Two scenarios when you might consider restructuring split-dollar life insurance agreements
In recent years, credit unions have been dedicating more assets to split-dollar life insurance arrangements to reward and retain top executives. According to National Credit Union Administration 5300 data, assets for collateral assignment split-dollar life insurance—the most common type of split-dollar arrangement for credit unions—increased 120% from year-end 2015 through 2018.
If your credit union has been part of this trend, consider re-evaluating your split-dollar plans in light of this year’s decrease in long-term interest rates. You may be able to improve the benefit for your executive and/or make the underlying loan a more valuable asset for your credit union.
(Learn more about CASD or “loan regime” split-dollar insurance arrangements in the CU Management article, "Why Split-Dollar Life Insurance is Gaining Popularity.")
Underlying Advantages of Collateral Assignment Split-Dollar Programs
Before I get into the reasons you might restructure your existing CASD agreements, let’s look at why these arrangements are growing so quickly.
In a typical CASD plan, the credit union issues an executive a loan to pay the premiums on a permanent life insurance policy that the executive owns. In turn, the executive assigns the policy back to the credit union as collateral for the loan. This arrangement has a couple of key advantages over other supplemental executive compensation tools, such as 457 plans:
- Tax-free income—executives don’t pay income tax when withdrawing from the life policy’s cash value. The death benefit also goes to beneficiaries tax-free.
- The credit union books the loan as an asset, on which it can earn interest, rather than as an expense.
Why You Should Re-Evaluate Existing Split-Dollar Arrangements
This summer, the yield on long-term U.S. Treasury Bond rates dropped below short-term rates for the first time in a few years. Since then, I’ve been working with credit unions to evaluate restructuring their split-dollar agreements, mainly in one of two situations:
Scenario 1: An executive who has an interest-free, short-term demand loan from the credit union can benefit from switching it to a long-term hybrid loan.
For credit union executives who received an interest-free loan to pay for a split-dollar life insurance policy, the IRS levies an income tax based on a market-based imputed interest (based on the IRS’s Applicable Federal Rate or AFR).
For example: A CEO has a short-term demand loan, interest-free, of $100,000 as part of a split-dollar arrangement. If the IRS’s short-term blended AFR is 2.42%, the executive will be taxed on $2,420 of imputed (estimated) income.
Some credit unions give the executive a bonus to cover that additional income tax, while some executives pay it out-of-pocket.
If your credit union has one or more split-dollar agreements like this in place, consider converting the loan to a long-term hybrid loan, with the term being the executive’s lifetime. The IRS’s (annually compounded) long-term AFR for November 2019 was 1.94%, compared with the short-term blended AFR of 2.42%.
If your credit union is paying a bonus for that amount, you’ll save money. And if the executive is paying the additional tax, you’ll be increasing the value of this benefit.
Scenario 2: An executive refinances an existing split-dollar arrangement’s long-term hybrid loan because the rate is higher than the IRS’s current long-term AFR.
This one is simple. Treat an existing long-term loan for life insurance premiums as you would a mortgage loan during a period of reduced rates: Refinance it and reduce your compounding interest.
If your credit union created a split-dollar life insurance agreement more than a few months ago using the AFR for the premium payment loan, chances are the long-term hybrid loan rate was considerably higher than October 2019’s rate of 1.86%. In July 2019, it was 2.5%; in October 2018 it was 2.99%.
If your credit union is looking into improving an executive’s existing supplemental compensation, this could be a good opportunity to accomplish that. This is also an opportunity to review an existing split-dollar policy’s performance so far and make adjustments if the policy isn’t projected to meet the target benefit.
Adjusting Split-Dollar Agreements Requires Due Diligence and Expertise
Many factors play into whether it makes sense for you to restructure a split-dollar agreement. Ask your provider to help you analyze whether the loan within your credit union’s split-dollar program is eligible for a switch in term lengths, a refinance or other adjustments. And always involve your legal counsel, and that of the executive, to ensure that each party is represented fairly.
Eric Earle is an executive benefits advisor for CUESolutions platinum provider CUNA Mutual Group, Madison, Wisconsin. For more information about supplemental executive compensation, read the CUES ebook, Non-Qualified Executive Benefits: A Guide for Credit Union Leadership. To learn more about becoming a CUESolutions provider, email Kari Sweeney.