Should you lower the rate on your CEO/Executive’s Split-Dollar Loan?
Loan Regime Split Dollar (also known as Collateral Assignment Split Dollar) has become a VERY popular deferred compensation arrangement for credit union and non-profit executives. When structured appropriately, the plan is relatively flexible, has advantages from a taxation and booking standpoint. A properly managed plan may allow for modifications that support your credit union and executive’s needs.
Within the last year, the current financial environment has led to lowered interest rates. Because of this traditional life insurance policies dividend rates have declined. As we look to the future, we forecast this trend may continue. The low rate environment we’ve seen has caused the AFR (applicable federal rate) to decline as
The AFR is the minimum interest rate that the IRS allows for private loans. As of December 2020, the AFR was 1.31%.
As a result of the lower policy dividend expectations and the lowered AFR, many credit unions are considering lowering the rate of interest on the loan component of their Loan Regime Split-Dollar Plan (also known as Collateral Assignment Split-Dollar Plan). As a key stakeholder at your credit union, what should you consider when reviewing this type of adjustment?
What is split-dollar?
Split-dollar life insurance is, put simply, an agreement between two parties that ‘split’ the benefits and ownership rights of an insurance policy. The employer and employee share the premium cost, cash value, and death benefits of a permanent life insurance policy.
There are two types of split-dollar – “Loan Regime” or Collateral Assignment Split Dollar and “Equity Regime” or Economic Benefit Split Dollar. The most popular version in credit unions currently is Collateral Assignment (Loan Regime).
Under a collateral assignment split-dollar life insurance arrangements (CASD) the key executive is the owner and insured of the life insurance policy. The role of the business in this policy is to pay premiums using a loan or series of loans to the executive to pay premiums due on the policy. On the business’ balance sheet, it is looked at as a long term asset and is normally classified as a loan.
With CASD, the beneficiary is split between the business recovering repayment of the loan plus any accrued interest on the loan and the executive’s beneficiary. The is all secured by a collateral assignment using forms provided by the carrier or a duly qualified attorney. The collateral assignment protects the credit union from improper action by the executive. A key aspect of most plans in force today is the repayment of the loan from death benefit proceeds. Meaning, the plan will persist until the death of the executive. For reference, a 65-year-old male in 2019 is expected to live to age 85 on average, a female of the same age is expected to live to age 87.
Historically, the loans made to finance the purchase of the policy have taken different forms depending on the prevailing rate environment. Currently, the most common structure is a term loan arrangement. The term loan structure involves the credit union making a single loan for the entire amount of premiums due to the policy. This loan can bear interest or not bear interest. Commonly, the rate of interest is set at the minimum required rate under section 7872 to avoid income taxation. This rate is the Applicable Federal Rate and is declared through ongoing revenue rulings throughout the year.
The rate of interest charged on the loan to satisfy this requirement is not set in stone. This is the crux of the current push to refinance existing loans for the plan at lower current rates.
What should you consider with regard to adjusting the interest rate of your credit union’s split-dollar insurance agreement(s)?
This analysis requires consideration of both qualitative and quantitative factors. From the qualitative standpoint – the plan objective and goal of the board with regard to the plan must be reviewed. Was this plan structured in order to provide a benefit target regardless of policy performance, or was the benefit target known to be at risk based on other negotiated benefits to the executive? In short, is the board obligated to adjust the plan based on its philosophy or other norms? Will the same approach be used for other executive participants in a similar plan? Will the same accommodation be expected to continue after the executive has separated from the Credit Union? Remember- the plan ends at the executive’s death.
Quantitatively what is the cost to the credit union of making such a change? Is there a way to recover a portion of the income expected by the credit union if rates change direction between now and the end of the plan? What is the present value of such an adjustment (the value today of sums to be paid in the future)? What further changes may be warranted if policy performance is challenged? Finally – what is the best, worst, and expected case scenario given what we know today? Obtaining that information and reviewing that information with a knowledgeable non-conflicted party is key to both making the right decision for the Credit Union and executing your fiduciary duty as a board member.
With a decrease in long-term interest rates, it might seem like a favorable time to consider restructuring your collateral assignment split-dollar plans. This choice, when executed properly, can help improve your executive’s benefit.
What other alternatives might you consider?
Other alternatives you might consider under advisement may involve augmenting the current plan with a secondary plan that is different in form – for example – balancing a 457(f) arrangement with the CASD arrangement. Additionally, for larger plans on higher compensated executives, you may consider further diversifying. This can be done by using a combination of Traditional (Whole) Life, Indexed Universal Life, and 457(f) to further spread the risk of any one plan design derailing the benefit to the executive.
We have deep experience at Newcleus Credit Union Advisors modeling the contingencies of all plan types. In addition, we have worked with both credit unions and their legal council to develop innovative solutions to the concerns outlined above. We would be delighted to discuss your situation and see how we might help you.