top hat group, employers may still face risk of employee claims, especially if the NQDC plan includes forfeiture provisions.

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Risk Management of BOLI

8/17/2020

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By Scott Richardson, JD, CLU, ChFC

EXECUTIVE TAKE-AWAYS

BOLI remains an attractive asset for a bank’s balance sheet.
BOLI carriers are not immune to the 2020 economic environment. A thorough evaluation of an existing or proposed carrier remains a critical element in BOLI program management.

Interest rates have been historically low for a number of years and fell even further in early 2020. Many predict low rates to continue for the next few years, with some mild expectation for a return to a rising rate environment. BOLI crediting rates will generally lag the market, but without mark-to-market risk of other fixed income investments. A bank should understand how crediting rates are determined in order to set proper expectations.
For existing programs, a bank can either make internal or external exchanges or look to make policy-level changes to improve yield. While rare, banks should periodically evaluate whether whole or partial liquidation of their BOLI is warranted. Every bank should understand the tax consequences of doing so and develop a strategy for effectively managing the process.

INTRODUCTION

After rising in recent years, economic contraction caused by the coronavirus has rapidly softened loan demand. While the PPP program from the SBA added billions in loans, the margin on PPP loans is extremely thin with an expected short life. During the pandemic restrictions, liquidity at many banks has increased from federal stimulus as well as depositors simply spending less. With 40 million becoming unemployed in just a 3-month period, many borrowers are expected to struggle to keep current on loan payments, affecting interest income and requiring increased reserves. Yields on traditional bank investments are at historically low levels, with Fed Funds near 0% and both the 5-year and 10-year US Treasury rates below 1%.

Yet the cost of employee benefits continues to rise, adding even more pressure to margin. As a result, banks are rediscovering the value of a well-designed Bank-Owned Life Insurance (BOLI) program.

Why? For almost 40 years, BOLI has been the preferred tool for banks to offset the cost of employee benefit programs. According to Call Report data from the FDIC website, at the end of 2019, sixty-five percent (65%) of banks reported BOLI holdings totaling $178.2 billion, compared to $122.8 billion a decade earlier.

BOLI generally provides a competitive tax-equivalent yield with little or no mark-to-market risk (which is very appealing for when we exit the low period of the interest rate cycle). The annual growth in policy values is included in noninterest income, which many banks are trying to improve. And, the death benefits in excess of cash value can serve three valuable purposes: offer a very efficient supplemental life insurance benefit to the insured employee, help the bank recover the cost of providing employee benefits, and protect the bank against the loss of key persons.

Before purchasing BOLI, however, a bank is required to conduct a thorough analysis of the BOLI marketplace. If a bank already has BOLI, it is required to do an annual risk assessment. Financial Institutions Letter 127-04 (FIL 127-04), the interagency statement on the purchase and ongoing management of BOLI, provides a clear roadmap for either analysis.

This paper will not address all of the elements of a thorough analysis. Rather it will focus on the insurance carrier, the product, and how a bank can make changes to either. These are particularly important in light of the recent crisis in financial services.

THE BOLI CARRIER

FIL 127-04 opines that carrier selection “is one of the most critical decisions” in the BOLI purchase process. This applies not only at initial purchase, but throughout the holding period of the BOLI.

Of over 800 life insurers in the U.S., there are approximately 30 carriers who have inforce BOLI policies, with perhaps 8-10 of those actively issuing new business. If a bank has BOLI from a carrier that does not actively issue new policies, the bank should Risk Management of BOLI | 3 understand how that may affect policyowner service and policy performance.

The 2020 economic crisis cause by the pandemic has not skipped over the insurance industry. Rating agencies such as S&P and Moody’s have placed the entire industry on “outlook negative” in early 2020 as the industry grapples with low interest rates and underwriting concerns over the coronavirus. It’s not unrealistic to expect that one or more of the carriers who have issued BOLI will be downgraded. A thorough review of a carrier’s ratings history over multiple years is a necessary first step

Ratings, however, are not the only source of information a bank should review. FIL 127-04 provides that a bank should “perform a credit analysis on [the] carrier in a manner consistent with safe and sound banking practices for commercial lending.” Like a bank does with its call report, an insurer must file quarterly and annual statutory financial statements with its home state insurance department. These statutory filings are commonly called “blue books” due to their covers, and contain detailed information about the insurer’s assets, liabilities, capital, and earnings. Most carriers provide their blue books free of charge, and a bank should review the blue books for the last two or three years. There are also subscriptions to 3rd parties who evaluate carrier financials over multiple years to identify trends and summarize their findings.

THE BOLI PRODUCT - GENERAL DESIGN

BOLI falls into one of three types of insurance: (a) general account (GA), (b) separate account (SA), or (c) hybrid separate account (HSA). The defining difference between these types is the level of risk the bank is taking in either the insurer, the assets that support the product, or both.

With GA BOLI, the cash values are part of the insurer’s general account assets. This means the bank has direct credit risk exposure to the insurer, but not to underlying assets themselves. If the insurer invests in a fixed income asset that declines in value or defaults, the bank is not directly impacted. Because the insurer is the risk, FIL 127-04 provides that GA BOLI is risk-weighted at 100%. If a bank has GA BOLI from a carrier with recent downgrades, especially multiple downgrades, it should strongly consider either an alternative carrier or an alternative product, discussed below.

A bank should understand how much of an insurer’s general account supports its GA BOLI, as that can have a large influence on crediting rates. For example, a carrier may look to its entire general account portfolio (for example, with a whole life chassis), or it may segment its general account (for example, with a universal life chassis).

With SA BOLI, the cash values are allocated to or among various portfolios that invest in bank-eligible securities. The portfolios are in an entity that is statutorily separate (hence, separate account) from the carrier, so that carrier’s credit risk is reduced (although not eliminated). However, the bank takes on the credit risk of the underlying investments. FIL 127-04 allows a bank to “look through” to the underlying assets when risk-weighting SA BOLI (subject to a floor of 20%).

To reduce mark-to-market volatility that can occur with exposure to holdings of such assets, most SA BOLI includes a Stable Value Wrapper (SVW). With a SVW, the bank pays the insurer or a third party an annual fee, and in return the SVW provider offers a sort of “shock absorber” to the bank. (The value of the SVW is risk-weighted at 100%.) However, the SVW has limits on how much market value fluctuation it can absorb, as many banks with SA BOLI discovered in the Great Recession and years following it. The result for some was write-downs to SA BOLI holdings; for others, rapid reduction in crediting rates as the portfolio was reallocated to money market investments. Due to the reduced appetite for banks to invest in SA BOLI, as well as the reduced interest from carriers and SVW providers to offer the product, there were few SA BOLI transactions from 2009-2019.

Nevertheless, a bank with or considering SA BOLI should insist on stress tests, showing a large, rapid change in underlying values (both increasing and decreasing). A bank should clearly understand how it might exit a SA BOLI design.

SA BOLI is typically sold through private placement and is a complex financial instrument (the private 4 | Risk Management of BOLI placement memorandum and supplements can be as long as 100 pages). It was initially designed for large money center banks, but was pushed down market in the early- to mid-2000s so that it was available to most community banks. FIL 127-04 provides that before purchasing SA BOLI, “management should thoroughly review and understand the instruments governing...[the policy].” Because of this heightened oversight, most community banks avoided separate account, often because they lacked internal resources. Instead, community banks who wanted some of the advantages of separate account opted for the hybrid separate account design.

With HSA BOLI, the cash values are allocated to or among various separate accounts, similar to SA BOLI. However, the insurer offers minimum guarantees and acts as the “backstop” for market value fluctuations. There is no need for a stable value wrapper/provider, and HSA BOLI is not offered through a private placement. Unlike with SA BOLI, however, a bank is not allowed to look-through to the underlying assets for risk-weighting and HSA BOLI is weighted the same as GA BOLI.

A bank with or considering HSA BOLI should clearly understand the investment philosophy of the separate accounts and understand how the insurer will respond if market value falls below book value. Moreover, a bank should clearly understand the limitations of re-allocating among the separate accounts.

THE BOLI PRODUCT – INTEREST CREDITING

Once a bank understands the risks and rewards of the three product types, it also needs to understand how the carrier determines the crediting rate. GA BOLI policies, and some HSA BOLI policies, generally use either the “new money” or “portfolio” method.

Under the new money method, the carrier sets the initial policy interest rate based on what it can earn on the BOLI premium when first invested. Renewal rates are generally based on then-current market rates. Under the portfolio method, the carrier sets the policy interest or dividend rate based on what it earns on the portfolio of assets it uses to support its BOLI.

It is important to recognize that both methods generally lag movements in market rates, whether the market increases or decreases. In the declining rate environment of the past decade, BOLI rates have declined slower than traditional bank investments. When we enter a rising rate environment, as many predict, one should expect BOLI rates to increase slower than those other investments (although GA and HSA BOLI do not have the mark-to-market risk of those other investments that is inherent in a rising rate environment). At any given time, one of the methods will generally project higher current yield than the other; however, over the long holding period for BOLI, differences in the timing of the two methodologies should generally be minimized.

Another crediting method for GA BOLI that has become available in the past year or two is an “indexed” method. Under the indexed method generally, the 12-month change in the S&P 500 is measured solely to determine the crediting rate – BOLI cash values remain general account assets and are never invested in the S&P itself. If the change is 0% or less, the crediting rate that month is 0%. This is the floor rate, usually before cost of insurance is deducted, and some carriers offer a floor higher than 0%. To offset the risk to the carrier of offering the guaranteed floor rate, there is a maximum or cap rate. For example, if the cap rate is 8%, then a change in the S&P 500 of 8% or more results in a crediting rate that month of 8%. While indexed BOLI has more variability in the monthly return, it offers greater upside potential in a low fixed crediting rate environment without mark-to-market risk.A bank should insist on detailed projections of BOLI yields, not only at issue but at each policy anniversary. This is imperative for inforce BOLI programs that support an executive benefit (such as a split-dollar arrangement or even a SERP) as even a small decrease in crediting rates can have a dramatic effect on the long-term benefits.

When reviewing projections, it is important to focus not just on the first year or even the first five years, but on the total expected return. Some carriers have designed policies that have lower early year expenses with higher later year expenses. The bank should also insist that those projections show not only the cumulative return, but the year-by-year return. This allows the bank to clearly see if a carrier is “front-Risk Management of BOLI | 5 running” the product at the expense of longer-term performance.

(SA BOLI generally uses the “yield-to-worst” method and HSA BOLI can use either the “portfolio” or “book yield” methods. Both yield-to-worst and book yield methods are formulaic, and the stress test recommended above should help the bank clearly understand how crediting rates will respond to market changes.)

MAKING CHANGES TO AN EXISTING PORTFOLIO

If a bank determines that the existing carrier or the existing product design is no longer desired, alternatives should be evaluated. Beyond holding the policy until maturity, the bank generally has two options: change the carrier/product or liquidate.

As a general rule, any changes to a carrier or to the underlying product will require the bank to re-establish insurable interest under state law. Therefore, the first step is knowing which insureds are still actively-employed by (or serve as directors of) the bank. The second step is knowing whether there are any restrictions from the carrier on the existing policies.

Under IRC Section 1035, a life insurance policy can be exchanged without causing the built-in gain to be recognized for income tax purposes. (Conceptually, this operates like IRC Section 1031 for property exchanges, something familiar to most bankers.) Once a bank has identified those policies on the active insureds, it must then determine whether an “internal” or an “external” exchange is warranted. (See the discussion below about IRC Section 101(j) for issues relating to exchanges on inactive insureds.)

An internal exchange is where the bank (with the consent of the insured) changes the underlying product but remains with the same insurer. (Not all carriers offer an internal exchange program, or one that is easily implemented.) Most of the time, this can be done without medical underwriting. The most frequent internal exchange is from a carrier’s GA BOLI to its HSA BOLI. This allows the bank to reduce—not eliminate—credit risk of the carrier.

If an internal exchange is not available or desirable, the bank should consider an external exchange. An external exchange is where the bank changes the insurer (again, with the consent of the insured). Before initiating any external exchange, the bank must consider whether the current BOLI has any restrictions, such as crawl outs, surrender charges in general or charges specific to an external exchange. The existence of those restrictions should not preclude an external exchange but do impact the economics of the transaction and must be considered into the overall evaluation.

For an external exchange, where there is one or a handful of policies, medical underwriting will be required; for larger groups it may be possible to implement on a guaranteed issue basis.

A bank should be mindful of the impact of internal or external exchanges to any existing benefit plans. For example, if a policy is part of a split-dollar arrangement that is grandfathered from the 2003 final split-dollar regulations, it is likely that exchanging (internal or external) is a “material modification” of the arrangement that results in loss of grandfathering. This could result in a change to the imputed income the split-dollar participant is required to report each year. On the flip side of that, policies issued after 2019 are required to use a new mortality table that generally results in higherdeath benefits initially, potentially providing greater benefits to certain split-dollar participants.

When a vendor proposes either internal or external exchanges to a bank’s current portfolio, a bank should understand how the vendor will be compensated. Generally, an external exchange results in significantly higher first-year commissions than an internal exchange (servicing commissions are often the same and may be even lower). While this should not deter a bank from pursuing an appropriate exchange, the bank should understand the motivations of the vendor’s recommendation. Attractive as they may be, a bank may not able to take advantage of the internal or external exchange options. Generally, that is due to one or both of the following: (a) lack of insurable interest on inactive insureds, or (b) inability to satisfy the requirements of IRC Section 101(j).

As noted above, a bank is generally required to re-establish insurable interest under state law in order to do an exchange. While a state may permit a bank to acquire a policy on a retired employee, most require consent (positive or negative). The longer a bank has held BOLI, or if it acquired its BOLI through acquisition, the more likely that bank’s insureds are no longer employed. Some states may allow a bank to rely on the initial consent an insured provided, however, that is the exception.

Even if a bank can re-establish (or maintain) insurable interest, it still must comply with IRC Section 101j, which applies to all employer-owned policies issued after August 17, 2006. Under 101(j), employers have certainty of the tax-free receipt of death benefits (and therefore the tax-free buildup of cash value) if the insured (i) was given proper notice, (ii) consented to the purchase, and (iii) was a director or among the top 35% of employees ranked by compensation. For policies issued prior to August 17, 2006, an exchange may result in the loss of grandfathering under IRC Section 101(j). While there is an exception in 101(j) that would appear to exclude 1035 exchanges from the notice, consent, and compensation tests, any policy that has a “material modification” to it as a result of the exchange is not eligible for the exception. Given that it is unsettled what constitutes a material modification, few carriers are willing to accept an exchange on an inactive insured and those that do require the employer – your bank – to indemnify the carrier against the tax risk of losing the exception.

If a bank cannot or does not want to maintain its current level of BOLI, it can liquidate the policies by surrendering them—at book value for GA BOLI and HSA BOLI—to the insurer for cash. Generally, the surrender proceeds will be sent to the bank within 10-30 days. However, because the BOLI is not held until maturity, it loses the tax benefits, and the entire gain is recognized as ordinary income. (In all likelihood, no accruals have been made for this potential tax liability, the primary reason that regulators consider banks “illiquid.”) While some banks may have sufficient tax-loss carry forwards to offset the reportable income, all banks are required to pay any Modified Endowment Contract (MEC) excise tax applied to the gain. Surrendering only some BOLI may result a bank’s tax advisor requiring a tax expense accrual on your remaining BOLI, therefore, it is critical to consult with your tax advisor before initiating any surrender.

A bank must also pay special attention to the anti-abuse rule in the tax code that applies to MECs (the “MEC aggregation rule”). Under that rule, all MECs issued by the same carrier in same calendar year to the same owner are treated as one policy. In effect, the policy level basis is ignored. An example is the best way to illustrate this:

Assume a bank purchases ten MEC policies from Carrier A in 2010, each with an initial premium of $100,000 (aggregate basis of $1,000,000). In 2020, each policy has a cash surrender value of $160,000, or aggregate cash surrender value of $1,600,000. Under the MEC aggregation rule, the bank is required to recognize as ordinary income the first $600,000 (the aggregate gain) that is surrendered, regardless of how many policies are surrendered, even though each policy has its own basis. In addition, the 10% MEC excise tax would apply to the amount of gain recognized.

The MEC aggregation rule has generally served to limit a bank’s ability to partially liquidate its BOLI by surrendering one or a few policies. However, a favorable Revenue Ruling from 2007 (Rev. Rul. 2007-38) allows a bank to separate policies that are exchanged from those that are not when applying the MEC aggregation rule. For a bank desiring to reduce its BOLI holdings, one strategy to consider is to exchange policies where insureds are active, wait the appropriate amount of time, then surrender those that were not exchanged.

Continuing the example above, assume six of the initial ten employees are still active. If the bank exchanged those six policies, it would retain four policies with $640,000 of aggregate cash surrender value and $400,000 of aggregate basis, for an aggregate gain of $240,000. By strategically exchanging policies, the bank could liquidate the remaining four policies and avoid recognizing $360,000 of ordinary income (keeping in mind the caution above about the potential tax expense accrual requirement).

SUMMARY

BOLI remains a strong, strategic asset-liability management tool for banks, especially given the current economic climate. In mid-2020, the yields over traditional bank investments are compelling, and if rates increase BOLI rates should reset higher (although with some lag), without mark-to-market risk that exists with traditional fixed income alternatives.

Carrier selection remains a key indicator of program success. Ratings are one component a bank should review, however, more important are statutory financials over multiple years to identify credit risk and select appropriately.

Product changes have given banks more options, but banks should take extra care to make sure those options are worthwhile or even desirable for their profile.

Every bank should understand the consequences of liquidating – in whole or in part – their BOLI holdings. Where appropriate, the bank should take steps to do so, but in a manner that provides the greatest flexibility.

While monthly recordkeeping and general policy service are important parts of a BOLI program, working with a vendor who can provide the bank with experienced face-to-face relationships may be critical to the successful operation of the program.

ABOUT THE AUTHOR

Scott Richardson has worked extensively with federal and state bank regulators over the years and the team at IZALE Financial Group has helped design and implement over 1,100 of nonqualified benefit plans and BOLI programs. He is a shareholder in community banks and serves as a board member of a community bank.Scott holds a law degree from William Mitchell College of Law, Saint Paul, Minnesota (now known as Mitchell Hamline). Scott received the Certified Life Underwriter (CLU) designation in 1993 and the Chartered Financial Consultant (ChFC) designation in 1994. Scott can be contacted via phone at 847-902-3401 or via email.

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A Better Bottom Line

7/28/2020

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by R. Scott Richardson, JD, CLU, ChFC, Founder & CEO IZALE Financial Group

It is jaw-dropping how much has changed in a quarter. The pandemic has a firm grip (and seems to be tightening it!), the US has experienced the sharpest GDP decline in history (relative to the time frame) and millions of Americans are suddenly unemployed. We have seen the S&P 500 plummet 34% from its February 19 high, only to climb back up 38.5% to end June at 3,100.29. (Notice how returns work - while the S&P is up 4.5% more than it declined, it was still below the market high; the S&P would need a total return of 51% from the low to get back to that high!)

In the midst of that, however, we are hearing how credit unions have stepped up to help, whether through helping the Federal government distribute some of the $3 trillion it has injected into the economy (and the ever-changing rules that came with that!) or by offering their own assistance to their members. And you had to do that while figuring out how best to work remotely yet serve members and keep your own employees safe. The work that has been done thus far is nothing short of amazing.

As credit unions know, there is a cost, however: we’re hearing from many clients who have revised their budgets for 2020 to reflect a substantial drop in net income. Several are even forecasting very lean earnings for 2021. All are looking for ways to enhance earnings, and there is also a focus on reducing expense.

One area that is often a target for tightening during these times is compensation and benefit expense. It does, after all, represent one of largest expense categories on the P&L. At a time when you have asked so much more from your team – and by most accounts they have delivered - we caution you to carefully consider those decisions and review some of the ways we’ve helped clients adjust their budgets while valuing their people.

Here are some of the ways that IZALE has helped clients this year:

Client A, a $1 billion FCU, has used BOLI for several years to offset the cost of all employee benefits. With deposits up, loan demand tempered, and traditional yields down significantly, they allocated additional money to BOLI and immediately (with no market risk) boosted earnings by over $140,000.
Client B, a multi-billion FCU, had an established 457(f) for several executives. We helped them evaluate the merits of continuing that plan vs. using a split-dollar loan structure, deciding the latter met their objectives. The client recaptured more than $5 million of prior expense while offering more net cash flow to executives.
Client C, a multi-billion state CU, needed a program for senior executives. They have a rational process for first quantifying how much of a benefit they want to offer. The board, with input from the CEO, evaluated 457(f), split-dollar loan, and Restricted Executive Bonus Arrangements (or REBA), and decided that a combination 457(f) + REBA most met their objectives.

While there is no one best way for every institution to value their people or improve earnings, we believe you should evaluate all options and choose the one (or ones) that check the most boxes for the institution and executives (not vendor). Our examples above describe ways we’ve assisted larger institutions, but we helped clients in all asset sizes implement programs appropriate for their budget. IZALE has never charged for evaluating plans, and we welcome the opportunity to share what we’ve learned from helping to design (or redesign) over 1,100 executive benefit plans over the past 20 years.

Original publication in the Defense Credit Union Council Alert Magazine July 2020

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by R. Scott Richardson, JD, CLU, ChFC, Founder & CEO IZALE Financial Group

IZALE Financial Group

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