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A separately managed account with a stable value annuity ‘wrapper’ can help make these earnings more predictable over a longer period.
This column was reprinted with permission from the original.
Total investments in pre-funded employee benefits programs have increased drastically as credit unions continue to navigate challenges in attracting and retaining talent amid rising benefits costs and tight labor market conditions.
In 2021, total assets in pre-funded benefits programs increased by over 24% from $21.92 billion to $27.25 billion and have continued to grow throughout 2022. As non-traditional investment allocations increase with the intent to offset the rising cost of hiring, retaining and rewarding talent, the potential for return variability and financial statement volatility also grows. While increasing your institution’s direct exposure to alternative securities may potentially provide higher returns, certain non-section 703 investments can also cause income statement volatility due to GAAP-required accounting designations.
Understanding Your Pre-Funding Investment Authority
Since 2003, federal credit unions have had expanded investment authority to pre-fund employee benefit plan obligations under National Credit Union Administration regulation 701.19(c). Many states mirror this language, which allows credit unions to invest in otherwise impermissible asset classes and build a portfolio with a return profile more likely to keep pace with their rising benefits costs. There are two broad categories that credit union pre-funded benefits investments fall under: insurance assets and securities.
There is no regulatory cap on the aggregate size of 701.19(c) investments for federal charters, and there are nearly unlimited strategy options based on risk appetite and return objectives, subject to performance volatility and assessment of suitability given the benefit provided. As your benefits expense rises, the materiality of these assets on your balance sheet increases, as does the need to clearly understand your portfolio structure and underlying risk profile.
Institutions with pre-funding plans exceeding 25% of net worth should expect more regulatory scrutiny under the examiner guidelines known as “expanded examination scope,” which is designed to “identify potential risk to the credit union and evaluate management’s understanding of the employee benefit-related investments,” per the NCUA Examiner’s Guide. Institutions must have a solid understanding of the risk exposure and have prudent risk controls in place to ensure the safety and soundness of the program.
Pre-Funding Solutions
Whether or not your institution intends to fund in excess of 25% of net worth across pre-funding assets, expanded investment authority goes hand-in-hand with the potential for greater risk. A pre-funded benefits portfolio should complement the balance sheet in an asset/liability management framework with attention given to macro-factor risk exposures including interest rate, credit and liquidity risk. Additionally, the institution should have a clear understanding of the various methods of benefits pre-funding, their cost structures, transparency and accounting implications.
Insurance products have long been used by financial institutions, mainly in the form of institution-owned life insurance (COLI/BOLI/CUOLI). Most purchasers of these products are attracted by “guaranteed” returns and accounting friendliness, but a deeper dive might leave you thinking otherwise. Besides offering a tax shelter that is often misaligned with the needs of credit unions, policies can be very costly upfront and the ongoing cost of insurance can change, impacting your return.
Separately managed investment portfolios have seen increasing popularity in recent years as an alternative to insurance products, offering more transparency, simplicity and customization at lower overall costs. Most portfolios are constructed with a combination of fixed income and equity positions, designed to enhance the long-term return potential while managing risk within the constraints of an asset-liability management framework.
Is Your Benefits Pre-Funding Plan Creating Accounting Headaches?
When constructing pre-funded benefits strategies, many investors are attracted by equity return potential, with long-term average annualized returns often ranging from high single-digit to low double-digit figures. An allocation to equities can help institutions reach their return and benefits cost offset objectives with a lower overall allocation to non-traditional assets on the balance sheet. However, it's important that investors understand the potential for return variability and the mark-to-market GAAP-required accounting treatment.
Equity exposure in federally insured credit unions more than doubled in 2020 from $2.7 billion to $6.5 billion and increased another 42% in 2021 to $9.2 billion. However, by June 2022, industry equity exposure fell to $6.6 billion, likely due to the decline in equity valuations more so than divesting. Heightened market volatility or economic downturns can cause periodic markdowns that flow through the income statement to capital, creating potential short-term headaches on the path to long-term enhanced returns.
A Middle Ground to Volatility Management
If an allocation to equities is a necessary element to help your pre-funded benefits portfolio achieve its long-term return objectives, but the accounting treatment and marking exposure through the income statement each month is unattractive or untenable, there is a middle-ground approach to consider.
A separately managed account with a stable value annuity “wrapper” provides an accounting solution to help smooth out short-term variability and make employee benefits pre-funding portfolio earnings more predictable over a longer period. The annuity is an insurance contract with the institution as the sole beneficiary. The credit union selects the asset allocation and books the total return through a stable-value crediting rate, which can be fixed for up to 12 months when the annuity is created. It then adjusts quarterly based on actual investment performance according to a transparent, formulaic crediting rate-adjustment process.
While the “wrap” only provides an accounting solution without any economic benefit, credit unions can benefit from a lower cost than traditional credit union-owned life insurance policies, increased customization and transparency, and the potential for enhanced earnings while also managing income statement volatility over an amortization or “smoothing” period.
As credit unions continue to seek new ways to enhance their recruiting and retention efforts, we expect to see total industry assets in non-traditional investments continue to increase. We also anticipate that a middle-ground approach, including a stable value wrapper, may become more attractive to those institutions seeking less volatility from a short-term accounting perspective.
Brittany Rollek is managing director/client experience and Nick Trentmann is director, advisory services at CUES Supplier member ALM First.
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The content in this article is provided for informational purposes and should not be relied upon as recommendations or financial planning advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. While such information is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. Statements herein that reflect projections or expectations of future financial or economic performance are forward-looking statements. Such “forward-looking” statements are based on various assumptions, which assumptions may not prove to be correct. Accordingly, there can be no assurance that such assumptions and statements will accurately predict future events or actual performance. No representation or warranty can be given that the estimates, opinions or assumptions made herein will prove to be accurate. Actual results for any period may or may not approximate such forward-looking statements. No representations or warranties whatsoever are made by ALM First Financial Advisors as to the future profitability of investments recommended by ALM First Financial Advisors.
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