Split Dollar Plan Implementation: Leveraging Today’s Higher Interest Rates

Structuring an executive retention program using Split Dollar plans provides unique financial advantages for both the credit union and the executives. One decision point in the plan design process is whether to pre-fund the life insurance policy premium used to create the Split Dollar arrangement. A credit union has a number of options to pre-fund the life insurance premium in a Split Dollar arrangement. One of those options is to utilize a Premium Deposit Account (PDA) offered by the insurance carrier. 

How Does a Premium Deposit Account Work?

The life insurance policy premium is paid over time, with multiple scheduled annual payments, mainly to preserve the tax advantages of the policy. With a PDA, the amount to fund the entire premium schedule is sent to the insurance carrier. Funds in the PDA earn interest at the insurance carrier’s stated interest rate, thereby reducing the effective cost of the insurance premiums. The PDA also serves as collateral for the Split Dollar plan until the scheduled premium payments are completed. The annual payments are automatically made from the PDA on the scheduled date. The funds in a PDA can be liquidated should the need arise, without penalty in most cases. An annual 1099 is issued by the insurance carrier to Split Dollar participant for credited interest, which is taxable to the participant as ordinary income.

Does a PDA Make Sense in Today’s Market Conditions?

Premium Deposit Account interest rates are very favorable today, having risen in line with general market interest rates. Current PDA rates range from 4.5% to 5.5% or higher.1 Additionally, some insurance carriers offer incentives, such a 10% interest rate in the first year. Once a PDA is established at the insurance carrier, the PDA interest rate is locked in; i.e. it cannot be reduced. Given the interest earnings help to reduce the overall cost of a Split Dollar plan, today’s PDA interest rates make them more attractive to credit unions. Minimizing the expense while maximizing the benefit is important to participants.

Are There Alternatives to a PDA?

There are several alternatives to using a PDA. The initial premium payment is sent to the insurance carrier, with the remaining balance allocated to any of these pre-funding alternatives: 

• Side account at the credit union
• Single premium immediate annuity (SPIA) through an insurance company 
• Investment account through a brokerage firm

What Happens to the Remainder of the Premium Payments?

With a side account at the credit union, the remainder is held in a member account owned by the participant, with restricted access. The remaining insurance premiums are sent by the credit union annually from the side account to the insurance carrier. A side account can be advantageous when the credit union has liquidity and/or concentration concerns. This option offers more control over the remaining premiums. 

Factors to Consider when Evaluating a SPIA

If your executive benefits provider recommends a SPIA, there are several key considerations:

• The Exclusion Ratio, which determines taxable amount
• Net earnings (after the commission to your provider)
• Complexity and administrative needs
• Impact upon a potential need to surrender
• Is a SPIA the only option?

There are limited situations where a SPIA is the only viable choice, but the risks should be evaluated and managed nonetheless.

What are the comparative features of SPIAs and PDAs?

When utilizing a SPIA, the remaining premium balance is sent to the same or different insurance carrier to fund the SPIA. Similar to a PDA, a SPIA credits interest on the SPIA balance, and the credited interest is taxable to the participant as ordinary income. 
The critical difference between SPIAs and PDAs lies in the risk to the credit union. Most SPIAs pay commission to the vendor, making the net interest earning generally less than a PDA, which are not commissionable. Also, the majority of SPIAs have surrender charges. 

How does an investment account through a brokerage firm work?

With an investment account, the remaining premium balance is sent to a brokerage firm, together with the desired allocation among the various investment options. This option can potentially provide the highest earnings, but there is the risk of loss of principle and fluctuating interest rates. As with SPIAs, fees and commissions can lower the net interest earnings. Investment accounts are also more complex to administer. 

Summary

Each credit union must assess its own risk tolerance, among other financial factors. For the majority of credit unions and situations, the Premium Deposit Account is usually the more safe and sound option over side accounts, SPIAs, and investment accounts. The PDA generally offers more favorable yields and other carrier incentives. The risk of losing principle is mitigated since the interest rate is locked in. The insurance carrier takes on the responsibility of paying future premiums, thus eliminating the possibility of missed or delayed payments which may be highly detrimental to your Split Dollar plan.

When properly implemented, incorporating today’s high yield savings rates into your Split Dollar plan can significantly impact your financial strategy for both expense efficiency and the actual benefit to your executive.

Pre-funding is one of many decision points in designing a Split Dollar plan. Learn more about Split Dollar plans »

Liz Santos is Chief of Staff for Gallagher’s Executive Benefits team. She has consulted with credit unions, trade associations, nonprofits, and financial services organizations to achieve their strategic goals for more than 20 years. She supports the service teams as well as develops client communications and educational resources. Liz also oversees research projects such as the annual Gallagher Executive Compensation and Benefits survey.

1 Source: PennMutual.
This material was created to provide information on the subjects covered, but should not be regarded as a complete analysis of these subjects. The information provided cannot take into account all the various factors that may affect your particular situation.  The services of an appropriate professional should be sought regarding before acting upon any information or recommendation contained herein to discuss the suitability of the information/recommendation for your specific situation.

Consulting and insurance brokerage services to be provided by Gallagher Benefit Services, Inc. and/or its affiliate Gallagher Benefit Services (Canada) Group Inc. Gallagher Benefit Services, Inc., a non-investment firm and subsidiary of Arthur J. Gallagher & Co., is a licensed insurance agency that does business in California as “Gallagher Benefit Services of California Insurance Services” and in Massachusetts as “Gallagher Benefit Insurance Services.”