Understanding split-dollar life insurance can be challenging. At Newcleus, we’re here to simplify it. What many people don’t know about split-dollar is that there are many associated risks when it comes to this type of deferred compensation plan.
Let’s break down what split-dollar is, the benefits and associated risks (many of which are unknown), as well as how your organization can move forward in viewing split-dollar.
What Is a Split-Dollar Deferred Compensation Plan?
In short, a split-dollar plan is an agreement between two parties to split the cost and benefit of the life insurance premiums, cash values, and death benefits.
The split-dollar plans we’ll speak about here are known as either Loan Regime Split-Dollar or Collateral Assignment Split-Dollar plans. There is also a type of split-dollar called Equity Regime or Endorsement Split-Dollar, which may potentially add to the confusion, but those are quite different and we’ll address those in a future article.
What Are the Benefits of Split-Dollar Plans?
Tax-exempt entities (like credit unions) often use split-dollar plans to encourage top executives to remain with the company by providing an income-tax-free benefit to the executive.
In addition to income-tax-free benefits, split-dollar plans can also allow:
- The sponsoring credit union to book accrued income from the arrangement (if structured properly)
- Recovery of funds used to provide the plan
- Using less capital to achieve a given benefit target
- A secure counterparty to repay the credit union
The Risks of Split-Dollar
While split-dollar plans have tremendous potential benefits to the executive and the credit union, this is a type of plan where what you don’t know can hurt you!
Given the prolific use of split-dollar, many have been led to believe only the good about this type of plan. As we all learned in basic economics, there is no such thing as a “free lunch.”
Our goal for the remainder of this article is to help you better understand what you need to know about your plan (if you have one) or what you should know before entering into this type of arrangement.
To begin understanding your risk is to understand that as an executive, your benefit is absolutely NOT guaranteed under a traditional loan regime or collateral assignment split-dollar arrangement.
And to board members, did you know that the distributions you allow under this arrangement could affect whether or not your CU gets repaid under this plan?
How Newcleus Views Split-Dollar
At Newcleus, we see split-dollar plans as a tool in your kit—a hammer, perhaps. But you may need a rivet-driver, and not even know it.
Split-dollar plans need to be structured very carefully in order to reap the benefits and manage the risks. If you fail to do so, some of the risks you may face include:
- “Income” is being booked throughout the plan’s life.
- When does that actual cash flow occur?
- What does that mean for the risk of the plan?
Interest Rate Risks
- Because plan funding and credit union repayment extend over a long period of time, what happens if interest rates go up in the future?
Opportunity Cost Risks
- What are your alternative options?
- A proper break-even analysis is essential to your success.
A Final Word on Understanding Split-Dollar
While the use of split-dollar plans in compensation packages is widely accepted, split-dollar plans are often under-explained and poorly understood by boards of directors.
Newcleus wants to outlay the actual balance of risks in split-dollar. There is no benefit to an uneducated client and every benefit to a clear understanding of the risks and rewards of a well-designed split-dollar plan.
As you weigh the split-dollar plan proposed to you or review your existing split-dollar configuration ask:
- What happens if the policy rate of return doesn’t measure up to expectations?
- How much can your plan lag before the participant takes a benefit “haircut?”
- How much lower return can be tolerated before credit union repayment is in jeopardy?
Or, what happens if…
- The executive is terminated prematurely?
- The new board decides to restrict benefit payments?
- The credit union falls on hard times and ceases to exist?
- The policy performs below expectations?
For most boards of directors, inherited compensation packages do not have a clear roadmap as to how decisions that affect their executives were made.
We’re here to help you work through these plans in a logical fashion. To close this article, here are a few questions to consider that we’ve put together through our experience in restructuring a variety of unsuitable compensation plans.
- Do you have a clear plain English summary of the plan, its objective, how the credit union agreed to provide the plan, and the obligations and benefits to each party under the plan?
- Could you trace from inception to the current state exactly how the plan took its current form and the other options that were available that you didn’t select?
- Do you know the true opportunity cost of the program to the credit union under various circumstances? (Remember, there is no such thing as a “free lunch!”)
- Did independent third parties (i.e. attorneys, CPAs) review any of the plan design components before installation?
- Do you know where the plan “breaks?” Under what circumstances does the plan fail to pay the benefit to the executive? When would it fail to repay the credit union? How many things have to go right for the plan to work as intended?
- Historically, how many plans have exceeded initial modeling versus underperformed initial modeling?
- What variables within the policy can affect the benefit to the executive and repayment of the credit union?
- What controls does the credit union have to protect its repayment under the plan?
- What protections (if any) does the executive have to protect their expected benefit from the plan?
- What happens if the credit union/sponsor and executive are at odds with one another?
- What happens if a future board doesn’t look favorably on the plan or former executive?
- What if your current agent retires or goes out of business?
- What happens to your accounting if the executive cannot demonstrate the “ability to repay” any shortfall between policy cash value and note value (plus interest)?
Newcleus is Here to Help
Reach out to one of our professionals at Newcleus today.
Our team has found that when a full assessment and proper due diligence are performed, most executives and sponsoring credit unions decide to use split-dollar as one of a number of diverse SERP options. Split-dollar has inherent risks – which is why it also has such a strong upside reward.
Utilizing various forms of executive compensation allows you to keep your key executives in place to enhance your credit union’s growth. Do you know how quickly your credit union needs to grow to remain competitive? Read our recent article describing how to get started on your credit union’s strategic growth plan.