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Rebuilding Retirement Plans

November 2009 – Vol: 32 No. 11
by Karen Bankston

Rebuilding Retirement Plans
Boards consider options to deal with executive benefit shortfalls.

By Karen Bankston

Editor's note: The following first appeared in the December 2009 issue of Credit Union Management.

As the tantalizing but tentative first indications that the economy may be righting itself emerge, directors of credit unions that have weathered the downturn thus far in relatively good shape may be tempted to breathe a sigh of relief and turn their full attention to the future.

However, some CUs may still be confronted with financial fallout that requires rethinking conventional wisdom. Among these concerns is the performance of investments funding their executives' long-term compensation program, which may be especially troublesome if both the 401(k) and supplemental retirement plans have suffered significant losses. (Read more on CEO compensation trends on p. 26.)

 Even as the stock market seems to be posting more consistent gains, board members must make a realistic assessment of whether the funding mechanism for a supplemental executive retirement plan will not only get back up to speed but make up lost ground before the CEO is ready to retire.

 The annual review of the performance and operation of executive retirement plans has taken on special urgency at many CUs in recent months as boards assess the validity of the assumptions on which those plan designs are based. Joe Tripalin, ChFC, of OM Financial Group and a partner in CUES Executive Benefits, says directors must focus on two central questions: Is the investment ahead, behind or on schedule? If it's behind, is it reasonable to believe it can catch up, with some revisions?

Tripalin offers this example: A credit union puts together a SERP based on a market investment expected to produce an 8 percent annual return over 10 years. "Now you find that the investment is under water by 4 percent and you're already halfway through," he notes. "At this point, you need to consider whether it's realistic to assume that it can achieve 12 percent in the remaining years to make up that ground."

Taking Stock
The economic vagaries are keeping benefits consultants busy as CU boards scramble to assess their options to turn around poor-performing investments that fund executive retirement plans, says Andrew Sheeter, Sheeter Consulting, Orlando, Fla.       

"If it's a long-standing investment, the current value may still be higher than the original investment, but if you started a plan two years ago, it could be way underwater," Sheeter says. "The need to switch course on how a plan is designed can be a difficult pill to swallow, but in many cases it's not a difficult change."

With everyone on its executive team at least a decade from retirement, the board of $1.1 billion State Department Federal Credit Union, Alexandria, Va., is opting to ride out the downturn with the expectation that the currently less-than-stellar-performing components of its benefits plan will turn around in the coming months and years. 

Earlier this year, the board renewed its contract with CEO Jan Roche-a CUES member-for another five years, and "our intention is to continue the relationship until she chooses to retire," says Board Chair Marlene Schwartz. Thus, the long-term compensation program for Roche and four vice presidents has as its central goal the retention of executive talent.

The benefits plan is funded with "a pretty varied portfolio," Schwartz notes. "We're fairly conservative about things like that. We're not out to get rich quick, and we're not out for our executives to get rich quick."

The pension committee of the State Department FCU Board has been monitoring performance of the credit union's executive benefits program, 401(k) plan and pension funds. All three have components that have declined in recent months, she notes. "They're all secure investments, and they're not doing badly, just not as well as they have in the past. We believe we have time to recoup any lost ground, especially since all of our executive staff have 10 to 20 years before they're ready to retire, so we feel comfortable leaving the plan as is.

"We're in a position where we have the flexibility to weather temporary hits," Schwartz adds. "And we're big proponents of 'need over greed.' The executive team will have needs when they retire, but the credit union has no responsibility to make them rich."

If the CEO's retirement is still a decade or more down the road, waiting out the market for investments to turn around may be a good idea, Sheeter says, but the most recent economic downturn has been a wake-up call for credit unions to realize that the potential losses in using mutual funds as an investment vehicle may affect not only the CEO's benefits but organizational revenue as well.

"Wide fluctuations-to the good and bad-have to be reported on income statements, creating a yo-yo effect," he notes. "That's not what credit unions want. In the wake of the corporate bailout and poor performing loans, credit unions don't need any additional write-downs."

Moving Toward Safer Waters
Over the past several years, many organizations have moved from a defined benefit to a defined contribution retirement program, which relieves the employer of the requirement to come up with the money to fund stated benefits, whatever the state of the economy and the investment underlying the retirement plan. That move may shift the risk of underperforming plans to the executives covered by those plans, but it doesn't relieve the credit union of its commitment to adequately compensate those same executives for their leadership in steering the credit union through rocky economic times that are beginning to feel more like the rule than the exception.

"What both the executive and the board want is to be able to know, when they do all the right things in putting this program together, that they have a high likelihood that it will perform as they expect it to," Tripalin says. "They don't want to have to turn around and fix it down the road or just say 'Sorry' to the CEO if it doesn't perform up to expectations."

In the past, many boards tied informal plan funding to market-driven investments, but the losses those funds have suffered in recent years have called into question the likelihood that stocks will return at or above historical averages any time soon. "Most credit unions now look to products that address the principles of safety and soundness," says Christine Burns-Fazzi, principal of Burns-Fazzi, Brock, a CUES Supplier member based in Charlotte, N.C.

Finding a surer way to weather those economic ups and downs is behind another trend in retirement planning-away from market-based investments and toward insurance-based funding with a more reliable return. "Based on what happened in the stock market in 2001-2002 and again in 2007-2008, those equities haven't returned anything," Tripalin says. "As a result, providers have gravitated to more insurance-based funding. The dividends from good insurance companies-very solid AAA rated companies with a long and strong history of paying dividends-are more secure and predictable than other options."     

Sheeter is a proponent of executive benefit plans funded with business-owned life insurance. The current first-year yield on those plans is 5 percent on average. Given that the money that goes into those plans is typically from Fed funds currently earning about 16 basis points, the difference is a big positive for credit unions, he says.

The economy has not been kind to any business sector, but Sheeter notes that, even though the insurance industry hasn't been unscathed, there have been no insurance company failures. "We use mutual insurance companies, which are conservatively run and positioned and have held up well," he notes.

Effecting a Fix
Getting the funding mechanism right the first time is certainly a worthy goal, Tripalin says. A fix can be quite complex. If they use market- or equity-based funding, for example, credit unions may face penalty or surrender charges if they sell early. Boards may need to consider whether to stick with those investments or even increase the funding with the aim of improving performance. Another option is to supplement the first plan with a new funding vehicle. Either way, the board may need to draw up a new agreement with the CEO.

"Any of those solutions requires a lot of board discussion and soul searching to figure out the right thing to do. The central question is always, 'Are we using member assets appropriately?'" he notes. "Get it right the first time is the mantra. That way, the executive's happy, the board's happy, and future boards are happy because they won't have to try to back up and do something else."

For boards that are confronted with an underperforming plan-"and there are hundreds of them out there"-Tripalin recommends that they consider several key questions:      

1. Is it realistic to count on the investment bouncing back? For example, can a plan based on the assumption of a 7 percent annual return that has earned essentially nothing to date with eight years to go turn around to produce a 9.5 percent return? "My answer to most boards is, 'That's unlikely,'" he says. "Investment markets are going to be muted, and returns over the next few years will likely be lower than historic market returns."

2. Are we willing to put more money into this plan? If its performance is flat now after four or five years, will more money kick-start performance? Again, Tripalin counsels a realistic assessment of this question.

3. Should we abandon this plan, and if we decide to do so, what will it cost? Starting over may sound appealing, but CUs need to total up possible penalty and surrender charges and compare them to the option of waiting until penalty periods have expired.

4. What are our options for developing a new plan, either in place of or in addition to the existing SERP?

First Source Federal Credit Union, New Hartford, N.Y., is one of those organizations changing course with its benefits plan. With its CEO, CUES member Michael Parsons, planning to retire in 15 years at age 65, the $225 million credit union had developed a long-term compensation program covering both retirement benefits and a retention incentive with payouts along the way. When the first incentive payout came due this year, there was a shortfall in the return on investments, says Board Chair Jim Torrance.

"The plan we put in place about five years ago didn't have enough time to recoup what we had intended and the credit union to still get back its original investment," Torrance says. "It was a two-tiered investment, with a variable and fixed-rate annuity, and the variable annuity lost ground."

The First Source FCU Board met with several investment specialists to discuss its options for getting back on track. The board decided to cash in its previous plan, which it could do without penalty, and develop a new investment program and vehicle with Burns-Fazzi Brock. "It's an annuity with a guaranteed rate, so we feel we'll be where we need to be," he explains.

"This is a long-term solution with a secure investment that will both guarantee the credit union being made whole on its investment and an adequate return to cover both the retirement benefits and incentives along the way for our CEO."

In choosing an insurance-based product to fund a benefits plan, Burns-Fazzi recommends that credit unions assess the creditworthiness of the carrier, product structure, market risk, guarantees and liquidity of the funding mechanism.

And this level of due diligence must be an ongoing commitment with at least annual reviews of plan performance, she adds.

"The review should cover the current performance of the plan, how it compares to what their peers are doing, and how the current economy is affecting the informal funding." Informal funding refers to tax law requirements that SERPs are "unfunded promises to pay," which means that the CEO has no rights to any specific asset intended to fund the retirement benefits.

Starting From Scratch
As challenging as these new economic realities have been for credit unions with a SERP in place for their CEO, SERP-less credit unions face a different sort of dilemma-that of when to act. From the first signs of the mortgage market meltdown, to the burgeoning financial crisis, to the recapitalization of corporate credit unions, some boards have put off plans to develop a long-term executive compensation program year after year.

"I've seen this with a number of credit unions where the boards were considering something in 2007, and then in 2008, and here we are toward the end of 2009, and they still haven't done anything," Tripalin says. "Some boards have said, 'We need to understand the impact of recapitalizing the corporates,' or 'We need to get a handle on our paid-in capital.' They are dealing with big numbers, and obviously credit unions don't have an endless supply of money. But now they have most of the information they need to assess the impact of those issues, and their CEO is not getting any younger. The longer they wait, the more expensive it can be to put a plan in place."

Whatever the economic conditions, credit unions are committed to achieving long-term strategic goals such as succession planning, growth and development and/or retention of key talent, Burns-Fazzi notes. A well-designed benefits plan is central to those goals, but more than ever before, boards must consider the risks of the informal funding for those plans and develop a solid understanding of how they work.

"When considering implementing a plan, the board needs to determine the goal of the plan-retention, succession or development-and consider the safety and soundness of the informal funding instrument," she advises. "And they need to understand the effect to the bottom line."

Finding More Time
Of course, one other option many CEOs may be considering is delaying retirement until their retirement funding from the combination of 401(k), pension and supplemental plans can bounce back to acceptable levels. Tripalin relates the story of a credit union that developed a plan for a CEO who planned to leave at age 55. She celebrated her birthday recently-but not her retirement. The credit union recouped its full investment, but the plan funded only $15,000 for the executive, who is now working with the credit union's board to develop a new program for her next targeted retirement date.

"I think we're going to see a lot of CEOs who had planned to retire at 60 or 62 who will be working at age 65 or longer," he adds.

However, Tripalin warns that pushing back the payout date on some SERPs requires careful planning and additional reporting to comply with the new 409A rules implemented earlier in the decade.

"If you're a year away from the SERP benefit vesting date, it may not be easy to push back that date," he cautions. For example, if the SERP specifies a payout in 2010, but the executive doesn't declare those funds as income until 2013, the discovery of that discrepancy by the IRS could result in significant tax penalties.

Those timing concerns are yet another reason for regular monitoring of plan performance, Tripalin adds. "If you set up a 10-year plan eight years ago, you might get lulled into thinking that the plan must be on track. If that's not the case, any changes you need to make must be done in the context of these rules."

Karen Bankston is a long-time contributor to Credit Union Management and writes about credit unions, membership growth, marketing, operations and technology. She is the proprietor of Precision Prose, based in Stoughton, Wis.



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