Here’s help understanding better options than a single premium immediate annuity.
We are frequently seeing a single premium immediate annuity as part of a split-dollar loan proposal. This is bad and should stop.
Let me explain what we mean.
Split-dollar loans remain a popular form of executive benefit, driven by a more favorable financial impact on the credit union compared with other benefit forms and the potential for income-tax-free benefits for the executive.
A split-dollar loan uses a life insurance policy owned by the executive that is paid for by the credit union. The credit union’s payments are treated as a loan to the executive under Internal Revenue Service income tax regulations (hence the name). If the credit union is to be repaid by the policy cash value or death benefits premiums plus interest at the IRS-determined applicable federal rate, the executive recognizes no taxable income.
The key under the income tax regulations is that each credit union payment must use the applicable federal rate for the month such payment is made. Once the payment is made, the AFR is locked in until the loan is repaid. Payment periods for the underlying life insurance policies are typically seven to 10 years, which presents a modeling challenge to project—guess, really—what the AFR will be in future years (especially in this rising rate environment). To eliminate this uncertainty, it is generally better to have all credit union payments pre-paid at inception and thus lock in a known rate.
To maintain favorable income tax treatment on policy distributions, however, these premiums can’t be prepaid per se. Doing so creates a modified endowment contract, which is a cash value life insurance policy that gets stripped of many tax benefits.
Instead, the best practice is to use the insurance carrier’s premium deposit account or PDA. With a PDA, the insurer accepts advance premiums without commission and often even credits interest on the PDA balance. The best PDAs also have no surrender charges.
But what if your carrier doesn’t offer a PDA? Or has one with a surrender charge? Or limits the deposit needed to fund the policy? This is most often where we see the single premium immediate annuity or SPIA presented as a solution for premium pre-payments. (Beware the broker who presents a SPIA when the carrier offers a PDA!)
A SPIA is one of the simplest types of annuity contracts. When you establish one, you make a single large deposit with an annuity company, and your payments begin immediately. While SPIAs are easy to understand, buying them requires some foresight.
The challenge is that—unlike the best PDA accounts—all of the SPIAs we’ve seen have surrender charges. This means that one party or the other (the credit union or the executive) suffers by having to account for the surrender charges as if they applied. The only party that wins is the broker who gets additional commission.
A better solution for when the desired PDA is not available from the carrier is to have the credit union hold the premium pre-payments—yes, a PDA at the credit union. There is no commission, there are no surrender charges creating accounting issues, and future policy payments can be paid from the account.
Executive benefits plans like split-dollar loans are so important in today’s world where the war for talent rages on. But as you put benefits in place, be sure you’re getting the best advice so you can structure you plan to the fullest benefit of the executive, the credit union and, ultimately, the members they serve.
Scott Richardson is founder/CEO of IZALE Financial Group, a CUES Supplier member. The team at IZALE has helped design and implement more than 1,150 benefit plans for financial institution executives, and services more than $2 billion of cash surrender value for their clients. To learn more about the nuances of split-dollar loan design, contact IZALE Financial Group today. Let us help you implement and service a program tailored for your objectives.