Getting Started with Benefit Liability Management

Sponsored by BFB Gallagher

Benefit liability management isn’t a new concept in the credit union industry, yet many are unsure of what it means. Sometimes called benefits pre-funding, it is simply purchasing an otherwise impermissible investment to offset employee benefit expenses. Before implementing benefit liability management, several key questions must be considered. While there are no right or wrong answers, it’s important to note that each credit union must carefully decide what’s appropriate for their particular situation and their membership.

1. Which investment is right for my credit union?

You’ll need to determine your CU’s risk tolerance: conservative, moderate or aggressive. This determination guides your selection of investment products, construction of the investment policy statement and ultimate impact on the financial statements.

2. What investment options are available?

The options available are institutional insurance/annuities, institutional index universal life, structured CDs and asset management (mutual funds, ETFs and stocks). Some sample portfolio options:

Conservative: 100 percent fixed institutional insurance/annuities

• individual life insurance policies on the lives of executives, but the credit union is the owner and beneficiary
• guaranteed floor crediting rate, with current rate yielding around 2.50 percent APY
• predictable income to offset predictable benefit expenses

Moderate: 25 percent fixed institutional insurance, 50 percent IUL, and 25 percent structured CD

• provides the safety and soundness of institutional insurance
• IUL – provides an upside of market returns with a guaranteed investment floor of 0 percent, a cap rate declared annually by the carrier where the index credit is determined by the growth of a market index
• structured CD – an investment in a group of indexes or stocks over a set amount of time, typically with a principal guarantee at the end of the term
• partial predictable income with upside potential in strong equity markets, while downside protection in times of market correction

Aggressive: 25 percent IUL, 25 percent structured CD, and 50 percent asset management

• limited safety and soundness with the 0 percent floor in the index life and principal guarantee in the structured CD
• volatility with the asset management (mutual funds, ETFs)
• purely market driven portfolio, with an upside in a strong equity market and guarantee of principal in the IUL and structured CD with a potential downside with the asset management

3. What is the accounting treatment?

Institutional insurance and IUL are relatively straight-forward as they are cash value policies with the credit union as the owner and primary beneficiary. These policies are accounted for in accordance with FASB Accounting Standards Codification Topic 325-30, Investments in Insurance Contracts. Under ASC 325-30, the credit union should record the cash surrender value of the policies as an asset (i.e. Other Asset) with changes in the cash surrender value being recorded as income (i.e., Other Non-Interest Income). Upon the death of the participant, the death benefit proceeds in excess of the cash surrender value are recorded as income.

Structured CDs are debt securities and could be classified as Available-for-Sale or Held-to-Maturity investments. The CD is valued daily, but can be marked-to-market monthly or quarterly. Changes in market value for AFS and HTM investments are recorded on the balance sheet as accumulated unrealized gains/losses. The market value of the CD fluctuates based on a variety of factors including performance of the index, time remaining to maturity, general interest rate environment, supply and demand for the CD. Earnings are impacted and a gain/loss is recorded when a coupon is paid, interest is earned from an original issue discount, at maturity, or if the CD is sold/redeemed back to the issuer or secondary market prior to maturity.

The value of the underlying investments within asset management has the potential to be the most volatile. Similar to structured CDs, the stocks and mutual funds could be classified as an Available-for-Sale investment and valued as above. Currently, unrealized gains/losses are recorded on the balance sheet until the funds are sold. However, this will change when Accounting Standards Update 2016-01 becomes effective, which generally revises the required accounting for financial instruments, with a primary focus on equity investments. ASU 2016-01 takes effect for credit unions in December 2018, at which time those equity investments reported as Available-for-Sale will have to reflect both recognized and unrecognized gains/losses in earnings each period. Those investments reported under All Other Investments, which includes life insurance, will see no change in their financial statement reporting.

4. What compliance review is needed?

NCUA has identified seven risk categories. The credit union is expected to document its analysis of these risks:

Market Risks (quantitative measure)

• Credit risk – What is the credit rating of the carriers the board is considering?
• Interest rate risk – How will changes in the market affect the credit union’s earnings and capital?
• Liquidity risk – What is the risk to earnings if the investment has to be liquidated?

Institution Risks (qualitative measure)

• Transactional risk – How does the purchase of the investment affect the bottom line of the credit union?
• Compliance risk – Is the purchase of the investment compliant with all laws, rules and regulations?
• Strategic risk – Does the structure of the investment align with the credit union’s philosophy?
• Reputation risk – Does the board fully understand the investment?

5. Is it necessary to use a firm to implement benefit liability management?

Generally speaking, unless you have a dedicated resource who is securities licensed, has experience in portfolio management, and has access to a wide range of investments, you should engage a firm to design and service your program. The right firm can guide you through the process and help with your due diligence documentation. Ongoing administration, support and compliance are critical to the success of your program. Best practice is to engage a firm as soon as you begin considering benefit liability management.

Benefit liability management is an efficient way for a credit union to offset existing benefit expenses. With the right preparation and documentation, you can implement a regulator-friendly program for your credit union.

Jennifer Jackson, area vice president, has more than 15 years of experience in the financial services industry, specializing in the design and implementation of executive benefit plans. Her expertise includes regulatory compliance, financial analysis and retention strategies.

Kraig Klinkhammer, COO, oversees investment and portfolio strategy. He works closely with asset management firms and life insurance carriers to ensure our clients have access to a wide variety of effective and compliant solutions. He has more than 20 years of experience in asset management, executive benefits, and institutional life insurance.

Disclosures:

Insurance Products: 1) are not a deposit or other obligation of or guaranteed by, any bank or bank affiliate; 2) are not insured by the FDIC or any other federal government agency, or any bank or bank affiliate; and 3) may be subject to investment risk, including possible loss of value.

Indexed Universal Life products are not an investment in the "market" or in the applicable index and are subject to all policy fees and charges normally associated with most universal life insurance.

Life insurance policies have terms under which the policy may be continued in force or discontinued. Current cost of insurance rates and interest rates are not guaranteed. Therefore, the planned periodic premium may not be sufficient to carry the contract to maturity. The Index Accounts are subject to caps and participation rates. In no case will the interest credited be less than 0 percent. Please refer to the customized illustration provided by your agent for additional detail. The policy's death benefit is paid upon the death of the insured. The policy does not continue to accumulate cash value and excess interest after the insured's death.

Bank certificates of deposit are FDIC insured up to applicable limits and offer a fixed rate of return. [Variable annuity returns/mutual fund yields] and principal will fluctuate with market conditions.

Mutual funds and ETFs are sold by prospectus only. Before investing, investors should carefully consider the investment objectives, risks, charges, and expenses of a mutual fund. The fund prospectus provides this and other important information. Please contact your representative or the Company to obtain a prospectus. Please read the prospectus carefully before investing or sending money.