Boards can do an analysis, then use supplemental retirement programs to help close any gaps.
Sponsored by Risk Strategies/IZALE Financial Group
The COVID-19 pandemic ushered in an era of workplaces changes that may prove as disruptive as the industrial revolution. The introduction of remote work allowed employers—both you and your competitors—to retain key people who could not otherwise make it to an office and expanded the area from which to recruit new talent. As the economy regained steam, this fed into larger-than-normal increases in cash compensation. For many, this has resulted in an imbalance with other forms of compensation.
It is critical to balance current cash compensation with the long-term goal of wealth accumulation. When it comes to helping CEOs and other top credit union executives prepare now to have enough income in retirement, boards often don’t know where to begin. The best practice is to start with a “retirement income analysis.” If you’ve done an RIA before, it is best practice to recalibrate it every three or four years.
The goal of an RIA is to reasonably estimate the percentage of an executive’s income that could be replaced by current employer-funded programs. The RIA should capture the 401k-match potential, expected profit-sharing contributions, projected pension benefits, existing executive benefits and half of the projected Social Security benefit. Reasonable rates of return during the accumulation and distribution phases are applied, arriving at an estimated benefit in retirement.
This estimate is then compared to the executive’s projected final average cash compensation at retirement. When estimating FACC, use reasonable short- and long-term growth rates. The most common long-term rate is 3.5%, although there is some trend toward 4%. The short-term rate should be the same for “seasoned” executives and reflect more rapid increases typical for those new to their roles. For example, the cash compensation of a first-time CEO is often 85% of the mid-point for the position. As experience is gained, the cash compensation is adjusted to reach the mid-point by the fourth or fifth year. This means increases could be 10% for the first few years.
Next, divide the estimate of future benefits by FACC. The result is a projected replacement ratio, and that should be compared to the target replacement ratio, that is, the percentage of final average cash compensation the employer wants to provide as retirement income.
There is considerable art in setting a target replacement ratio, with two key elements:
- Know where an executive’s current cash compensation is relative to the market. We have clients who are below market in current cash compensation, and they adjust the target upward. Conversely, those who are above market adjust the target downward.
- We encourage use of a “factor per year of service” that is comparable to the factors of a non-executive employee who would serve your organization for 30-plus years. This means that an SVP who serves your organization for 30 years could have a higher target replacement ratio than the CEO hired at the age of 55 who would only serve 10 years.
The Role of Supplemental Retirement Programs
If the target ratio exceeds the projected ratio, there’s a shortfall. (If there’s no shortfall, some boards desire a minimum level of benefit from supplemental executive retirement programs anyway.)
The question from the RIA should be: If we do nothing more and there’s a shortfall or we want to offer a minimum benefit, how do we do that? Only then should you consider one or more of the four solutions for providing supplemental benefits.
- 457(b): This program has an annual contribution limit ($22,500 for 2023), which can be invested or given some rate of return. Typically, only the contribution is a net annual expense for the credit union and results in a growing balance sheet liability. The executive can vest before retirement without triggering ordinary income tax, and there can be no in-service distributions. At termination, you can offer an election in how vested amounts are paid.
- 457(f) or Supplemental Executive Retirement Programs: This program has no annual limit except reasonableness. It can be a current contribution that is invested or given some rate of return or a defined benefit at a future date or dates. A SERP generally has the highest expense and results in a growing balance sheet liability. Vesting causes immediate recognition for income tax purposes, which should also trigger a lump sum payment to avoid a cash flow crunch for participants. Understand the impact on the employer of the Tax Cuts and Jobs Act of 2017 on such distributions.
- REBA or Restricted Executive Bonus Arrangement: This uses a life insurance policy owned by and insuring the executive. Life insurance enjoys the most favorable tax treatment (no tax on accumulation, ability to structure tax-free distributions, tax-free death benefits) while providing greater benefit security to the executive. Premiums are expensed annually by the employer and taxed as ordinary income to the executive, often with a tax gross-up bonus. The cumulative expense is comparable to a 457(f), however, there is no balance sheet liability.
- SDL or Split-Dollar Loan. An SDL arrangement also uses life insurance. However, premiums are treated as a loan for income tax and accounting purposes. The policy is assigned to the employer and is often the only source of repayment of the loan. This results in significantly lower income taxes for the executive and an asset for the employer. Interest on the loan accrues, is imputed to the executive, or some combination of both. SDL has the lowest P&L impact of the options, as a tradeoff to using liquidity on the balance sheet.
Chris Richardson is senior consultant with Risk Strategies/IZALE Financial Group, a CUES Supplier member. The team at RSC/IZALE has helped design and implement more than 1,175 benefit plans for financial institution executives, and services more than $2 billion of cash surrender value for their clients. Don’t put the cart before the horse. To conduct a no-cost RIA and learn more about these options, contact us today.