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On Time for Retirement

December 2012 – Vol: 35 No. 12
by Glenn Harrison

Split-dollar life insurance helps CUs provide solid supplemental executive retirement plans

alarm clockCredit unions with at least $100 million in assets are more likely to include split-dollar life insurance in their CEO’s supplemental retirement plan now than they did one or two years ago, according to the Credit Union National Association’s 2011-12 CEO Total Compensation Survey. Still, only 16 percent of the credit unions surveyed offered this benefit.

Split-dollar life insurance hasn’t reached the penetration of the 457(b) and 457(f) tax-deferred retirement accounts, which were offered by 45 percent and 31 percent of the survey respondents, respectively. These percentages are flat or down from the previous two years, however.

A split-dollar program offers stability and tax advantages that can perfectly complement—or replace in some cases—457(b) and 457(f) investment fund accounts, says CUNA Mutual Group’s Jane Chesbro, VP/specialty distribution strategy and operations. “I think the percentage of executive compensation packages that include split-dollar life insurance will continue to increase as credit union boards learn more about these products,” she says.

A split-dollar life insurance agreement is a contractual arrangement between employer and employee to share the premium obligations and the coverage benefits of a life insurance policy. While there is no formal restriction on the type of policy that can be paid with a split-dollar arrangement, most agreements focus on the purchase of a permanent life insurance policy. Permanent life insurance accrues equity in the form of cash value, a policy feature that is often an important focal point. (See accompanying article, “Split-Dollar Life Insurance Basics.”)

Chesbro believes the turbulent economy’s effect on executive retirement account balances has pushed the industry further along the learning curve for split-dollar arrangements. “Credit union boards and executives are looking for more predictable benefits that balance the risk of investments,” she says. “Split-dollar life insurance can do this, but the terminology for it can be confusing at first. It’s important to know what split-dollar life insurance is, and what it is not.” (See accompanying article, “What Split-Dollar Life Insurance Is Not.”)

Part of a Larger Package

As the economy continues its slow recovery and hard-hit banks return to profitability, the competition for top executive talent could become even stiffer, Chesbro says. “The leaders who guided credit unions relatively safely through the financial crisis are probably very attractive to banks that need to stabilize their bottom lines right now,” she says. “If credit unions want to keep their talent at home, or find the best talent from outside, they need to have competitive retirement packages.”

What Split-Dollar Life Insurance is Not

1. A specific type of life insurance policy. The term “split-dollar” refers to an arrangement between an employer and employee to split the premiums, ownership rights, death benefits—or a combination of these three elements—usually for a permanent (or “whole”) life insurance policy on the employee.

2. Corporate- or business-owned life insurance. COLI/BOLI are generally life insurance policies purchased by a company on one or more key employees. The company is named as the beneficiary of the death benefit, and it can use that, or the policy’s cash value, to fund certain employee benefits. These policies can also be used for “key person” life insurance, which offsets the loss of a key employee.

Retirement packages are especially critical for recruiting and retention. While the salaries of credit union CEOs compared to their bank counterparts have improved overall, boards still need to keep in mind that they want to retain their CEOs in a competitive talent market. Additionally credit unions are not allowed to use some compensation strategies, such as stock options, that banks can use to retain their top leaders.

Besides this age-old issue, credit unions need to address the gap between what executives earn in their peak years and what their standard retirement benefits can generate in retirement income.

It’s a matter of lifestyle. A useful rule of thumb is that maintaining your lifestyle after retirement requires an annual income of 60 percent to 80 percent of your final-year salary. Income from a pension and/or a 401(k) plan plus Social Security can replace 60 percent to 80 percent of the final salary for many workers. Not so for a highly paid credit union executive.

The Employee Retirement Income Security Act and other regulations limit the amount that credit unions can contribute to a pension or 401(k) plan. That, and the cap on Social Security income, means that these retirement benefits replace a much smaller proportion of a highly paid worker’s income than a more modestly paid worker.

To help executives close this gap, credit unions may provide additional retirement benefits that comply with ERISA and other regulations.

Supplemental executive retirement plans are one way for credit unions to accomplish this. And Chesbro says split-dollar life insurance is beginning to play a larger role in SERPs, not simply to add a life insurance component, but to provide additional retirement income. CEOs aren’t the only executives getting these policies, she adds.

“It’s a great way to keep a successful senior executive team together long-term. Also, for younger executives, it’s a better value because the premiums are generally lower,” Chesbro says. “They may be able to withdraw some cash value before they retire, for things like a down payment on a house or college for their kids.”

The Three-Way Safety Net

Scott Albraccio manages CUNA Mutual Group’s executive benefits sales specialists. Throughout these recessionary times, Albraccio and his team have worked with credit union boards and executives to reconfigure SERPs that weren’t performing up to original earnings projections.

“As we were doing annual reviews of executive benefits programs, we were seeing even very conservative investment accounts underperforming—as you’d expect under these extraordinary circumstances—and in many cases, we were able to help shore up retirement income projections with split-dollar life insurance,” Albraccio says.

The cash value generated by permanent life insurance depends on the dividends paid by the insurer, which can vary according to the performance of underlying instruments, such as bonds. Albraccio recommends carefully choosing conservative insurers with established histories of outperforming minimum guaranteed dividends. When this is true, life insurance provides a stable, reasonably predictable cash value.

Albraccio calls split-dollar life insurance a three-way safety net:

  1. Cash value is a safety net for the executive’s retirement income. If the cash value is high enough, executives may be able to borrow from the cash value without triggering income taxes.
  2. A death benefit protects the executive’s family in the short term, and the estate in the long-term, by providing lump sum payment that’s tax free as long as the program is properly structured.
  3. The credit union will be reimbursed for the premium payments by the policy’s death benefit or by its cash value.

Split-Dollar Tax Advantages

In creating a SERP, non-profit cooperatives are allowed to augment retirement benefits of highly paid employees through certain “non-qualified” deferred compensation accounts that comply with tax codes, including 457(b) and 457(f) plans. (“Non-qualified” refers to a plan that can be offered to individuals without being made available to a complete employee class. These programs are also called “executive carve-out benefits.”)

In general, a 457(b) account allows executives to defer compensation much like a 401(k). As with a 401(k), there is a limit on how much can be deferred into a 457(b) plan ($17,000 in 2012). An executive can contribute to both types of plans simultaneously.

A 457(f) account doesn’t cap the amount a credit union can contribute. However, regulations require that a 457(f) include a “substantial risk of forfeiture.” For example, if an executive leaves before a stated date or event, the executive forfeits the benefit. Thus, a 457(f) is sometimes called “golden handcuffs.”

The credit union owns these accounts, not the executives. When the executives become eligible to receive the funds, they’re disbursed in a lump sum and taxed as regular income.

As with a 457(f), a split-dollar agreement doesn’t limit how much a credit union may contribute toward it. But unlike a 457(f), split-dollar agreements don’t have to include a risk of forfeiture, are not subject to lump-sum taxation, and don’t require mandatory distribution at a given age.

Also, the death benefit payout is generally income-tax-free to beneficiaries, and if the agreement is structured correctly, the payout may also be free of inheritance tax.

Albraccio says many credit unions combine 457(b) and/or 457(f) accounts with split-dollar arrangements to make sure executives have the income and flexibility they’ll need in retirement.

He stresses that a properly executed split-dollar agreement is necessary to avoid taxation, and to ensure the loan of premium dollars is sufficiently collateralized. “It’s critical that credit unions work with an attorney to represent their interest, someone who has experience with these contracts and regulations,” Albraccio says. “And you need a partner that understands this insurance market and is willing to regularly review the SERP’s progress and make adjustments when necessary.”

Glenn Harrison is a freelance writer based in Stoughton, Wis. He wrote this article on behalf of CUNA Mutual Group, Madison Wis., a CUES Supplier member and CUES strategic partner.

Split-Dollar LifeInsurance Basics

1. Life insurance payout is used as collateral. The term “split-dollar” refers to an arrangement between an employer and employee to split the premium, ownership rights, and/or death benefits for a permanent (or “whole”) life insurance policy on the employee. This is not group life insurance, so the employee must meet the insurer’s underwriting standards.

In a typical arrangement for credit union executives, the credit union and the executive split the death benefit and the cash value. The credit union pays the full cost of the life insurance premium in the form of a loan to the executive, and the executive owns the policy.

In return, the executive assigns a portion of the policy’s death benefit back to the credit union to repay the loan.

This is called a “collateral assignment” (or a “split-dollar loan regime”) because the executive is using the policy’s death benefit and cash value as collateral for the loaned premium dollars.

The death benefit should be high enough to repay the credit union when the executive dies, plus deliver a substantial amount to the executive’s personal beneficiaries. The agreement can be structured so that, when the executive retires, a second benefit kicks in that provides the executive with the funds to repay the credit union for the life insurance premiums. In that case, the split-dollar agreement ends when the executive retires, and the full death benefit will be paid to the executive’s heirs.

The premium payments can also be calculated to generate enough projected cash value for executives to use in supplementing their retirement income.

2. A contract secures a split-dollar agreement. Many other split-dollar arrangements are possible, depending on what the credit union and the executive want to accomplish. However the split-dollar program is structured, it must be spelled out in a contract that details the responsibilities of both parties.

In some credit unions, these contracts stipulate exactly when the executive is eligible to withdraw from the policy’s cash value. It may also establish that if the employee leaves the credit union voluntarily before a set number of years, he or she is responsible for repaying the credit union’s loan of premium dollars.

3. Bonuses can pay for additional income tax. The amount the credit union lends the executive to make premium payments isn’t taxed as income. However, because the credit union isn’t charging interest, the Internal Revenue Service does consider the amount the executive would have paid for interest at market rates to be taxable income.

Example: Credit Union ABC loans Executive X $40,000 in 2012 to pay the life insurance premium under a split-dollar arrangement. The IRS determines that the market rate for this type of loan is 5 percent. So Executive X will owe income taxes on $2,000 of income. The 5 percent is considered “imputed interest.”

Many split-dollar agreements require the credit union to pay the executive an annual bonus to defray the income tax on the loan’s imputed interest.

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