Risk Factors for Credit Unions to Consider When Designing a Split-Dollar Plan

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Risk Factors for Credit Unions to Consider When Designing a Split-Dollar Plan

When deciding which executive benefits to provide to your leadership team, your board may have landed on the benefits afforded by choosing a collateral assignment split-dollar plan. This benefit type is a legal agreement between the credit union and executive that incorporates retirement distributions with life insurance coverage. While split-dollar plans are relatively common, designing these plans varies by credit union based on multiple factors—some of which, if unexamined, could put the executive, credit union, or both at risk. On “C.U. on the Show,” Doug welcomes returning guest Matt Haid to discuss the importance of split-dollar plan design, funding vehicle options, and best practices that can help reduce risk and benefit both the credit union and executive. 

Matt is the area vice president of split-dollar and executive benefits within the benefits and H.R. consulting division at Gallagher. As a licensed life and health insurance agent, Matt has over 30 years of experience helping credit union leaders design, fund, and implement split-dollar life insurance, non-qualified benefit, and pension plans. 

Plan Design Elements to Consider

Matt discusses the various factors that could go into a split-dollar benefit and the significant decisions a credit union board have to make first, including: 

Each of these questions helps inform the further design of your plan, risks to consider, the probability of projections, and cost. Further, every credit union board has a different threshold for risk and expenses when adding new executive benefits

Based on data from Gallagher, the amount to provide is generally based on an executive’s position, the credit union’s size, and other factors. Additionally, when to provide the benefit could vary based on the executive’s age or be used as a way to help retain an executive to stay in their position longer. Still, you should consider various scenarios and other factors before implementing your plan.

Life Insurance Funding Vehicles

When choosing between an IUL or whole life plan, you must first consider how projections and premiums are calculated. A mutual company, not your credit union, decides if and how much dividends are paid within a whole life plan. IUL rates are based on the market that will likely provide reasonable, not necessarily high-yield returns over a more extended period. 

While we can’t predict the future payment of dividends, historically mutual companies have paid them, so these policies are considered less risky. This added protection, however, comes at a price. Matt explains how credit unions can expect to pay up to 30% more for a premium whole life plan based on risk level alone. Still, credit unions typically have the flexibility when working with a consultant to choose one or design a hybrid plan that incorporates features from both types of policies.

Other Plan Design Risks

Other plan design elements that could increase risk are underfunding a policy and tax liability. Matt provides valuable insight into how a credit union can evaluate these factors and protect their organization, executive, and the executive’s beneficiaries upon their passing. Stream the episode to learn more about:

  • How applicable federal rates (AFRs) can determine the speed at which you fund the benefits, whether lump payment or payment over seven to ten years
  • How credit unions can switch from a forgiven-interest loan to reduce their tax liability and recognize more income on their balance sheet 
  • Why it’s essential, and perhaps the greatest takeaway, that credit unions cover more than just the amount of their loan within the plan design to avoid underfunding a policy and facing recourse challenges later

Hear the episode to learn more best practices and strategies from Matt and Doug.

Matt Haid and Gallagher are not affiliated with or endorsed by ACT Advisors, LLC. 


Audio Transcription (pulled from the podcast)

Doug  (00:02)

My guest on today’s podcast is Matt Haid, area VP at Gallagher. Matt has over 30 years of experience working in executive benefits and is joining us again to discuss split-dollar plans. In today’s episode, we talk about plan design, including funding vehicles, taxation of premium loans, and the difference between recourse and non-recourse loans. Welcome back to the show, Matt. So let’s talk some more about executive comp and specifically split-dollar. So when you’re working with a credit union, and they have decided to investigate executive comp structures, what do you start with? How does the planning begin? 

Matt Haid  (00:31)

That’s a great question. So there’s a couple different plans that are out there. And we’re going to focus today on split-dollar plans. And once the decision is made that split-dollar fits the needs of both the credit union and the executive, there are a lot of important factors in designing that plan and funding that plan. Obviously, the very first thing to do is to decide how much benefit you want to provide to your executive or executives. There are many studies out there—Gallagher has their own study that we do among our clients and then even among credit unions that are not clients based on size based on current comp based on position—that will help guide credit unions into an appropriate benefit amount to provide for their executives. So that’s really the first step, how much do you want to provide? And then when do you want that to start? You know, Doug, if you have a 40-year-old executive, and you’re promising something at age 65, that’s a fairly long timeframe there. So there are ways, again, with a split-dollar plan, to start those a little bit earlier, or perhaps have what we call an interim payment in there, kind of like a bonus payment for staying for five years, 10 years. So all of those things are really the first steps and I think are crucial into the design of the plan, and how to fund that plan.

Doug  (01:57)

Matt, you mentioned your study, which I’ve always been very impressed with the scope of. Is it an annual survey that you guys do?

Matt Haid  (02:07)

It is an annual survey that we do.

Doug  (02:10)

Yeah, it provides a lot of data on salary and benefits. And so, you know, I’m used to seeing split-dollar plans somewhere in the 60 to 70%, target and final comp. 

Matt Haid  (02:56)

I would agree with you that 50 to 70% is typically the target. And just to further clarify that point, that’s of overall benefits that are being provided by the credit union. So it’s not necessarily coming just from the split-dollar plan. So if there’s a match on their savings plan, if there’s Social Security that’s being provided, if there’s other type of plans, so it all totals 70%. And what you see is a split-dollar plan making up any shortfall that isn’t already being provided. But that target, as you said, is typically between 50 and 70%.

Doug  (03:34)

So what’s important in the design of the plans with that outcome? What do you need to be thinking about? 

Matt Haid  (03:40)

So a lot of very, I think, important factors go into designing the plan. And I think the first one is what type of vehicle is going to be used to fund that plan. The most common vehicles are indexed universal life insurance and whole life insurance. Each of them has key features which help mitigate risk and maximize flexibility and efficiency. When we’re looking at whole life insurance policies, we are at the mercy of the mutual company as to what dividend rate is going to be provided in the future. We can’t choose what that rate is going to be. And so we are at their mercy. Whole life companies, mutual companies, have paid dividends for the last 85 years or so. But those dividend rates are coming down and there’s really nothing we can do to mitigate the risk of that rate coming down. The other type of product we’re looking at are indexed universal life products, which provide returns based on market rates of return. This is a different type of investment where we are targeting a very reasonable type of return over a very long period of time. If you have a 50-year-old executive you are providing the plan to, actuarial tables will tell you that executive is going to live to approximately 85, so you’re looking at a 35-year time period minimum, and so what we’re trying to do is target a rate of return that’s somewhere between 5 and 6%. And what we’ve seen with the indexed universal life products is that over time, because of that floor, and even with the cap, the market indices are going to provide you with that rate of return. They’re probably not going to provide you with a 10% rate of return, which you may want in other types of investments. But that’s not the goal here. The goal is to design the plan to give you enough return to provide the projected benefits.

Doug  (06:29)

So talk to me about several things. One is how does a board decide between one or the other? Or do you ever get really funky and make a combination of the two? I know there’s several questions there. But you can handle it, Matt.

Matt Haid  (06:42)

I think I can handle that. I love being tested like that, Doug. So how does the board decide? You know, I think it’s based on the amount of risk and then the amount of cost. Very generally, we’re all smart financial people here, the less the risk, the higher the cost, right? And so when you’re looking at whole life plans, they are less risk, because they typically are going to provide a dividend. I can’t say for certain in the future if they’re going to, but based on the fact that they’ve paid a dividend for the last 85 years, I’m pretty certain that they’re going to continue. But you’re going to pay for that protection. Typically, you’re going to see dollars necessary about 30% higher to provide that less risk. So the whole life companies are going to charge you about 30% more in terms of premium to provide the same level of death benefit to that executive. So they’re going to decide based on their comfort level with the level of risk they have. And different credit unions and different boards have different levels of risk.

Doug  (07:51)

So in the marketplace, do you have good data outside of Gallagher or just the whole credit union marketplace? How many of the split-dollar programs are whole life versus index? 

Matt Haid  (08:07)

That would be in our survey but it’s fairly balanced, you see, about 50/50. I think we’re going more toward the indexed universal life because it’s a newer product. So back 10–15 years ago, indexed universal life didn’t necessarily exist, or maybe one carrier had it. And so you saw a higher percentage of plans funded with whole life. But I think we’re trending to probably above 50% in the IUL. Well, you also did mention, do you get funky and use a combo? We absolutely see that. You know, boards are willing to take, say, 50% of the risk with a market-based plan. Another possibility is looking at a split and there’s no guideline as to what the split needs to be. It could be 50/50, it could be 70/30 IUL, it could be 70/30 whole life. So, we absolutely see that any good consultant should be able to provide that type of combination plan.

Doug  (09:18)

That’s interesting. And working with credit union executives all over the country, I have yet to run into someone having both structures. I see a lot of each of them, but I’ve not seen one person having both. So that’s interesting. It does exist. 

Matt Haid  (09:34)

It does exist. You don’t see a lot of that out there, but they absolutely do exist. And then we administer several of those plans.

Doug  (09:46)

So if you’re more risk averse, or maybe you also have additional deposits that you can reposition, whole life may be more attractive. I wonder what your thoughts are on the interest rate expectations, and how the interest rate expectations of the board might inform that decision. For example, as an investment firm, we think interest rates are going to modestly increase through the rest of this year through the rest of next year, a very low point in 10-year interest rates. So we would have an upward bias in anything we were positioning for interest rates. Now in this, we’re talking about something for 25 years or more. If you think interest rates are generally going to trend up, would that tend to lead you toward whole life over indexed? Or would that not be the key decision point? 

Matt Haid  (10:47)

Well, I think dividend rates typically lag interest rates. And so, it again depends on the timeframe you’re looking at. But I think in the long run, if you think just interest rates are going to go up, then you probably would lean toward dividends. If you think market rates are going to go up—S&P 500, Russell 2000, different types of market indices—then you’d probably lean more toward the IUL product. It’s important to understand that while the rate needs to be reasonable, the lower rate assumption, just because the dividend, for example, if we’re looking at a whole life product, and the dividend rate is currently 6%, that doesn’t mean we have to run our projections at 6%. If we want to take a more conservative approach, we can run the illustrations at 5%, build in some cushion there. Now that’s going to cost more, right? If we have a lower expected rate of return, you’re going to need more premium to get to the same endpoint; that’s simple compound interest assumptions there. But if a board is comfortable with that and they really want to take care of this executive and make sure that this executive gets the projected benefit—remember, split-dollar plans are not promised benefits, they are projected benefits—then maybe we will take a more conservative rate. And maybe if we feel that interest rates are going to go up, but they’re currently at 5.5% market rates, maybe we keep our assumptions at 5.5% right now and don’t use a higher rate, even though we expect it to go up because that’s just going to provide cushion and more probability that the projected benefit is going to be achieved. 

Doug  (12:36)

I’m used to the benefit for the executive coming into play at a target retirement age. At the age at which the credit union is trying to keep them until. 

Matt Haid  (12:50)

Exactly.

Doug  (12:50)

That’s the whole idea.

Matt Haid  (12:51)

That’s the whole idea. Exactly. Exactly. 

Doug  (12:55)

Talk to me about the funding side, and how the frequency of funding or how long the funding is versus short periods, a one lump sum versus payments over five years or payments over 10 years. How did the credit unions decide to fund these plans? And what are the best practices around the speed of funding? 

Matt Haid  (13:16)

So that’s a great question too. It would be great if we could take a one-time premium and just dump that into a life insurance policy. But that’s not how life insurance works, whether you’re talking about whole life or indexed universal life. So really there’s a couple of options, but the main two options are making a one-time loan. Typically, these plans and indexed universal life policy are going to be funded over seven years; a whole life policy is typically going to be funded over 10 years, most whole life policies require 10 years of premiums. But typically you are going to see 10 year- or seven-year funding. What we almost always suggest is if the credit union has enough cash and it will not affect their concentration—there’s a limit on how much they can have in these split-dollar plans as a function of their net worth—but if they have enough cash, we typically like to have them make a one-time loan and the reason why we do that, they make a one-time loan, some of the money is set aside say for the remaining six premiums. The first premium is paid and the rest of the money for the loan is set aside. The reason why we do that is so we can lock in the interest rate that is going to be charged on that loan. When a credit union does make a loan to an executive to provide a split-dollar plan, they’re forced to charge a minimum interest rate. That interest rate is the AFR or the applicable federal rate, which is published monthly. And the month you make that loan will determine what that AFR is. So If you make a one-time loan equal to seven of the premiums, now you’ve locked in that AFR and it can’t go up during the life of that policy. For the life of that split-dollar plan, that AFR is locked in. The nice thing about this is that if AFR rates go down, and the credit union is amenable, they can actually lower that rate and refinance the outstanding loan balance to that rate. By doing annual loans, meaning I’m only going to loan my participant one premium per year and do that for seven years or 10 years in our example, I’m subject to changes in the AFR. I have no way right now of predicting what that AFR is going to be a year from now, two years from now, five years from now. And so there is a little bit of extra risk taken there should the AFR go up next year and I need to make the annual loan. Now I’m loaning that at a higher rate.

Doug  (16:05)

That is a very interesting point. I see it from, again, when we’re building out a financial plan for a credit union executive, we’re projecting the next 20 or 30 years. And if the loan rate is not fixed, that means the tax impact to the executive is a variable number that I’m trying to incorporate into their financial plan. Can you talk to us about the tax liability that comes to the executive on the loan, how that can be fixed, how that can be variable, and the ability of the credit union to choose that? 

Matt Haid  (17:12)

When we make a one-time loan, interest is going to accrue on that loan at the fixed long-term AFR rate; that interest is not taxable to the executive if they are not forgiving that interest. The way that the plans are typically designed is that interest will continue to accrue, the credit union gets to recognize it as income on their balance sheet. But the executive, while they owe that interest, they are not taxed on that interest. That loan will continue to accrue interest at the AFR until such time as it’s repaid. And it’s not repaid until the death of the executive. And so all along even if the executive lives for 40 years, that loan is accruing interest, the credit union is recognizing that interest as income on their balance sheet. However, the executive is not paying any tax on that interest at any time.

Doug  (18:18)

So the tax liability I have seen some executives have to deal with is a result of plan design in working with the executive. How is it that some do have a tax liability?

Matt Haid  (18:33)

So that is what we would call a forgiven interest loan, as opposed to the one I described before, which is what we call loan regime split-dollar; it’s a general term in the industry. It may be Gallagher coined, or it may not, but that is a general term as opposed to a forgiven interest model, where that loan is actually accruing interest, but each year that interest is forgiven. If you make a million-dollar loan at 3%, if that’s what the AFR is at that time, then it’s going to accrue $30,000 worth of interest and the credit union can decide to forgive that interest. Now that’s not very beneficial to the credit union because they don’t get to recognize that income. But we do see that design every now and then. If the credit union decides to forgive that $30,000 worth of interest, that becomes taxable income to the executive, who will then have to pay tax at their personal rate on $30,000. It’s going to be reported on their W-2 as income of $30,000 that they will then owe tax upon.

Doug  (20:00)

So if you have the forgiven interest model, if you’re listening to this podcast and you have the forgiven interest model, which means there is this annual tax liability, and you’d like to do away with that, can you do away with it? Or is it permanent? 

Matt Haid  (20:15)

That is a fabulous question. You absolutely can do away with that. And that’s what we have been doing a lot of—taking over those plans that are on the forgiven interest model. At whatever time we take it over, whatever time an amendment is signed to switch to the loan regime, that loan balance is then determined. And then that loan balance now starts to accrue interest on it. But the executive no longer has to pay tax on that accrued interest. And the credit union starts to recognize that as interest income. 

Doug  (20:53)

I’ve seen that from the executive standpoint, and that’s a huge win for the executive. Because from my chair, I’m trying to project a tax liability for someone for the rest of their life based on an unknown tax rate and an unknown interest rate. So it’s a really difficult thing to deal with. Eliminating that is a huge win for the executive. From the credit union standpoint, is that a win for them as well? 

Matt Haid  (21:22)

In my opinion, yes it is. Because now they’ve made a loan that they’re accruing interest on and the others in the forgiven interest model, they’re not getting anything. They made a million-dollar loan and all they’re going to get back is a million dollars, as opposed to a million-dollar loan accruing at 2%. The AFR is actually a little bit lower than that right now. They’re accruing 0% interest, so from a credit union standpoint we feel it’s better for the credit union. It’s also based on assumptions, so I’m assuming the loan is going to accrue at 1.74% interest or 2% interest and I’m also assuming my policy is going to provide a 5 to 6% return, not guaranteed, but assuming that it’s going to provide a 5 to 6% rate of return. That’s arbitrage right there; you’re lending money at 2% but you’re getting money at 5 or 6% tax-free. And so there’s arbitrage there. So to me that makes the most sense. Everybody wins in that situation, as long as our assumptions hold true for the next 35 to 40 years. 

Doug (22:41)

Yeah, and you had mentioned cost earlier. And I was thinking to myself that if I understand the way the industry uses these tools, if you loan more money to the policy, the policy pays the credit union back when the executive passes away, plus interest, right? And that’s what they’re accruing along the way is this accrued interest on the loan, and they get that all eventually, assuming the executive passes away and the policy still exists. Is that right? 

Matt Haid  (23:16)

That’s correct. At the time of death of the executive, the credit union will, in fact, get their loan plus interest back. That’s a very important lead into really another piece of the design that I think is very important. And this is something we don’t always see from our competitors. When that death is assumed, okay, if I want to keep costs down, and I assume that executive is going to die at mortality age 82, 83, 84, depending on the health of that executive, I need to make sure the death benefit from that policy covers my loan plus interest through age 82, 83, 84, right? There has to be enough death benefit so when the executive dies, that death benefit, as you mentioned, goes to pay back that loan plus interest. If the executive lives past that, what happens is if there’s not enough death benefit to pay back that loan, then the credit union has two choices depending on the plan design. They can go after the executive’s beneficiary if it’s written into the design to make up for any shortfall the credit union didn’t get back based on the death benefit versus the loan plus interest. So that’s one thing; they can actually go after them. So if the loan balance has grown to 4 million, but there’s only three and a half million dollars of death benefit left in the policy depending on the design, we call that a recourse design. The credit union can go after the beneficiary to say you owe us $500,000. And we do see those types of designs out there. 

Doug  (25:12)

Wow. 

Matt Haid  (25:12)

Yup. The other thing that the credit union can do is just forgive that interest, not go after his beneficiaries. We would call that a non-recourse loan. So they can’t necessarily go after the executive for the shortfall. But the beneficiary in my example, where the loan balance was 4 million and the death benefit was three and a half million, that becomes forgiven interest again, there is that term again. So the beneficiary or the executive has $500,000 of forgiven interest, which will be taxable. So while they’re not going to have to pay $500,000 back to the credit union, they’re going to have to pay if they’re at a 40% tax rate $200,000 of forgiven interest to the government, which I know is not going to make very many people happy. So circling back to the plan design, designing a plan that only covers the loan balance to mortality age is, in my opinion, a bit risky. And I don’t think that’s a best practice. We always typically build in a little bit more cushion and make sure that they are based on our assumptions that the loan balance is going to be covered all the way through age 99. Do we think all of our executives are going to live to age 99? Certainly not, Doug. Certainly not. But what that does is it provides that extra cushion so that A) the executive can get that benefit that was originally projected, B) the credit union is always covered, to get their loan plus interest back, C) there’s no shortfall, so no recourse and no tax. And then D) something we haven’t talked about is when there are excess death benefits. So the executive has received their income stream, and now they’re at age 85. Because they started at age 65, they got 20 years of benefits, and that executive is still playing golf and having a great old time and lives for six more years. Fabulous, lives to age 91. Remember, our plans covered that loan plus interest to age 99. So at age 91, there’s still plenty of death benefit to cover that loan. In most cases, there’s excess death benefit above that loan balance. So let’s go back to that $4 million loan balance. Maybe there’s $5 million of death benefit in that policy. What happens to that million dollars, Doug? Well, there’s a couple different things there. One, what we typically see, the majority, is any excess is split 50/50 between the executive beneficiary and the credit union. So another benefit to the credit union, not only are they getting their loan plus interest, but they’re also potentially getting a piece of any excess death benefit. I want to be clear, that is not the only plan designed 50/50. Sometimes, some credit unions give all of the excess to the beneficiary, some credit unions keep all of the excess. And then we see everything in between, but typically 50/50, because that’s again, a benefit for both. It’s a benefit for the executives’ beneficiaries. It’s a benefit for the credit union by designing the plan out to cover through age 99. And again, assumptions coming through true that provide additional benefits to both parties. Very important in design.

Doug  (28:50)

It’s interesting. I have seen that. I have seen any additional when the policy ends up being better than projected. I’ve seen it where the credit union gets all of that. 

Matt Haid  (29:01)

True. 

Doug  (29:01)

And I’ve seen it more frequently, where the executive gets all of that. I’ve actually not seen a 50/50 one yet. 

Matt Haid ( 29:08)

Yeah, that’s funny. No, and they’re all out there. They are all out there. I again, I can’t give you percentages of what is out there. But they are all out there. But the key there, the key takeaway is that’s part of the plan design, and one is not necessarily better than the uncertainty—100% to the beneficiary is better for the beneficiary and 100% of the credit union’s better for the credit union, but one is not a best practice or a better design. But the key there, Doug, is to go back to when we are looking at that. So if we’re only covering to age 83, 84, then it doesn’t matter how the excess is split if there isn’t any access, and that’s the key there. I want that to be the takeaway. Yes, different design options, but the takeaway is to make sure that there is excess which can be split if desired. 

Doug  (29:13)

Yeah, what I’m hearing from you, Matt, is don’t risk underfunding the policy, because the problem for the credit union and the executive can be very large. 

Matt Haid  (30:09)

Absolutely. And I don’t know about you, I don’t want to be the one going to that executive’s beneficiary who just lost their spouse and say, oh, by the way, he or she had the split-dollar plan, and it came up short, and now you have a tax bill that you owe to the government. I don’t want to be the one to say that to them. Okay, I’d rather tell the credit union upfront, listen, it’s going to cost you a little bit more, but this is a best practice. And in the end, it’s going to protect both you and the beneficiaries or the executives from many consequences down the road. And that’s the key, very important.

Doug  (30:47)

Awesome, Matt, great ideas today. Thank you very much for your participation again on the podcast.


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