Since the early 1980s, bank-owned life insurance or BOLI has been the go-to strategy for banks to offset the cost of executive and employee benefits. At the end of 2020, more than 3,200 banks reported owning $184.3 billion -more than 10% of bank capital – in cash surrender value. In Illinois, 234 banks owned $6.9 billion. Over $3 billion was purchased in the 4th quarter of 2020 alone. What makes BOLI work so well?

BOLI is an institutional life insurance policy insuring bank officers (and sometimes directors). Unlike the typical life insurance policy we buy as individuals, BOLI is engineered to provide the least amount of death benefit gain and maximum amount of growth in cash surrender value (CSV). The growth in CSV is recorded monthly as “other non-interest income,” and is accrued without any provision for taxes. When held to “maturity” – in other words, the death of the insured – BOLI offers tax-equivalent yields nearing 4%. With increasing chatter from Washington, DC about raising the Federal corporate tax rate, equivalent yield will be even higher if that happens.

While BOLI can be surrendered to the insurer at any time for its cash surrender value, doing so triggers recognition of the previously accrued earnings as ordinary income. In most cases, there is also a 10% Modified Endowment Contract or MEC excise tax on the gain over the initial purchase. BOLI works best if the bank holds the policy until maturity, when all proceeds should be income-tax free. This makes it a long-term, illiquid asset.

Despite the long-term holding period, the crediting rate on BOLI can adjust at least annually. The crediting rate history shows BOLI moves in the general direction of broader interest rates, albeit more slowly and with a lag. Unlike directly-held fixed income investments, however, general account BOLI has no mark-to-market risk – something to consider as interest rates begin to rise.

If the current fixed-rate BOLI is not appealing enough, you should consider whether “indexed BOLI” is right for you. With Indexed BOLI, the crediting rate is not merely declared by the insurer – it measures the change to an external index like the S&P 500™, but with a minimum and a maximum crediting rate. It’s critical to note that the CSV is never exposed to the S&P500™ - CSV is still fully backed by the insurer at all times.

Recent changes to the tax code make BOLI more attractive. Buried in the 5,000-page appropriations bill that was signed by former President Trump in late December 2020 was a small but significant change to IRC Sections 7702 and 7702A. These code sections define life insurance and MECs, basically as a ratio of death benefit to cash surrender value.

It will take a few months for insurers to revise their product portfolios to capture this change, however, BOLI carriers have already taken action. Simply put, for policies issued after January 1, 2021, the death benefit required for a given BOLI purchase is 35%-55% lower than under the old code language. This means lower cost of insurance charges to drag down yield on CSV, as well as the ability to structure a purchase with significantly lower reputation risk.

While nearly all BOLI has been a single-premium policy, these code changes could result in more competitive annual pay products becoming available to banks. This could eliminate the MEC excise penalty and provide for more liquidity.

Regulators have long-required banks to follow interagency guidance on purchasing and monitoring BOLI. This includes a thorough pre-purchase analysis as well as an annual risk assessment. It includes vendor due diligence, which is why it’s important to partner with a provider that can provide technical and compliance support, such as CBSC’s Endorsed Partner IZALE Financial Group.

The interagency guidance also requires a bank to quantify the ability to buy BOLI by measuring the cost of employee benefits. And this is where some confusion comes into play. Often BOLI is co-presented with an executive or director benefit and it’s viewed as one and the same. Offering a benefit and buying BOLI are two distinct decisions that can certainly work together but are nonetheless distinct. Even if your bank does not purchase BOLI, it may still be prudent to offer supplemental benefits to key people.

One of the first steps to evaluating whether supplement executive benefits are appropriate is to do a Retirement Income Analysis or RIA. The RIA takes a snapshot of current benefits (401k, profit sharing, pension, social security, etc.) and projects them to retirement age, and calculates the percentage of final income that could be replaced by current benefits. The projected replacement ratio can then be compared to a targeted replacement ratio, thereby offering a rational and defensible starting point for quantifying a benefit amount.

Once your bank has targeted a benefit amount, it should then compare the three common approaches to delivering a benefit:

1. Supplemental executive retirement plan or SERP. This is a mere promise by the bank to pay a benefit at a future date. Accounting rules require the bank incur current annual expenses that build a liability for the expected benefit on the balance sheet. No specific asset is required; the bank will generally make payments from cash on hand. The bank receives a tax deduction when benefits are paid, and the executive recognizes the benefit as ordinary income as received. Early vesting provides an opportunity to recognize the benefit for FICA purposes, perhaps eliminating the self-employment tax exposure in retirement.
2. Restricted executive bonus agreement or REBA. This uses a life insurance policy owned by the executive (this is not BOLI!). Premiums are designed to accrue enough cash value on a tax-deferred basis so that at the designated date or age the executive can structure income-tax-free distributions to supplement income. The premiums are current tax-deductible expenses to the bank and reported as current ordinary income by the executive, and there is generally no accrual for any post-retirement obligation. Compared to a SERP, a REBA can offer savings to the bank of 20%-30% while providing the executive with greater benefit security.
3. Split-dollar loan arrangement or SDL. Like the REBA, SDL uses a life insurance policy owned by the executive. Instead of treating the premiums as current expense to the bank and income to the executive, they are expected to be repaid in full by the policy cash value or death benefits and are therefore treated for income-tax purposes as a loan. Federal Reserve guidance permits this without Reg O treatment, provided certain conditions exist. (Note: because of the Sarbanes-Oxley Act, SDL is generally unavailable to SEC-filers.)

Each benefit type offers its own advantages. For example, REBA and SDL may not be viable if there are underwriting concerns for the executive. The SERP provides the bank with greater control as the tradeoff to absorbing the largest expense of the three. After careful consideration and modeling the bank should choose the one or ones – yes, you can do different things for different executives – that best matches the bank’s objectives.

BOLI is a compelling tool that a bank can use to improve earnings. Whether you already own BOLI or it’s been a while since you’ve considered it, market forces present strong reasons for a fresh look. Supplemental benefit plans for key people are also tools that help you attract, retain, and reward the key people driving shareholder value. Even if you’ve had a SERP for years, it should be reviewed and other structures considered that might be more powerful for both the bank and the executive/director.

IZALE’s founder and CEO, Scott Richardson, helped develop the interagency guidance for BOLI, and the IZALE team has designed and implemented over 1,100 benefit plans. Drawing on his service as a director of an Illinois community bank, Richardson stresses the importance of a consultative approach that provides rational and defensible analyses that lead to customary and reasonable solutions.

To receive a complimentary Retirement Income Analysis, to get a second opinion on your inforce BOLI or to see how additional BOLI can help your bank, or to learn more about the differing ways to structure executive benefits, contact IZALE Financial Group today.

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.

John is “retired” now, forced into by the age of 50 due to Multiple Sclerosis or MS. His disability progressed quickly before stabilizing, but it took away his ability to operate DaVinci. His gait changed and he became less stable. Not only could he not work, his fishing is far less frequent than it used to be.

As tragic as John’s situation is, it could have been far worse. John worked for an employer who valued its people enough to offer a strong group long-term disability or LTD plan. Since John met the requirements for benefits (and there’s no current cure for MS to allow him to recover), 60% of his salary is replaced until he’s eligible for full Social Security benefits.

Like all group LTD, however, there’s a maximum benefit that is far below John’s pre-disability earnings. John had a good neighbor and friend, however, who showed him the value of insuring the risk that his employer didn’t. The individual policy that John bought “covers the gap” and nearly 70% of all of John’s pre-disability earnings have been replaced.

Consult with a professional advisor about your particular situation.

Are insurance benefits provided to board members considered taxable income? The answer is largely “yes,” but also, “it depends.”

“The general rule under the tax code is something provided in return for services rendered is taxable income to the recipient (board member),” says R. Scott Richardson, JD, CLU, ChFC, president/CEO, IZALE Financial Group, a CUES Supplier member in Elgin, Illinois. “However, insurance benefits can be treated differently.”

Richardson explains that while the value of accident and health insurance is not taxable for employees, it will likely be taxable for board members. 

“There are narrow exceptions where it would not be taxable income,” so consulting a tax advisor is worthwhile, he says.

In the case of life insurance, rather than take out a formal policy, credit unions can promise to pay a benefit (out of pocket) upon a board member’s death, in which case the beneficiaries would report the amount as ordinary income. The CU is essentially acting as its own insurance.

However, in the event of a policy paid for by the CU, Richardson reports there is a choice: “Either the board member reports the ‘economic benefit’ of the coverage as income each year, resulting in an income-tax-free benefit, or the board member does not report economic benefit, resulting in a benefit subject to ordinary income taxes.”

Life insurance is generally income-tax free except when someone else pays for it, in which case there’s some “economic benefit” to the board member, he explains. If the board member owns the policy but premiums are paid by the CU, the premiums paid by the CU equal the economic benefit and are taxable income. If the CU owns the policy and allows the board member to designate a beneficiary, then the right to designate the beneficiary is the economic benefit. If the board member reports the value of that economic benefit each year as taxable income, then death proceeds received would be income-tax free. If the board member does not report the value of the economic benefit each year, then death proceeds would be subject to ordinary income tax.
With long-term care insurance, Richardson notes that any benefits received under a qualified policy are not taxable, though the premiums likely would be. “Since board members are not employees, they would be treated as ‘self-employed’ for income-tax purposes.”

Jim Patterson, partner with Minneapolis-based law firm Sherman & Patterson, similarly notes that directors are under different tax rules than employees. “… directors are not subject to some of the tax benefits that employees get,” he said. “In the case of long-term care insurance, for instance, if that were provided to an executive employee of the credit union, it can be done so on a tax-free basis. But for directors, who are not employees, that would be considered taxable income.”

Even if these benefits are taxable, Richardson says there are still advantages for both the board member and the credit union. “First, paying taxes on $1 of reportable income requires much less cash flow than paying the $1 of premium out of pocket. Second, there are pricing discounts and underwriting concessions available to groups that can be the difference between being affordable and attainable versus not.”

Richardson concludes with advice to consult with tax professionals “to understand the full implications.”

Diane Franklin is a freelance writer based in Missouri. This article published with expressed permission from CUES