CARES Act impacts—followed by rising interest rates during a lengthy recovery—can make non-703 investments for benefits pre-funding and CDA programs worth another look.
The impact of the COVID-19 pandemic on credit union income statements won’t be clear for many months or even years, but it’s not too soon to consider some long-term recovery strategies. One of these could be shifting more of your investments to those allowable for employee benefits pre-funding programs and/or charitable donation accounts.
Some of the most likely income losses from this crisis include:
- Net interest margin: Restructuring loans at lower rates and deferring loan payments will hurt net interest margins. A flight to safety by members could also result in credit unions parking excess liquidity in short-term investments due to increasing interest rates that make long-term bonds unattractive.
- Fee and other income: The National Credit Union Association issued guidance on March 16 about reducing or waiving fees for non-sufficient funds, skip-pays, loan restructurings and foreign ATM usage.
- Loan losses: Despite federal relief efforts, charge-offs will probably increase for most credit unions, at least through 2020. And, in times of financial distress, lenders must often tighten underwriting standards to manage risk.
To begin repairing income statements, your board and leadership team should take a fresh look at all potential income sources, including investments.
Easing Burdens on Employees and Communities
Benefits pre-funding programs and CDAs can aid your efforts to support employees and their communities through the many difficulties COVID-19 will create in the coming months and years. These programs can use expanded investment options—including managed money portfolios—allowed by NCUA and many states.
These portfolios can include directly owned securities (rather than securities contained in a mutual fund, for example), which otherwise generally aren’t permissible under the Code of Federal Regulations, Part 703. NCUA recommends that credit unions invest no more than 25% of their net worth in non-703 investments, and a maximum of 15% for any single non-government obligor.
An employee benefits pre-funding program is designed to offset expenses for, among other things:
- health insurance plans;
- supplemental executive compensation; and
- group life and disability insurance.
Charitable donation accounts help credit unions fund philanthropy using investments with the potential to generate greater returns, at greater risk, than certificates of deposit and other traditional credit union investments. NCUA regulations require that credit unions donate at least 51% of CDA investment returns to qualified 501(c)(3) charities at least every five years. Credit unions that fulfill this and other requirements can retain up to 49% of the CDA’s returns as income.
Managing Investments and Liquidity in a Rising Interest Rate Environment
In addition to using managed money portfolios to fund employee benefits expenses and charitable programs, these investments may be able to offset interest rate risks that typically accompany economic recoveries.
Anticipating that interest rates on standard credit union investments will be steadily increasing, as they did after the Great Recession, credit unions may lean toward shorter-term investments for some time.
NCUA and/or state examiners will certainly want to see that credit unions are managing interest rate risk effectively. However, if you are using managed portfolios that include equities to potentially offset loan margin compression, you may have to address examiners’ concerns about liquidity. This is because these equities have a reportable liquidity of 10-plus years. But in reality, you can choose equities that usually can be converted into cash in a few days.
Liquidity may be a serious short-term issue if you are making a high volume of Paycheck Protection Program loans to member businesses. But the deadline to apply for these PPP loans, according to the Coronavirus Aid, Relief, and Economic Security Act is June 30, 2020, so any liquidity crunch that PPP loans create should be brief.
Also, the CARES Act includes changes to the Central Liquidity Facility to provide liquidity support to the credit union system through the end of 2020. This, plus a slowdown in auto lending and an increase in savings, may actually leave credit unions with excess liquidity early in the recovery.
Expert Assistance is Crucial
A professionally managed portfolio can be an advantage over mutual funds in that the portfolio’s equities are chosen for your credit union’s specific needs and risk tolerances, in contrast with mutual funds that are managed for mass markets. Also, the portfolio can be rebalanced when you choose.
You may also balance the funding for CDAs and benefits pre-funding programs with more conservative instruments such as insurance products that otherwise aren’t allowed under Part 703.
In whatever way you choose to manage your income statement in the aftermath of COVID-19, be sure to get expert assistance and document the reasons behind your choices.