Split-Dollar Versus 457(f) Plans and What Credit Unions Should Evaluate
When building an executive benefits package that seeks to recruit and retain top talent, the question arises: with multiple options, which benefits should we include? Popular choices that uniquely benefit credit unions are the collateral assignment split-dollar (CASD) and 457(f) plans. Both are retention tools that provide retirement benefits to executives—but which is better? As with most decisions, it depends.
To offer insight is returning podcast guest Mike Downey, senior managing director of Newcleus Credit Union Advisors. According to Mike, you may not necessarily need to choose one over the other, but there are key differences and advantages to each you should evaluate.
Significant differences between a split-dollar and 457(f) include the level of complexity, how long the plan is active, and how the benefit is funded or offset by the credit union.
For example, a split-dollar is a life insurance policy arrangement that only ends upon the executive’s death. A 457(f) offers shorter, incremental benefits to an executive and ends at its vesting period. Credit unions should first consider what they’re trying to achieve. Is it a retention tool that a long-term benefit such as the split-dollar can fulfill? Or is it a recruitment tactic that can provide shorter, incremental benefits to an executive with the promise of a protected payout sometime in the future, as with a defined benefit 457(f) plan?
When choosing a benefit, credit unions should also consider:
- Is the executive insurable? A split-dollar is a life insurance policy, whereas a 457(f) may offer more flexibility.
- What is the credit union’s asset size? Does your credit union have the capital to set aside 457(f) funds to grow its earnings and take on additional liability, or is a split-dollar a better fit?
- What investment options will fund or offset a 457(f); what other investment options should you consider for for-profit entities, such as CUSOs?
Stream the full episode for more details about 457(f) plans, including:
- How credit unions can turn 457(f) funds into a perpetual income pool and repurpose dollars for future succession and benefits planning.
- Why your credit union may consider a defined-benefit 457(f) plan over a defined-contribution 457(f) plan.
- Why a hybrid, diversified approach to split-dollars and 457(f) plans may not be as uncommon as you think.
Listen to learn more.
Hello Credit Union executives. Welcome to “C.U. on the Show,” where we give you up-to-date information on how you can reduce risk, keep key talent, and take a strategic approach to your personal financial wellness hosted by me, Doug English, a Certified Financial Planner™ and former credit union insider with Act Advisors. Back as my guest today is Mike Downey, senior managing director at Newcleus Credit Union Advisors. Mike helps credit unions with retaining and rewarding key executives. Mike has been on my podcast before, where we took a deep dive into the risks of collateral assignment, split-dollar plans. Now, if you haven’t, give a listen to that episode.
Today, we’re going to drill into the 457(f) form of a supplemental employee retirement plan. We have Mike Downey back to help us dig into the 457(f) plan design—what to look out for, what the risks are, what the choices are. So, Mike, thanks for joining us again for that.
So talk to me about the 457(f). I’m used to seeing collateral assignment as the primary solution that credit unions have selected for executive retention and retirement income. So in the first place, why would I choose a 457(f) over a split dollar?
Well, I think first, right off the bat, a split-dollar is a life insurance policy and not everybody’s insurable. Two years ago, I was uninsurable. You know why? Because I had a sleep study and I wasn’t using the C-PAP and I didn’t have a follow-up and they were like, so I had to go and now I wear this mask and now I’m insurable. So it’s not always those major things that may not make you insurable. You know what I mean? Just maybe a simple follow-up that we just haven’t done with the doctor or something. So where I’m going with that is not everybody’s insurable at one given time or the other.
Understood. All right. So if you’re not insurable, 457(f) is another way to provide an executive benefit program. Are there other reasons for why I might go over collateral assignment ?
Simplicity. It doesn’t have some of the complexity that comes with a loan regime split-dollar, especially if that loan regime has partial vesting or so forth, a 457(f) is pretty simplistic.
What I’m used to seeing in 457(f) is it says here’s a value that you’re going to get at a particular point in time. And when that point of time is reached, that transaction is executed and the credit union’s done. Is that right?
That’s correct. It’s just an IOU. And then there’s of course some of what ifs if they leave or are terminated for cause and so forth.
So it is a lot simpler. So with the collateral assignment, that is a lifetime arrangement, the life of the executive, right?
Literally a lifetime, that’s correct, because that plan does not unwind or stop until the death of the executive where a 457(f) it ends at that vesting period.
Does it make sense for a credit union with a new CEO they just recruited in to start out with an (f) plan and go to collateral assignment later, kind of seeing how the relationship develops or does that not make sense?
I think it really, once again, step back and look at the situation. They look at all their options available to them at that particular time and not necessarily pick one over the other, but what are they trying to accomplish? Because it’s not uncommon to see a hybrid these days, having both plans, having some of the benefits coming from an F plan and some of the benefits coming from a loan regime split-dollar.
All right. Talk to me more about that, when you see that kind of a combination, because I’ve only seen that a few times. When you’re going to put a 457F together with a collateral assignment. What does a normal combination look like?
Yeah, so let’s take an executive 45 years old who will retire at age 65. The loan regime might be ideal to provide that benefit at age 65 because that’s more of a 20-year long-term horizon. But if the credit union wants to use a retention aspect to help that executive put their kids through school, college, or maybe even align with the business plan, make sure they’re there for five years or to align with some kind of succession plan of a CEO or another executive, and then you’re looking at what I call a shorter term or incremental type of benefit. That’s where the (f) plan really can work well because it’s simple. If you’re here five years, you get X number of dollars. And then that just coincides with that long-term plan, your long-term SERP as that loan regime split-dollar. So to put both plans together might be the best of both worlds because you’re able to efficiently provide the safe retention payout, and then still have that long-term commitment piece, which is the loan regime.
So let’s talk about the plan design options if you’ve decided you’re going to have a 457(f) plan for some portion of your benefit package. Okay. Talk to me about the ways I might design the plan.
Primarily we see two different types. One is a defined contribution, right? And that’s where credit unions say, Hey, you know what, we’re going to set aside a million dollars. And Doug, you get the earnings off of this million dollars as your benefits sometime in the future. That can be risky because let’s go back to 2007, 2008. What if your payoff, your benefit, your vesting, was at that time? You may have gotten no benefit because of a timing issue, of a market issue and so forth. So if it’s a defined contribution design, I would say that puts more risk on the executive getting a benefit. On the flip side, if you do a defined benefit where there’s a specified dollar amount that’s promised to the executive at some point of time, that really puts the risk then on the credit union to make sure they either offset that funding or have the funds available to pay that benefit.
So the defined contribution verses the defined benefit, I clearly get the differences in the risks. Which is the more common structure that you see?
I think because for those of us that were around in 2007, 2008, and even though that was what, gosh, we’re getting old, 14 some years ago, we still feel some of those effects when we’re designing. And I think we see primarily more the defined benefit plan.
So the Credit Union has to deliver on their promise.
What it does is it defines what the benefit is. So let’s say hypothetically that executive is getting recruited to go to another credit union. They know exactly what they’re giving up, where if you have this variable earnings only or defined contribution design and maybe up one week down the next there’s a lot of uncertainty. So I think the defined benefit provides certainty and can really help with that retention aspect
Alright, so we’ve got these two choices: defined contribution or defined benefit depending on the outcome. Who’s going to carry the risk? Next step, what are the investment vehicles that we’re going to use for either one of those designs? And can you give us some examples in strengths and weaknesses of each?
Absolutely. I think credit unions are an advantage as compared to let’s say the community banks, because a credit union can invest in equities, right? So the investment options for credit union, they can, they can offset that promise with mutual funds, ETFs, individual stocks, investment-grade corporate bonds. It could be some form of institutional life insurance, which is quite popular. You know, we call it QUOLI, credit union-owned life insurance. It can be some form of annuities to make that promise to pay and so forth. So credit unions are very fortunate because they have a lot of different investment options they can do to offset or to help fund that promise to pay. The key comes down to two things. One obviously is investment risk, safety of principal, volatility. But the second thing that’s really important is to look at the accounting treatment of those investments. If a credit Union is going to own an annuity, does that annuity have surrender charges? What does that mean from an accounting standpoint? It’s mark to market accounting. They gotta write down to the surrender value. So you put a million dollars in, you may only be booking 900 depending on the pricing and so forth. So accounting really comes into play, Doug, along with investment risks. I think accounting is very important because that could potentially impact their income statement too.
You know, they’re not going to want to write that down. I would think they would seek to avoid having to write down that value, right?
That’s why credit unions, being conservative by nature, sometimes tend to be more conservative, which lends to that life insurance type funding, the QUOLI and so forth, because of safety of principle, somewhat predictable returns and so forth, but it’s not uncommon. And in fact, there’s probably 8 billion of securities listed on call reports in the industry. So there’s a significant amount that still have equity type of exposure and so forth.
And then I’ve seen some credit unions simply put the 457(f) on the balance sheet as a liability and never fund it. It’s just a liability of the credit union.
Do you see that often?
I do. ? But you know, if we look at current interest rates or yields on permissible investments, they’re traditional permissible investments. I mean, I’m looking at the tenure right now. It’s 1.35. You can put that in QUOLI and get two and a half net first year. So to pass up the opportunity to get higher yields on your investments, because NCUA does put a somewhat of a limit to how much they can do in these types of investments, but I think they’re missing out by not taking advantage of getting higher yields. And higher yields don’t always mean more risk, because some of those insurance-based products, you have the insurance carrier backing the promise, right? So you have safety of principle. You’ve got minimum guaranteed yields. So at the end of the day, they really have a gift, so to speak, from NCUA to invest for higher yields.
And that’s that CUOLI solution. So my understanding that the credit union- owned life insurance as the investment chassis for the 457(f), is that the most common structure that you’re seeing?
I still think it’s pretty, pretty split between that. And some form of like managed money, you know, like an equity type of diversified portfolio. I still think there’s a balance there. I don’t think one over the other from what we’re seeing.
Vastly different risks, though. I mean, one is, one is a pretty low risk instrument dependent on interest rates, right? That’s the CUOLI. and the other is full-on equity market risk, right?
Yeah,. But once again, I think, you know, as an advisor, you tend to make sure it’s allocated properly and diversified properly in a nice balanced type of portfolio. Rarely do I see a credit union have a hundred percent exposure without some kind of counter investment to mitigate that investment risk. Don’t put all your eggs in one basket, so to speak.
I have heard that one before, for sure. So talk to me about if you have a defined benefit, you’ve got to deliver a certain value to the executive, and you’re the Credit Union.. What are you going to do to be able to manage the risk of providing that benefit? Do it just come out of your earnings, or how are you gonna handle that?
I think the wise thing to do is match up the investment or some funding to offset that liability, and you fund it properly to meet that obligation. So, as an example if you promised, a defined benefit, you have to accrue that liability up to that point. It makes sense to have an asset to offset that liability. So upfront match that asset with that liability, and then manage and review and monitor that asset annually. If it’s equity-based at least quarterly to make sure that it is on track.
All right, let’s talk about the excise tax in the 457(f). When are we going to run into the excise tax? How much is it, is there any way around it, what are the strategies for dealing with that?
Yeah, so the excise tax is triggered when the 457(f) benefit is over a certain limit or total compensation of the executive exceeds $1 million. that excise tax is on the credit union. So even though the credit union will say , hey, we’re tax exempt, that does not avoid that excise tax. So a number of ways to mitigate that would be to have multiple vesting, different payouts and time it where it doesn’t go over those amounts. And it also makes sense to use other plans. Once again, I’m going to fall back on using multiple plans. So if you combine an F with the split-dollar plan, that can help minimize that if you keep that benefit under those amounts.
So if you have a 457(f), does the funding vehicle change the excise tax?
Okay. So if you have a 457(f) and total comp exceeds a million dollars in any particular year, the credit union is going to owe 15% excise tax on the amount, over the million. Right?
And based off of the benefit.
Okay. So then that’s why you might choose to either time the total compensation. So that you don’t bump over a million, but if you’re a very large credit union, you’re probably there already, right? Your total comp for your senior executive is probably in the million range. I’m used to seeing that commonly. So you’re already paying it, right?.
So then with the collateral assignment, you’re going that route that is not subject to the excise tax at all. Is that right?
That’s correct. And I think that’s one of the attractive features of the loan regime, because going back to the F plan, one of the biggest downsides, we just talked about excise tax, but just regular taxation, because the taxation is based off of vesting, or I’m going to be technical here, when there’s no longer a risk of forfeiture. So basically vesting triggers taxation. So unlike, let’s say Doug, a 401(k) or an IRA where you’re paying tax upon receipt of the money, with the 457(f), you’re paying tax on the entire benefit on when there’s no longer a risk of forfeiture.
Yup. So that can easily bump over the million dollar range. I’ve seen credit union CEOs that are in the 500,000 in annual comp range when they get the annual leave, sick leave, and the 457B and maybe a 457(f), and they kind of all pile onto each other. It’s not difficult to go over a million dollar income for a year or two.
Yep. That’s correct. With the F plan, I would say the design itself can cause some risk, but if you’re really using the F plan for the, to use as r the retirement benefit, those are lump sums. Those are significant amounts as you were mentioning before. And once again, the reason for that is why is there a lump sum payout on an F plan, where if you’re paying tax on that benefit anyway, you might as well receive that payout, but you can structure it in a manner to have multiple payouts to try to mitigate that excise tax risk. And that’s once again, to diversify your plans, have multiple plans that can mitigate risk because honestly, there’s no one perfect plan out there. Maybe, hey, this is the ideal, but I think multiple plans can achieve that same target benefit, which then ultimately reduces risks.
Given that large credit unions tend to have higher comp and a higher comp gets you at or near the excise tax. Anyways, the excise tax is 15%. So it’s pretty significant dollars. Would it be correct to assume that the mid-sized credit unions might have more activity in 457(f) because they don’t have the excise tax issues and the large credit unions might have more activity in collateral assignment, or is that not how the market is working?
That’s a great question, Doug. I mean, if I look at it, I really don’t think the market is, is leaning toward that. But you make a very good point because the mid-size credit unions aren’t as concerned as that excise tax. I mean, an F plan could push them over that, but it’s not as a concern, because as you said, the larger credit unions are already dealing with that to begin with. But let’s take it a step further. What about the smaller credit unions? Because historically the smaller credit unions really felt they couldn’t have enough capital and take on the accrued liability to do an F-plan that would have any significance to the executives. That’s where loan regime split-dollar might be a better fit because it doesn’t take up all of that capital. And it’s not an accrued liability. It’s a performing asset. So you make a very good point. Does it? Does a plan really? Depending on the asset size of the credit union, I would say with the smaller credit unions, we’re seeing more and more of the loan regime split-dollar because of that capital constraint.
What I’m hearing you say is that if you’re a smaller credit union with some constraints on your capital, and are looking to provide a retention or retirement supplement for your executive, the amount of dollars you’ve got to put in to provide a given level of benefit is likely to be less with the collateral assignment versus the 457(f). And are there more aspects to that to make it less taxing for that small credit union?
Yeah, I mean, because I think you can structure the loan regime to have more favorable cash outlay and be more affordable for smaller credit unions. And that once again goes down into the plan design. We’ve seen some of the smaller credit unions provide a nice, significant benefit for their executives and you’re talking, the funding is no different than a car loan or a truck loan, but it can be designed that way where I think historically the mindset of the smaller credit unions say, hey, we can’t do any, we can’t afford to do anything. we can’t provide that. We just don’t have the scale and we’re just not there. That’s not necessarily the case if a split-dollar plan or a bonus plan or some kind of life insurance-based plan is structured properly because for an Fplan to really be efficient, we’ve seen large sums of money set aside. And the earnings off of that provide the benefit, right?
That way the credit unions get their money back
They get their money back and it comes down to opportunity cost of the money and so forth. But for the some of the smaller credit unions, they just can’t, they just don’t have that capital to do that.
Very interesting. So the smaller credit unions may take a look at collateral assignment first and then get into the mid-sized category. You can kind of make a mix of the two depending on what your outcome is.
Yeah. And then going back to your midsize comment, I mean, they might be in the best situation because they don’t have to be necessarily concerned with the excise tax if it’s structured properly and they can use multiple plans and not have to worry about that excise tax.
All right. So we may have covered this already, but I’m going to just go back in one more time. Contrast for me as a credit union, the difference between just holding the 457(f) as a liability on the balance sheet versus funding. I think you said CUOLI was the most common funding choice. So contrast those two for me and how I would evaluate those choices.
You’re going to have an accrued liability just plain and simple with an F plan.. It just comes down to how are you going to offset that liability. Okay? So you can either offset that liability with something conservative, like the CUOLI and we just match up that cash value with the, with the accrued liability. Or you can do it obviously with some other type of investment to do that, but either way from gap accounting, you’re accruing a liability because it’s an IOU a promise to pay.
Yup. And then if I simply keep that, those assets in the credit union, I assume the primary difference is the earnings potential on those assets and the credit versus what they would be earning in an outside vehicle.
That’s correct. And then, you know, we also have to take into consideration the what ifs. So what if the executive dies? What does that mean? What do they get? Do they get the accrued amount? If you use CUOLI that could really help because then you have cost recovery to the credit union. You’re able to provide that benefit to the estate of the executive. So the funding could come into play based off of some of those what if scenarios. What’s nice about the 457(f) asset is pretty simple; if the executive leaves, then that accrued liability reverses., that was income now. And they use those same funds for the next exit, you know, it could be perpetual where I think one of the downsides to the loan regime, that capital is tied up indefinitely.
It’s a long, long, long term plan.
It’s a long, its very long term. So with the 457(f) you can actually repurpose, so to speak, some of those dollars for the next person. So you have a perpetual pool of money, of capital that is used for succession planning and benefits. So there is more flexibility, I should say, with the 457(f). So yes, taxes, ooh you know that’s a bad word, but you have more flexibility with the 457(f).
And then certainly is much simpler, much shorter, Mike, if you’re a large credit union, and you’ve got a for-profit entity, but you won’t do so. Talk to me about who should be the contractor with the executive and how to evaluate one entity versus the other. What are the choices? What are the thought patterns there?
Yeah, that’s a great question. We were asked this quite frequently. That’s a great question. And it comes down to how is that executive, what entity is paying that executive and that’s key to an employee and that employee is getting their paychecks from the for-profit. Then we can design a plan for that for-profit. And because it’s a for-profit, it does open up the plan options for those executives meaning no need to do a 457(f), a traditional SERP that reduces that tax obligation. They know that tax liability, but, Doug, it does come down to they need to be getting their paycheck from that particular entity.
Interesting. Okay. Well, I know that I’m starting to see some of that activity with some of the executives, having their paycheck come from the for-profit entity. And so what I think I’m hearing you say is if they had that as a choice that would give them more ability to choose their funding vehicle. Is that right?
Yeah, because you can do some vesting without taxation. So we designed things in the for-profit world a lot different than we do on the non-profit. So you could have someone a hundred percent vested and only paying tax when they received the benefits sometime in the future. So we can truly do what I call true non-qualified deferred comp in a for-profit area.
Interesting. The bankers are always targeting the credit unions’ taxation, or lack of taxation. But what I’m hearing you say is actually being a taxable entity could be an advantage.
It can be , but the community bankers are at a huge disadvantage because they cannot do loan regime split-dollar; it’s a huge advantage for credit unions trying to recruit and retain talent. We see a lot of crossover from community banks over to credit unions, you know, and credit unions have a huge advantage in offering that particular benefit.
Very good. Awesome, Mike. Thanks again.
Anytime, always enjoy talking with you, Doug.
That’s all the insider credit union knowledge we have for this episode. Are you enjoying the conversation? Be sure to subscribe and share your thoughts with other credit union leaders by leaving us a review. See you next time on “C.U. on the Show.”
Speaker 3 (26:29):
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Economic forecasts set forth may not develop as predicted. All performance referenced is historical and are no guarantee of future results. Indexes are unmanaged and cannot be invested into directly.
Mike Downey and Newcleus Credit Union Advisors are not affiliated with or endorsed by ACT Advisors, LLC.
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