Under CASD plans, key personnel receive ownership of a life insurance policy the premiums for which are paid by the employer, but are repaid to it as interest-bearing loans,(Photo: Shutterstock)
Companies without stock or other types of equity have a limited toolbox from which to create customized incentive/retention arrangements for top executives. Salary and bonuses are the first line of attack, but they are mostly short-term focused and involve a one-way outflow of funds. Unfunded "457(f)" deferred compensation plans can achieve incentive/retention goals, but are taxable to the executive (and potentially to the business), also involve a one-way outflow of funds and place the risk of underperformance of funding assets on the company rather than the executive.
Enter collateral assignment split-dollar (CASD) plans, where key personnel receive ownership of a life insurance policy the premiums for which are paid by the employer, but are repaid to it as interest-bearing loans, and until repaid such loans are collateralized by the insurance policy.
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CASD plans achieve incentive/retention objectives, enable the employer to recover the cost of the plan, if properly structured are tax-free to the executive and also avoid the 21% employer-side excise tax on certain compensation paid to a tax-exempt organization's most highly compensated employees, and place the financial risk of underperformance of the plan-funding insurance policy on the executive rather than the employer, whose only legal obligation is to advance the agreed premiums rather than guaranteeing a specific retirement benefit amount.
If your business decides to establish a CASD plan, here's a brief list of best practices:
1. Right-size the benefit
Task a board committee to work with senior management to properly size the intended benefit, based on industry compensation information for peer institutions. Combine the executive's projected end of career employment income, including the estimated annual benefit from any ERISA-covered retirement plans and social security benefits, and target an all-in after-tax retirement income replacement of between 60% and 75%. The gap between the identified projected retirement income of the executive and what the Credit Union is willing to supplement is your CASD plan benefit target.
2. Choose the right team
Ask colleagues and trade associations who they have used as agents/consultants and their experience with them; check online and at industry gatherings. Look for those who specialize in CASD plans rather than general life insurance agents. Your agent/consultant is key, as they will help you select and negotiate pricing and coverage issues with the life insurer(s) who best fit your needs, ones with superior long-term credit ratings, dividend history and expertise with CASD plans. All the major insurers issue life policies to fund CASD plans, but you need an expert to select among and deal with them.
3. Select the right insurance policy
Although this topic merits a separate article (and there are many out there), understand that:
(i) whatever life policy illustrations you are shown, they are (apart from any insurer-guaranteed "crediting rates" on whole life policies of typically 2%) merely projections–estimates of how the policy may perform over decades, and the more aggressive the projected rates of cash value growth (and rates much above 5% are in the current interest rate environment aggressive), and/or the shorter period of time the illustration covers (say to insured age 85 versus 100) the greater the risk the policy will underperform, leaving the covered executive with less (and due to the magnified effect of interest compounding, potentially much less) of a retirement benefit than planned and possibly creating interim accounting issues, and
(ii) there are major differences between "whole" and "indexed universal" permanent life insurance and the exposure of internal policy values to external investment risks, and as a result although whole life policy return illustrations will be more conservative, they also carry with them lower risks of long-term underperformance and thus are a more reliable planning tool.
The right agent/consultant will guide you through the differences between the two type of policies, their structure, performance risk profiles and illustration/projection characteristics, so you can avoid sales hype and choose wisely.
4. Accounting treatment
CASD plans are accounted for in a specific way – the premium payments (including at least some of the interest accruals) are carried as a loan asset on your books. But because most commissions and other sales expenses typically are charged against the life policy up front, in the early years of a CASD plan the premium loan often will exceed the offsetting policy cash value, leaving the immediate collateral value of the policy short. The temporary collateral shortfall often can be offset by the executive's backup personal promissory note, and then the premium loan will be carried at full value.
Where a CASD plan is "non-recourse" (where there is no backup executive personal loan obligation), the chances are greater of a write-down of the premium loan to equal policy cash value until (typically within 7 to 10 years) the policy cash value exceeds the total premium outlay. This issue is more complicated than can be addressed here, and ignores the full collateral protection provided by the life policy death benefit, but the key is reviewing CASD plan accounting issues (including ongoing interest accruals) with your auditors before you buy the policy and establish the plan.
5. Regulatory compliance
Beyond general safety and soundness supervisory considerations, many industries have guidelines to be aware of, For example, NCUA has established two guidelines for employee benefit pre-funding investments, including but not limited to CASD plans. First, if total benefit pre-funding investments (including paid and committed life policy premiums) exceed 25% of a businesses's net worth, the arrangements will receive heightened examination scrutiny, and separately if pre-funding investments placed with a single issuer/insurer exceed 15% of worth, you must justify such excess investment concentration with "mitigating factors," such as third-party reinsurance of the policy death benefit or using policies issued by several insurers.
For state charters, additional state-specific rules often apply, ranging from full and automatic alignment with NCUA's rules to notice and/or approval requirements and compliance with state-level requirements such as maximum loan amounts and (though seldom in practice applied to CASD plans) bans on preferential insider loans. State charters need to address these rules either through experienced legal counsel or by direct (pre-purchase) contact with their regulator.
6. Tax issues
If structured properly, including setting the interest rate on the premium loans at or above the Applicable Federal Rate, no one will have income tax on a CASD plan. The employer avoids the 21% excise tax under IRC Section 4960 and the executive has neither imputed income tax on the premium loans nor income tax on borrowings against policy cash value. Finally, there is no income tax on the net death benefit to the executive's designated beneficiaries. Estate tax issues are beyond the scope of this article but will not be a consideration for most individuals under current law.
7. Documenting the plan
Retain an experienced attorney to help negotiate and draft the plan documents, which will define the company's obligation to make premium payments, create a general vesting schedule including designated special events such as death, disability, resignation/ termination and change of control that will accelerate vesting or cause the forfeiture or reduction of plan benefits, specify the interest rate on the premium loans, define any limited backup personal liability of the covered executive for repayment of the premium loan, and prescribe a process (usually arbitration) for disputes to be resolved and (key) to automatically modify plan terms if required by your regulator. Keep a full set of executed plan documents, including any amendments, in your files.
Finally, adopt a detailed policy governing the creation and administration of all CASD plans; regulators expect to see such a policy in place and followed by you.
8. Diligence is key
The need for proper diligence does not end when a policy is purchased and plan created. Both before and after a CASD plan is established, do your homework – after the life policy purchase, keep track of actual policy financial performance and ongoing financial condition/ratings of each policy issuer. Review all the information your selected agent/consultant provides but also do an independent review of relevant information, especially peer recommendations and generally available topical literature. Do the diligence and document it so it's readily available for your examiners.
Steven Eimert is an attorney at the Boston, MA law firm of Sherin and Lodgen LLP. He has for more than thirty years represented credit unions nationwide in compliance, governance, CUSO and executive compensation matters. He also represents OM Financial Group, a credit union executive retirement planning consultancy/life insurance agency and is a principal and general counsel of CU Real Estate Solutions, LLC, which arranges and invests in sale-leaseback transactions for credit unions. He can be reached at [email protected]
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