Why and how you may need to adjust SERPs because of COVID-19, excess liquidity and the excise tax
When my colleagues at CUNA Mutual Group and I write articles about how and why credit unions should create supplemental executive retirement plans, our closing message is often this: Once you’ve created a SERP, it’s important to regularly review the plan’s progress.
This time, I’m starting with that message. And to show you why we say it so often, I’ll relate some key things we discover during SERP reviews that prompt credit unions to make adjustments that can improve SERP outcomes—for the executives and for the credit unions’ bottom lines.
The mix of products used to supplement executive retirement income most often includes 457(b) and 457(f) plans, and split-dollar life insurance agreements.
To fund the CU’s contributions to SERPs, boards are allowed by National Credit Union Administration rules to use certain investments that otherwise aren’t allowed, such as equities, corporate bonds and insurance products.
Using these less-familiar instruments is one of the reasons it’s smart for boards and executives to keep a close eye on SERP performance.
Auditors and examiners often look for you to document some extra oversight of these investments. And in recent years, we’ve come across a few more reasons to review and adjust some SERP products. This article will examine three key developments that have caused a significant number of credit unions to adjust course.
Adjusting SERPs hasn’t been high on the priority list for credit union executives and boards as they’ve dealt with the pandemic’s immediate challenges. As the crisis passes, however, it will certainly leave behind changes in credit union C-suites that will require a thorough review of executive retirement plans.
For example, COVID-19 has prompted some executives to delay or hasten their retirement. Other executives may have performed so well in responding to the pandemic that credit union boards wish to reward them now, to keep them from being poached by competitors.
The more far-reaching effect of COVID-19 on SERPs, however, is likely to be the 2020 economic downturn that some economists warn may become a double-dip recession in 2021.
Any significant economic downturn will affect some underlying investments included in SERP arrangements. A well-designed SERP takes this into account. Here’s a typical scenario:
A CU gives its CEO a 457(f) plan that vests in 10 years, with a target payout of $200,000. The plan is funded by a managed portfolio that includes equities and other market-based investments. A recession at the five-year mark causes the portfolio to underperform, and the projected payout for the 457(f) at the 10-year vesting date drops to $150,000. In addition to adjusting the portfolio’s investment mix, the CU typically has several other options:
Add more money to the portfolio funding the 457 (f). This option is simple: The credit union contributes more to purchase additional investments and increase the potential yield.
Supplement the 457(f) with a 457(b). This is one reason a 457(b) is often a good benefit to complement a 457(f). It provides an additional savings vehicle for executives with easily trackable results.
However, keep in mind that a 457(b) is not usually an adequate replacement, which is why it’s often used as an addition to an executive compensation program, rather than a primary component. For starters, the credit union’s annual contribution to this type of account is capped (the limit is $19,500 for 2021).
A 457(b) also does not have the retention power of a 457(f), which the IRS requires to include a “substantial risk of forfeiture.” In plain English, this most often means that executives are required to remain employed with the credit union until the agreed-upon vesting dates (or a series of vesting dates). Because a 457(b) is always fully vested, it provides less incentive for executives to stay put.
Restructure the plan to be “defined benefit,” ensuring it provides the target benefit. SERPs can be designed as defined-benefit rather than defined-contribution programs. Many credit unions have shied away from this structure because it places the risk of investment performance on the credit union.
In our example above, the investment portfolio could certainly be adjusted to maximize its ability to recover from the market slump over the following five years—and it’s not unusual to accomplish this, as steady recoveries often follow downturns. But if that doesn’t happen and the resultant performance is, for instance, $175,000 of investment gains, the credit union would need to pony up the additional $25,000 to provide the promised $200,000 payout.
Allow the payout to remain below its target benefit. The credit union can take action to try to improve the investment portfolio’s net performance, such as by adding invested dollars or changing investments. But if the portfolio doesn’t perform, the executive gets whatever the portfolio ends with.
For example, if the resulting net performance is $175,000 of investment gains, the executive would receive $175,000 only, and the credit union would not need to commit further capital. While this is certainly a realistic option, if the size of the benefit is significantly different from what was intended, it may not be the most motivating for executives.
Replace the 457(f) with a split-dollar life insurance agreement. Depending on your executive’s age, tenure, insurability and other factors, this may be a good option because the life insurance products used in these plans are generally less volatile sources of long-term income than equity-based portfolios.
2. Excess Liquidity
Excess liquidity is another driving factor when credit unions turn to split-dollar arrangements, both for converting 457(f) plans and for new SERPs.
Through October 2020, credit union surplus funds had reached a record high of $591 billion. And the industry’s liquidity position is expected to continue increasing in 2021, according to the December 2020 Credit Union Trends Report from CUNA Mutual Group.
While excess liquidity can be used to fund any type of SERP, using a “loan-regime” split-dollar insurance arrangement actually adds a loan to a credit union’s books.
The credit union loans the executive the amount needed to pay the premium on a life insurance policy, which is then provided as collateral to secure the loan. Generally, the loan is repaid out of the proceeds of the insurance policy’s death benefit. Ordinarily, the executive uses the policy cash values for supplemental retirement income.
Before you decide to employ a split-dollar life insurance program, consider these two caveats:
- Although the cash value growth of a whole life insurance policy isn’t directly tied to stock market results, it may be loosely tied to the performance of stock indices (indexed life insurance). The growth may also be tied to the insurance company’s ability to generate dividends (whole life insurance), depending on the type of insurance product used.
- If an indexed product is used, make sure you fully understand the product. If a whole life product is used, make sure the insurance carrier has a history of consistently strong dividend payouts. Additionally, regardless of product type, the credit risk the credit union is assuming is with the insurance company. Look for a track record of high ratings for stability and management from AM Best, Standard & Poor, etc.
- Split-dollar arrangements can take several months to implement. It takes time for underwriting to determine the premium you’ll be charged, and after that, writing the agreement can be complicated. The credit union and the executive should have legal counsel—with experience in split-dollar agreements—participate in drafting and executing these agreements.
3. The Excise Tax
The Tax Reform and Jobs Act of 2017 included a 21% excise tax that credit unions must pay on annual executive compensation in excess of $1 million to any one of the credit union’s top-five paid executives.
SERP payouts can push some executives’ annual compensation above (or further above) the $1 million threshold and trigger or increase the tax.
Some credit unions got hit with that tax in 2018 because the excise tax was added to the legislation just before it passed near the end of 2017—in some cases, there wasn’t time to find and implement suitable SERP adjustments to avoid the excise tax for 2018 SERP payouts.
When a SERP contributes to the excise tax, it’s usually because of a 457(f) plan payout. But deferrals into the other 457 plan commonly used in SERPs, the 457(b), also appear to be subject to the excise tax (IRS Notice 2019-9).
As for split-dollar life insurance policies, executives generally don’t have to pay income tax on withdrawals from the policies’ cash value, so that income isn’t subject to any excise tax charged to the credit union.
Even with 457(f) plans, however, credit unions have been able to minimize their exposure to the excise tax by following any or all of these three steps:
Step 1. Eliminate surprises: Review 457(f) vesting dates and payout amounts. Keep in mind that 457(f) plans aren’t all set up the same. Some plans have multiple vesting dates at multi-year intervals, and others have just one vesting date. Some plans have specific payout amounts, and others pay out whatever the underlying investments generate over a given time.
Look for payouts that would trigger a significant excise tax where otherwise your executive compensation would be subject to little or no excise tax.
Step 2. Restructure 457(f) plans if you can gain an excise tax advantage. You may be able to reduce an executive’s recognized income from a 457(f) plan in a given year by adding more vesting intervals. For example, instead of two planned payouts of $50,000, six years apart, shift the plan to four vesting dates three years apart, with payouts of $25,000 each.
As I mentioned above, you may also be able to supplement or replace, in whole or in part, a 457(f) plan with a split-dollar life insurance agreement.
Always work with legal counsel experienced in SERPs to make this type of change.
Step 3. Amortize the cost of the tax. If your best course of action will still result in future excise taxes, work with an accountant to minimize the impact of the tax on your income statement in any single year by accruing the expense to spread it over multiple years.
One last note about the excise tax: Remember that once an employee is considered a “covered employee” for purposes of the excise tax, that person is always a covered employee. This means that an individual who becomes one of the five highest-paid because of a SERP payout remains in the group of employees the credit union must monitor for purposes of the excise tax—even if that person isn’t among the five highest paid in subsequent years.
Don’t Wait for Execs to Ask
I began this article with the advice I usually save for the end, but it’s so important that I’ll repeat here anyway. None of the adjustments I’ve described can be possible without regularly reviewing SERP progress with your SERP providers, along with any necessary counsel from an attorney, accountant or investment portfolio manager.
Scheduling these reviews has proved critical for credit union executives, because often they won’t otherwise bring attention to their own retirement/retention benefits. Don’t let that impulse stop you from getting the most out of your investment in your best talent.
A Basic Overview: The Three Main SERP Engines
Supplemental executive retirement plans can be powerful incentives for attracting and retaining the best executive talent for credit unions. These plans provide income beyond what regulatory restrictions allow a 401(k), pension and Social Security to generate. Here’s a brief overview of the three engines that most commonly power SERPs.
This is a defined contribution plan reserved for the highly compensated employees in management. It has annual contribution limits ($19,500 in 2021). A 457(b) basically augments a 401(k) plan to generate more retirement income. Like a 401(k) plan, contributions are made pre-income tax, and earnings grow tax-deferred until they’re withdrawn. Unlike a 401(k) plan, however, the employer owns the assets until the executive withdraws them.
The participant and/or the employer can contribute to a 457(b) plan, up to the annual limit. These plans are common first steps in supplementing an executive benefits package. They’re simpler to set up and administer than 457(f) plans.
In contrast to 457(b), a 457(f) plan can be designed as a defined contribution or a defined benefit plan. The 457(f) plan also has no inherent contribution limits, so it offers more flexibility to design a program tailored to an executive’s needs. However, currently only the credit union, not executives, can contribute to the plan.
To execute a 457(f) plan, the credit union and executive enter into a written agreement, stipulating specific compensation that’s typically tied to employment over a period of time. For example, the offer to the executive might be summarized as: If you stick around for the next five years, the credit union will pay you $100,000. In effect, the credit union issues an exclusive IOU that shows up as a liability on its books, recorded over time, as an annual expense of $20,000 for five years. When the vesting date arrives, the payout is made and the IOU is complete.
Money allocated for a 457(f) plan must be subject to a “substantial risk of forfeiture.” In other words, the money won’t be taxed as income for the executive as long as the executive is prevented from receiving the money until that person meets certain requirements spelled out in the plan (typically, remaining with the credit union for a specified period).
“Split-dollar” refers to the concept of sharing the costs and benefits of a life insurance policy—including the premium payments, cash values and/or death benefits—among multiple parties. The most common type of split-dollar plan used by credit unions is the collateral assignment split-dollar (CASD), also referred to as loan-regime split-dollar.
In the CASD design, the executive owns the policy. The credit union makes an advance (or loan) to the executive to pay the policy premiums. The executive, in turn, assigns the policy back to the credit union as collateral for the loan.
The policy’s cash value grows tax-deferred. The goal is for the cash value to increase so the executive can eventually tap that money for retirement income. These plans can include vesting requirements for retention or performance goals based on the credit union’s strategic needs.
In a typical CASD arrangement, when the executive dies, part of the policy’s death benefits are used to repay the loan, with interest, to the credit union. The remaining death benefits go to the executive’s beneficiaries.