Durability: Will your executive benefits plan retain its value over time?

Good household budgeters often estimate expenses on the high side and revenue on the low side—so their actual bottom line hits the target. For the first 15-plus years of my now 30-year career in finance, I helped individuals with their personal finances and saw this approach work time and time again. Being thoughtful and thorough helped people come out well, despite any unexpected bumps.

When I started helping credit unions and other non-profits with supplemental executive retirement plans(SERPs) more than a decade ago, I found that a similar approach works here, too. When structured in a safe and sound way—and not created based on too rosy a projection—SERPs are more “durable.” That is, they are much more likely to retain their value over time. This means executives can rest easy knowing they’ll retire with the funding they’re expecting! It’s also important for boards that want to set up plans that truly benefit their top leaders when they retire.

Let’s talk a bit more about creating durable SERPs by focusing on two areas: structure and thorough projections.

Building more than 300 supplemental executive retirement plans to date that are delivering their original projected benefit or greater has given me a lot of time to think about how to do it well. A key factor in structuring a plan to actually pay out as planned when an executive retires is to build it on whole life insurance.

Stay with me. 

When a SERP is based on whole life insurance, the credit union and the executive get a fairly stable dividend based on the insurance company's performance. The returns are more consistent and avoid sequence of returns risk, which I’ll explain in a moment.

This is in contrast to indexed universal life insurance plans, which carry a lot more volatility, making it much more difficult to ensure a plan will deliver on its promise at retirement. This problem with IUL includes non-guaranteed caps, sequence of returns risk (which we often call “the luck factor”), and IUL’s inherent complexity. We offer a webinar that explains these in more detail.

An insurance company sets an annual maximum—a cap—on the rate of return IUL policyholders can get. The rate is chosen to ensure that the insurance company does well and can change at any time. There is no underlying guarantee that an insurance company will set the cap at a particular rate nor does any rule say it must set the cap at a particular rate. What this can mean in practice is that even if the market soared to 20%, the insurance company’s annual cap could limit you to a 7.5% return on your IUL investments. You ultimately are losing more upside potential than gaining downside protection.

With IUL, returns don't depend on average market performance—they depend on when those returns happen. This is called "sequence of returns risk" and, while it’s not likely to happen, the wrong timing can decimate an executive’s retirement funding.

During the accumulation phase (when you're putting money in), a few bad years can significantly reduce a policy's growth potential. But the real danger comes during the distribution phase when the executive is ready to withdraw money for retirement. Each withdrawal during a downturn depletes the policy’s cash value faster, creating extreme pressure for retirement funding. If you want to consider the worst-case scenario, factor in the cost of insurance and the way the cap might limit your investment growth.

We think if more executives and boards fully understood sequence of returns risk, they would only structure SERPs using the much more predictable and reliable whole life insurance product.

As if sequence of returns risk weren’t enough, IUL policies are mind-bogglingly complex. The ultimate retirement income from an IUL plan will be affected by many factors—caps, cost of insurance, fees, sequence of returns risk, and the cost of interest. This complexity makes it difficult to accurately project the plan’s outcome.

The good household budgeters I talked about at the beginning of this article estimate future income and expenses with meticulous caution. They consider a variety of scenarios by looking at all the influencing factors and the range of potential outcomes. This is exactly what needs to be done when setting up a SERP.

Some key things to consider include:

If a SERP’s anticipated returns are unfulfilled by the underlying investment (the life insurance policy), the executive’s benefit may be less—or far less—than projected when retirement withdrawals begin.

While SERP design doesn’t impact the cost of living an executive will face when retiring, the potential for higher-than-anticipated costs at retirement is another good reason to design your plan to be highly likely to deliver on—or even exceed—its projected payout. Such sound design will be helpful to the executive regardless of their ultimate income need at retirement.

If the executive faces a funding gap at retirement, how much stress will that cause?

Let’s recap. Here are three key ideas for SERP success based on PARC Street’s many years of experience setting up durable plans:

SERPs are a wonderful tool for credit unions and executives that want to PARC: Plan for retirement, better Attract the right people, Retain their key people, and deliver on a complete Compensation strategy.

The key to designing a good SERP isn't predicting the future perfectly. It's preparing thoroughly for whatever that future might hold. We’d be delighted to help you sort through the options.