As not-for-profits, credit unions are limited in what they can do to recruit and retain top talent, particularly since the excise tax was implemented. All of those 457(f) plans tied to the stock market are getting costly for both the credit union and your valuable executives. They’re taking significant losses right now during the coronavirus pandemic and likely would any bear market.
Executives and their boards should be investigating split-dollar, whole life Supplemental Executive Retirement Plans (SERPs), which are very viable options. Immediately turn a 457(f) liability – especially during this time of lost income – into a performing asset with a split-dollar plan. These SERPs are based on a life insurance policy the credit union executive owns, but the credit union has a lien against it, just like a mortgage. From the first premium payment, the credit union accrues interest on the retirement pay outs borrowed against it. Plus, split-dollar SERPs experience significantly less volatility and more consistent returns. In fact, the cash value is guaranteed to increase every year when funded with whole life insurance policies.
Every SERP is customizable to the board and executive’s risk tolerances. We generally don’t write Split-Dollar SERPs with Indexed Universal Life (IUL) insurance because of the volatility in these plans. They are expected to lose money about half the time when taking into account the bear market years, so we tend to stay away from them except for death benefits.
While the current environment is negatively affecting all retirement plans, whole life SERPS are only experiencing downward pressure on the dividend. IULs have even greater downward pressure because caps are continually reduced, lowering the potential return, plus the market volatility, especially as distributions are paid out. Insurance companies even recommend using 70% of the maximum illustration rate on IULs when setting plans rather than the full illustration rate.
In comparison, think about the 457(f): It’s essentially a bonus based on time the executive is paid at intervals or retirement. The credit union is accruing an expense and the payout is then treated as ordinary income on the executive’s W2, which means the executive is paying federal, state, and local taxes, plus the bottomless Medicare tax. In the worst-case scenario, between the 21% excise tax and federal and state income tax, the credit union could pay out $1.21 M to get the executive $500,000 in their pocket. As much as credit unions lobby to maintain their federal tax exemption, with a 457(f), the credit union is making a conscious decision to pay taxes!
Split-dollar SERPs, on the other hand, accrue interest income from the inception of the loan. The annual payments received by the executive in retirement are not taxable. And, when the executive passes away, the death benefit is divided between the credit union and the executive’s estate – tax free!1 The credit union is made whole by the insurance company on its principal and interest, and the executive’s family is taken care of as well. Particularly, if the executive passes away unexpectedly early, the total benefit to their family is even more substantial.
I don’t want split-dollar accounts to seem too good to be true; there are some downsides. First, the 457(f) concludes at a finite time, while a split-dollar SERP is indeterminate because it’s based on the time of the executive’s death, so it’s considered a long-term asset. The other potential negative is when the policy is taken out, the interest rate is locked in, and both the credit union and executive would have to agree to change the terms if the other party requested.
Boards should consider the split-dollar program is also superior as a retention tool. With a 457(f), the executive is 0% vested until they’re 100% vested, but using a split-dollar SERP, boards have more flexibility to build a custom vesting schedule for each executive. Recruiting executives away from solid credit unions with strong, attractive SERPs is incredibly difficult. Don’t let someone else steal your leadership with a better deal.
When converting from a 457(f) plan to a split-dollar SERP (OM Financial will even run a free stress test on your current plans), the credit union immediately turns a liability into a performing asset, something credit unions can definitely use right now while income is down due to coronavirus. Split-dollar plans help credit union boards recruit and retain talented leadership and earn additional income, while executives and their families are also covered. A split-dollar, whole-life SERP is something for boards and executives to consider as we all move forward during this time of uncertainty.
1Distributions under the policy (including cash dividends and partial/full surrenders) are not subject to taxation up to the amount paid into the policy (cost basis). If the policy is a Modified Endowment Contract, policy loans and/or distributions are taxable to the extent of gain and are subject to a 10% tax penalty. Access to cash values through borrowing or partial surrenders will reduce the policy’s cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured. The information provided is not written or intended as specific tax or legal advice. OM Financial Group, its subsidiaries, employees, and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.