Split-dollar life insurance is an arrangement between two parties to share the costs and benefits of a permanent insurance policy. Often these arrangements are between an employer (the “company”) and an employee (the “executive”), involving a whole life or indexed universal life (“IUL”) policy. Companies generally use the policies as a Supplemental Executive Retirement Plan (“SERP”), which are considered non-qualified benefit plans.
The two most common types of split-dollar life insurance arrangements are endorsement and collateral assignment, which are defined based on which party controls the policy. Within these agreements, there are multiple documents executed, most commonly:
Endorsement split-dollar life insurance is an employer-owned policy that endorses some or all of the death benefits to the employee’s beneficiary. The employer owns and controls the policy and, therefore, makes all policy decisions (i.e., surrender). A separate agreement is entered into between the employer and employee to define the split of costs and benefits between the two parties.
Collateral assignment split-dollar life insurance policies are owned by the employee with some benefits assigned to the employer. The employee owns and controls the policy while the employer makes the premium payments. Premiums are loans to the employee. Some level of interest on the amount borrowed must be paid. The employer is ultimately reimbursed for the premiums paid and related interest from the death benefit or the cash surrender proceeds.
There are different types of collateral assignment arrangements based on the structuring of the note within the agreement. They are as follows:
Policies are established with a fixed number of premium payments (generally 7 or 10) that are pre-funded by the employer and, therefore, treated as a single loan to the employee. The employer makes the first premium payment directly to the issuing insurance company and funds the remaining premium payments by either:
The method of funding has no impact on the accounting, as there is a single loan made to the employee.
Most commonly, companies utilize collateral assignment split-dollar life insurance set up under non- recourse or limited-recourse arrangements. As such, the focus of the accounting section will be on these types of arrangements.
ACCOUNTING FOR SPLIT-DOLLAR ARRANGEMENTS
The accounting for split-dollar arrangements is generally the same regardless of the structure of the agreement. Additionally, whether the promissory note is non-recourse or limited-recourse has no effect on the journal entries recorded over the life of the arrangement.
RECORDING THE LOAN AT ISSUANCE
In executing the transaction, the employer provides funding for the premium payments of the life insurance policy in exchange for a promissory note from the employee. The transaction meets the definition of a loan as defined by ASC 310-10, which states:
“A contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor’s statement of financial position. Examples include but are not limited to accounts receivable (with terms exceeding one year) and notes receivable.”
Upon issuance of the loan, the employer provides cash through one of the funding methods described above and establishes a loan receivable from the executive. As an example, assume the defined loan amount is $3.0 million. The value of the loan is measured at issuance equal to the cash outlay by the Company. ASC 310-10-30-2 states:
“As indicated in paragraph 835-30-25-4, when a note is received solely for cash and no other right or privilege is exchanged, it is presumed to have a present value at issuance measured by the cash proceeds exchanged.”
In these arrangements, the company does not provide any other right or privilege. The promissory note is received in exchange for the cash needed to fund the premiums of the policy. As such, the value of the loan is equal to the cash paid.
The journal entry to record the example transaction is:
|Dr Officer Loan Receivable||$3,000,000|
RECORDING THE INTEREST ACCRUAL
Once the loan is established, it begins earning interest based on the note rate, typically the long-term Applicable Federal Rate for the month and year the agreement becomes effective. Interest compounds annually. In the example transaction, assume an annual interest rate of 2.50%. Each month the company earns interest on the outstanding loan balance, and a journal entry is recorded to accrue interest on the loan. Interest is paid from the death benefit and, therefore, increases the receivable from the executive in each accounting period. The entry below represents the monthly accrual of interest:
|Dr: Officer Loan Receivable-Accrued Interest||$6,250|
|Cr: Interest Income||$6,250|
(calculated as $3,000,000 loan * 2.5% interest / 12 months)
RECORDING THE SETTLEMENT OF THE LOAN
The loan is settled upon death or surrender of the policy. The company is entitled to the value of the original loan and accrued interest from inception. The cash owed to the company is paid from the death benefit or surrender value, with the remainder being paid to the employee (surrender) or the employee’s estate (death). Based on the example, assuming settlement and surrender of the insurance policy 24 months post entering into the policy (i.e., $150,000 interest earned), the entries to record the receipt of cash and settlement of the receivables are as follows:
|Cr: Officer Loan Receivable||$3,000,000|
|Cr: Officer Loan Receivable-Accrued Interest||$150,000|
OTHER CONSIDERATIONS FOR SUBSEQUENT MEASUREMENT
At each period-end, the company needs to analyze the value of the outstanding loan for changes in the valuation. Generally, these loans are considered not held for sale and, therefore, are reported at outstanding principal adjusted for any charge-offs, allowance for loan losses, deferred fees, and unamortized premiums or discounts based on ASC 310-10-35-47, which states:
“Loans and trade receivables that management has the intent and ability to hold for the foreseeable future or until maturity or payoff shall be reported in the balance sheet at outstanding principal adjusted for any charge offs, the allowance for loan losses (or the allowance for doubtful accounts), any deferred fees or costs on originated loans, and any unamortized premiums or discounts on purchased loans.”
Additionally, the company should analyze at each period-end any probable collection issues and the need for an allowance that would reduce the asset balance.
VALUE OF THE LOAN
With an insurance policy securing the loan, further consideration is needed to determine the value of the loan. For endorsement arrangements, the employer owns the policy and, therefore, owns the surrender decision. The company values the loan at the lesser of the premiums paid or cash surrender value of the policy as of the period end date. This amount can generally be obtained from the statement provided by the insurance company.
For collateral assignment arrangements, the employee owns the policy, so the company does not control the surrender decision. However, the company does maintain the right to collect on the loan under the collateral assignment. Therefore, the company may need to consider the cash surrender value of the policy when determining the value of the loan. ASC 325-30-35-1 states:
“An asset representing an investment in a life insurance contract shall be measured subsequently at the amount that could be realized under the insurance contract as of the date of the statement of financial position…”depending on the type of note used in the agreement–non-recourse or limited- recourse– when determining the carrying value of the loan at each period-end.
For limited-recourse, the loan is secured by the cash surrender value of the insurance policy, but the company also has the option to seek repayment from the employee if the cash surrender value is less than the outstanding loan amount. Since the loan is secured by both the policy and by the employee, the cash surrender value is not the only consideration when determining the value of the outstanding loan. As such, the value of the outstanding loan does not need to be adjusted if the cash surrender value is less than the outstanding loan, and there is no further consideration needed at period-end for these types of arrangements.
For non-recourse notes, the loan is secured solely by the cash surrender value of the policy and, therefore, potential for a loss related to the loan exists if the cash surrender value is less than the loaned amount. The cash surrender value is the realizable amount of a life insurance contract at any given date. The accounting guidance does not allow a life insurance asset to exceed cash surrender value less an allowance for credit losses. The company is entitled to the premiums paid plus interest earned under these arrangements. The carrying value of the portion of the loan for which premiums were paid would need to consider the cash surrender value. This portion of the loan would be valued by the company as the lesser of the cash surrender value and the cumulative premiums paid by the reporting entity.
This is based on the premise that surrender is not within the control of the company and it is uncertain whether the company will be reimbursed for cumulative premiums paid upon death or surrender. Any premiums paid in excess of this amount should be recorded as an expense.
As an example, if the outstanding loan related to a non-recourse policy was $3,000,000 and the cash surrender value of the policy was $2,500,000, the company would need to reduce the carrying value of the loan to the cash surrender value and recognize a loss related to the loan. The entry below represents how the company would record the adjustment:
|Dr: Loss -Officer Loan||$500,000|
|Cr: Officer Loan Receivable||$500,000|
While the general accounting for these arrangements is similar, specific details and terms within all documents included in the agreement need to be evaluated when determining the appropriate accounting, and companies should consult their accountant with any questions. Additionally, there are potential individual income tax implications for the executive related to these arrangements that should be considered.
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“Times, they are a-changin’.”
Before long, most readers of this publication won’t get that reference to the great Bob Dylan song.
Fully half of baby boomers will turn 65 in the next 10 years and like the definition of classic rock, it will impact the credit union community tremendously in terms of retirements and their replacements.
The coronavirus pandemic is highly likely to accelerate the process. Consider the stress on a cooperative financial institution and its leadership when dealing with the relatively sudden economic crisis. In addition, the need for digital transformation has only become a greater imperative for continued member service. And on the flip side of that, is the transformation of the traditional retail business model. Regulatory pressures are mounting. That means alterations to management style and business model, quick and consistent learning curves and just change.
Half of CEOs plan to transition – whether retire or change positions – in the next six years. And it’s not just CEOs, but the entire C-suite that will be affected. If your credit union is not prepared with a succession plan, the transition will not go smoothly and it can take years, literally, for the credit union to recover. No credit union can afford that.
We are having to become more agile and very tech focused right now. That will require a very different skill set than when most credit union boards hired their last CEO, possibly decades prior. Fintechs have also invaded credit unions’ battle ground in the war for talent. Their products are innovative and exciting, which can be very attractive for a young executive and their pockets may be deeper, too. Ensuring your credit union has a competitive compensation and benefits plan – not just competitive for the credit union market, but for others who are trying to recruit the same talented executives – is critical.
Understanding the need for the type of leader your credit union will require is crucial and necessitates a clear understanding of the current strategy, as well as, what the credit union may look like five to ten years out. If your credit union is $100 million in assets right now and it’s expected to reach $400 million in assets in the next 10 years, that alone will require a different organizational structure, diversification of products and services and potentially charter or field of membership changes. Each of these pieces fall together to complete a framework for your next CEO candidate.
Include your credit union’s current CEO in these discussions, too. They are experts in financial services, in your market and particularly internally regarding your credit union.
Despite the stiff competition in the talent pool and a broad understanding of what’s in store for the future of financial institutions, only 68% of credit unions have succession plans in place. To maintain a thriving credit union, ensure your board is preparing for the future by:
Supplemental Executive Retirement Plans are important for not just recruiting but retaining high-quality leadership. Ensuring it aligns to the board’s vision for the credit union can be complicated, so it’s a good idea to retain outside experts. Many credit unions have long-time CEOs, and executive compensation plans have changed tremendously since the last time the board may have studied the issue.
In fact, we recommend credit unions treat their succession planning almost like strategic planning; it should be performed annually to stay on top of the issues of the day and your internal candidates’ progress. Are they filling skill gaps with education and training? How are they leading their current area of responsibility? How do they manage the politics of the organization? Review their strengths and weaknesses with brutal honesty. It’s a multi-year process to develop a real understanding of an internal candidate’s potential. Rigor matters.
Finding your credit union’s next CEO is the biggest decision the board can make and the succession plan must be carefully put in motion as early in advance as possible to ensure a smooth transition that keeps the credit union moving forward. And within that process there are a hundred other important decisions to make, from capabilities of the candidates to how they’ll be compensated. Prepare so your credit union doesn’t let your top talent go – like a rolling stone.
As not-for-profits, credit unions are limited in what they can do to recruit and retain top talent, particularly since the excise tax was implemented. All of those 457(f) plans tied to the stock market are getting costly for both the credit union and your valuable executives. They’re taking significant losses right now during the coronavirus pandemic and likely would any bear market.
Executives and their boards should be investigating split-dollar, whole life SERPs, which are very viable options. Immediately turn a 457(f) liability – especially during this time of lost income – into a performing asset with a split-dollar plan. These SERPs are based on a life insurance policy the credit union executive owns, but the credit union has a lien against it, just like a mortgage. From the first premium payment, the credit union accrues interest on the retirement pay outs borrowed against it. Plus, split-dollar SERPs experience significantly less volatility and more consistent returns. In fact, the cash value is guaranteed to increase every year when funded with whole life insurance policies.
Every SERP is customizable to the board and executive’s risk tolerances. We generally don’t write Split-Dollar SERPs with Indexed Universal Life (IUL) insurance because of the volatility in these plans. They are expected to lose money about half the time when taking into account the bear market years, so we tend stay away from them except for death benefits.
While the current environment is negatively affecting all retirement plans whole life SERPS are only experiencing downward pressure on the dividend. IULs have even greater downward pressure because caps are continually reduced, lowering the potential return, plus the market volatility, especially as distributions are paid out. Insurance companies even recommend using 70% of the maximum illustration rate on IULs when setting plans rather than the full illustration rate.
In comparison, think about the 457(f): It’s essentially a bonus based on time the executive is paid at intervals or retirement. The credit union is accruing an expense and the payout is then treated as ordinary income on the executive’s W2, which means the executive is paying federal, state, and local taxes, plus the bottomless Medicare tax. In the worst-case scenario, between the 21% excise tax and federal and state income tax, the credit union could pay out $1.21 M to get the executive $500,000 in their pocket. As much as credit unions lobby to maintain their federal tax exemption, with a 457(f), the credit union is making a conscious decision to pay taxes.
Split-dollar SERPs, on the other hand, accrue interest income from the inception of the loan; that’s why OM Financial brought the concept to the NCUA and was the first company to receive the agency’s approval for these programs. The annual payments received by the executive in retirement are not taxable. And, when the executive passes away, the death benefit is divided between the credit union and the executive’s estate – tax free! The credit union is made whole by the insurance company on its principal and interest, and the executive’s family is taken care of as well. Particularly, if the executive passes away unexpectedly early, the total benefit to their family is even more substantial.
I don’t want split-dollar accounts to seem too good to be true; there are some downsides. First, the 457(f) concludes at a finite time, while a split-dollar SERP is indeterminate because it’s based on the time of the executive’s death, so it’s considered a long-term asset. The other potential negative is when the policy is taken out, the interest rate is locked in, and both the credit union and executive would have to agree to change the terms if the other party requested.
Boards should consider the split-dollar program is also superior as a retention tool. With a 457(f), the executive is 0% vested until they’re 100% vested, but using a split-dollar SERP, boards have more flexibility to build a custom vesting schedule for each executive. Recruiting executives away from solid credit unions with strong, attractive SERPs is incredibly difficult. Don’t let someone else steal your leadership with a better deal.
When converting from a 457(f) plan to a split-dollar SERP (OM Financial will even run a free stress test on your current plans), the credit union immediately turns a liability into a performing asset, something credit unions can definitely use right now while income is down due to coronavirus. Split-dollar plans help credit union boards recruit and retain talented leadership and earn additional income, while executives and their families are also covered. A split-dollar, whole-life SERP is something for boards and executives to consider as we all move forward during this time of uncertainty.