CFO Focus: 4 Myths of Pre-Funded Benefits Portfolios

April 2018: Vol 41 No 4
Michael Oravetz
In all, this investment strategy may offer more flexibility than you think.

young woman warming up outdoors by stretching As employee benefit costs continue to rise, employers across the United States are searching for innovative ways to reduce this burden. Credit unions also are looking to thwart rising costs. While they are limited to investing in certain types of vehicles, Section 701.19 of the National Credit Union Administration rules and regulations provides relief, granting credit unions the ability to circumvent the scope of Section 703 on permissible investments. Thus, as long as they remain compliant with the regulations, credit unions can deploy investment strategies focusing on otherwise impermissible asset classes, such as corporate bonds and equities, to fund the benefits expense obligation. In this article, we aim to debunk some common misconceptions regarding Section 701.19’s “Benefits for employees of Federal credit unions.”

Institutions have long used insurance products as pre-funding investments. These investments come with their own set of due-diligence requirements, particularly as the structure increases in complexity. It’s important to remember that these products can be complicated and carry risks, so it’s vital to fully understand their nature and risks before purchasing. A securities portfolio is the other, potentially more straightforward, tool in the toolbox for credit unions looking to offset rising costs. Credit unions may use either tool, or both, to satisfy their pre-funding needs. 

Common misconceptions include:

  • Restrictions on pre-fund size: Although 25 percent of net worth is the commonly cited limit, the fact is a statutory pre-fund investment size limit does not exist. This misconception was likely borne out the interagency statement on the purchase and risk management of life insurance. In the statement, 25 percent of capital is discussed as a heightened scrutiny threshold, but not necessarily deemed unlawful. NCUA likely will use this limit as a proxy for balance-sheet materiality; in the end, the portfolio will be judged holistically. Institutions must meet safety and soundness standards regardless of the strategy undertaken.
  • Restrictions on pre-fund management: Each institution can, in fact, manage its own pre-funded benefits portfolio – marking a dichotomy between insurance products and a securities portfolio. When a credit union invests in an insurance policy to offset future benefits obligations, the underlying assets will be managed by the vendor or a designated asset manager. In comparison, pre-funding using a securities portfolio will allow the client to either manage its own assets, or work with an asset manager to have hands-on control of investment mandates. As a result, institutions can take a holistic approach to balance-sheet management when constructing the portfolio; that is, they can build and manage the portfolio with the balance sheet risk profile in mind.
  • Required exclusivity: There is actually no exclusivity when constructing portfolios; an institution may choose one portfolio, or any other number of portfolios, even in combination with an existing insurance investment. The institution’s risk appetite and interest-rate risk tolerance will drive the portfolio strategy, and does not have to pre-fund all future obligations. A credit union may choose to carve out pieces of the benefit obligation and invest in multiple strategies with varying returns, risk levels, or asset managers. 
  • No flexibility: Unlike traditional insurance products, these portfolios can be liquidated quickly, with very few barriers to exit. This allows the institution to maneuver resources toward or away from the securities portfolio as market conditions change, allowing for increased control over interest-rate and/or credit risk. 

According to S&P Global Market Intelligence, since the beginning of 2014, investments directly related to employee benefit costs have doubled within the credit union space, while securities investments have increased more than 300 percent over that time period, a testament to their value. While this type of investment is becoming more the standard than an exception, it is important for every institution to weigh the potential benefits of pre-funding future obligations. 

Michael Oravetz is a senior analyst with the ALM strategy group at ALM First Financial Advisors, LLC, Dallas. 

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