5 Steps to Get More from Employee Benefits Pre-Funding Plans
As credit unions continue to navigate challenges in hiring, talent retention, and demands for greater workplace flexibility, paying for rising benefits expenses is a common challenge. Financial institutions are focused on extracting the maximum value possible from their investment portfolios to keep pace with growing expenses amid the historically low interest rate environment and shrinking loan to deposit ratios.
NCUA regulation 701.19(c) offers federal credit unions expanded investment authority to pre-fund employee benefit plan obligations using non-traditional investments. Many states mirror this language, which allows credit unions to invest in otherwise impermissible asset classes and build a portfolio with a return profile more likely to keep pace with their rising benefits costs.
Here are five simple steps to help you get started:
1. Understand Your Options
There are two broad categories that credit union pre-funded benefits investments fall under: insurance assets and securities. Insurance products have long been used by financial institutions, mainly in the form of institution-owned life insurance (COLI/BOLI/CUOLI). Most purchasers of these products are attracted by “guaranteed” returns and accounting friendliness, but a deeper dive might leave you thinking otherwise.
Policies can be structured in a variety of ways, yet always with complex administrative and legal architecture. General account policies are most common given their seemingly straightforward return profile but lack risk transparency and require faith in the insurance carrier to provide consistent returns at stable fees. Separate account policies improve upon general account via added investment control but retain a key [costly] feature not to be overlooked: the tax advantage. Life insurance products are tax shelters, which is a strong selling point for taxable entities such as banks. However, this feature is often misaligned with the needs of credit unions, raising the question: Is traditional institution-owned life insurance the best investment vehicle for employee benefits pre-funding?
2. Define Your Risk Appetite
Separately managed investment portfolios have seen increasing popularity in recent years as an alternative to insurance products, offering more transparency, simplicity, and customization at lower overall costs. There is no regulatory cap on the aggregate size of 701.19(c) investments for federal charters, and nearly unlimited strategy options based on risk appetite and return objectives. As such, preliminary conversations between the Board of Directors and executive management team should center around risk preferences and education before defining and implementing a strategy.
Expanded investment authority goes hand in hand with the potential for greater risk. As with the core investment portfolio, a pre-funded benefits portfolio should complement the balance sheet in an asset/liability management (ALM) framework. Attention should be given to macro-factor risk exposure including interest rate, credit, and liquidity risk and the institution’s marginal capacity to take on each.
Pre-funded benefits portfolio strategies frequently lean on credit and liquidity risk exposure for enhanced returns, often via investment grade senior and subordinated corporate debt instruments. Institutions with higher risk tolerances may also elect to layer in equity exposure, known equally for its volatility and unmatched returns. Three common strategies, each with varying degrees of equity allocation, are shown in Exhibit 1.
Exhibit 1
Source: ALM First. Past performance is no guarantee of future results.
Returns are for the trailing ten-year period ending September 30, 2021. Returns are net of model fees, which is the highest fee a client would be charged for following this model. For more details on the methodology and benchmark comparisons please see the disclosure.
3. Consider the Accounting
Understanding the accounting treatment investments will receive is vital to the education process, particularly as it pertains to equities. While fixed income investments may be held available-for-sale, mutual funds, exchange traded funds (ETFs), and other common equity investments require a mark-to-market treatment which can cause volatility of the earnings statement and capital position.
Traditionally, more risk averse institutions have turned to insurance products or an exclusively fixed income portfolio, but another option exists: an insurance “wrap” known as a Stable Value Annuity (SVA). Compared to BOLI/COLI/CUOLI products, the annuity product is a much simpler and more cost-effective structure which also provides preferrable accounting treatment. The “wrap” is provided by an insurance carrier and the SVA technology smooths the accounting impact of more volatile market movements.....-->
As credit unions continue to navigate challenges in hiring, talent retention, and demands for greater workplace flexibility, paying for rising benefits expenses is a common challenge. Financial institutions are focused on extracting the maximum value possible from their investment portfolios to keep pace with growing expenses amid the historically low interest rate environment and shrinking loan to deposit ratios.
NCUA regulation 701.19(c) offers federal credit unions expanded investment authority to pre-fund employee benefit plan obligations using non-traditional investments. Many states mirror this language, which allows credit unions to invest in otherwise impermissible asset classes and build a portfolio with...