Over the past decade, the use of split dollar plans has grown significantly as credit unions look to strengthen executive benefit programs for key leaders. I have the opportunity to work with credit union executives and boards across the country to review existing benefit plans and design new plans. The spike in interest rates over the last few years and the uncertainty that surrounds future interest rates has led to two common questions. How do higher interest rates affect my split dollar plan? And, are new plans still a viable option?
When considering the impact of interest rates on a split dollar plan, there are primarily three ways that interest rates come into play.
- Applicable Federal Rate (AFR): The AFR is generally the interest rate that the credit union charges on the loan to the plan participant. The AFR is the minimum interest rate the IRS allows on private loans to avoid tax penalties. There is a long-term, mid-term, and short-term AFR. The IRS sets the AFR monthly based on the average market yields of outstanding U.S. Treasury marketable obligations.
- Life Insurance Policy Return Rates: Interest rates have a direct impact on the projected rate of return on the life insurance policy (or policies) funding the split dollar plan.
- Internal Policy Loan Rates: Most split dollar plans are designed to utilize internal policy loans to deliver the living benefit to the plan participant. These internal policy loan rates typically move with the interest rate environment and impact the policy’s net cash value.
Returning to the most frequently asked questions, let’s start with the easy question: Are new split dollar plans still a viable solution to provide an executive benefit plan? Absolutely! Split dollar continues to be the most common solution utilized in the credit union space. Whether your new split dollar loan is designed to accumulate loan interest or have the credit union forgive the required loan interest, the increased AFR has an impact on the required investment amount.
When comparing plans implemented today versus plans established four to five years ago, the required investment has typically been higher, but the projected return to the credit union has also increased. If the larger investment amount becomes a challenge for a particular credit union, i.e. liquidity, regulatory capacity, etc., there are plan adjustments that can keep split dollar a viable option.
How do higher interest rates impact my existing split dollar plan? Going back to my initial three points, here’s how each could impact your plan.
1. What impact does a higher AFR have on my in-force split dollar plan?
The answer is—it depends. As outlined above, split dollar plans can vary based on how the loan interest is managed. Interest can be accumulated over the life of the plan, or it can be forgiven in full or forgiven partially. Some plans lock in the long-term AFR at implementation, while others may introduce more volatility by using a short or mid-term rate. The impact of a higher AFR on your plan depends entirely on how the plan was structured.
Here are some of the most common loan interest-related scenarios—each of which may impact your plan or your credit union differently depending on how the plan is structured:
- Accumulate interest at the long-term AFR: The most common split dollar plan design is to accumulate interest at the long-term AFR. If your plan is locked in at a long-term AFR lower than the current rate, the higher AFR will not have a direct impact on your existing plan. Your plan will continue to accumulate interest at your locked in rate. If the current long-term AFR dips below your established rate, it’s worth discussing a potential split dollar loan refinance with your service provider.
- Forgive interest at the long-term AFR: If your plan design is to forgive interest and you locked in a long-term AFR below the current rates, the increased AFR will not have a direct impact on your existing plan. If the current long-term AFR dips below your established rate, you should consult with your service provider whether refinancing the split dollar loan makes sense.
- Forgive interest at a short-term AFR or blended AFR: If your split dollar plan is designed to forgive interest but you are using a short-term AFR or a blended AFR rate, the current higher AFRs may have a material impact on your split dollar plan or to the credit union. When using a short-term rate, the amount of forgiven interest moves with the current AFR.
Depending on when your plan was implemented, the original forecast may have projected a blended AFR or short-term AFR that is much lower than current rates. If rates have increased and the credit union is forgiving interest at a higher rate than initially modeled, it could be introducing an additional expense to the credit union by way of higher gross-up bonuses to offset the tax on forgiven interest vs what was assumed in initial models. This creates a material increase in expenses for the credit union. In split dollar plans designed to forgive interest, the executive may draw from their policy to reimburse the imputed income tax on the forgiven interest.
If the required AFR has risen significantly, the executive’s policy may not have been designed to offset the higher interest rate, and it could put additional stress on the policy—potentially jeopardizing the executive’s benefit. It is important to monitor this closely and take steps to minimize interest rate risk.
2. Impact of rising rates on life insurance carriers
When life insurance carriers take in premium dollars, they invest the money to generate stable, long-term yields for their general account. The general accounts of most life insurers are largely composed of investment grade bonds and mortgage-backed securities, typically making up about 75%–85% of a carrier’s portfolio. The effective maturity of a carrier’s portfolio can be quite long. Given the makeup and timing of the how carriers invest their dollars, it can take quite a while for the average yield in the carrier’s portfolio to move. The carrier’s general account typically lags current interest rates as it slowly adjusts with maturing investments and new premium dollars flowing in.
The increased rate environment is now starting to have a positive impact on the life insurance carriers. Over the last 12–18 months, we have seen carriers increase their cap rates on Indexed Universal Life policies and increase dividends in Whole Life products. Higher investment yields are favorable for in-force split dollar plans. When you break down a split dollar plan, the executive’s benefit is derived from the difference between the yield the life insurance policy generates and the loan plus any accrued interest that needs to be repaid to the credit union. Higher cap rates and increased dividends are positive for the long-term expected performance of existing and new life insurance policies.
3. Higher internal policy loans
One of the unique benefits to a split dollar plan is the tax-free nature of the income stream. This is achieved by utilizing the tax advantages of life insurance. When it comes time for a plan participant to receive money from a split dollar plan, there are two ways to access the benefit. One option is to take a withdrawal from the cash value of the policy. You can take withdrawals tax-free as long as the withdrawals do not exceed the amount of premiums paid into the policy.
The more common way to access the funds, and the way most split dollar plans are designed, is to keep the cash in the policy and take an internal policy loan from the life insurance policy. This allows the cash value of the policy to continue to compound via dividends and index credits. This maximizes policy growth while still providing income. The money received from the policy is tax-free, as it is technically a loan from the policy’s cash value.
Increased policy loan interest rates begin to have an impact when rates are significantly higher than when the plan was implemented. When split dollar plans are designed, it is necessary to make assumptions that are subject to change. One of those assumptions is what the internal policy loan rate will be in relation to the projected crediting rate of the policy.
As outlined above, a higher interest rate environment should provide enhanced policy performance, but it could also bring increased expense via higher policy loan rates. When making the decision on how you should handle this, it is important to work with your record keeper to confirm the most efficient strategy is being used for your policy.
Customization matters—and so does consistent monitoring
While most split dollar plans can appear to be the same on the surface, no two split dollar plans are exactly alike. It is critical to have a good understanding of how your plan was designed and the impact outside variables, like rising or falling interest rates, have on your plan.
We often reiterate that while supplemental retirement plans like split dollar are important for retaining talent, consistent, long-term plan service is just as vital—if not even more essential. Split dollar plans are long term, non-guaranteed benefits, and they require ongoing attention rather than a set it and forget it approach. It is important to partner with a firm that is committed to the long-term service required to give each split dollar plan the strongest opportunity for success.
If you’re evaluating how today’s rate environment impacts your split dollar strategy, now is the time to take a closer look. Reach out to BJ Burt to discuss how thoughtful plan design can help ensure long‑term effectiveness.
For credit union leaders considering whether a split dollar plan is right for your organization, start with these five questions every credit union board should ask before moving forward.
This material was created to provide information on the subjects covered, but should not be regarded as a complete analysis of these subjects. The information provided cannot take into account all the various factors that may affect your particular situation. The services of an appropriate professional should be sought regarding before acting upon any information or recommendation contained herein to discuss the suitability of the information/recommendation for your specific situation.
Consulting and insurance brokerage services to be provided by Gallagher Benefit Services, Inc. and/or its affiliate Gallagher Benefit Services (Canada) Group Inc. Gallagher Benefit Services, Inc., a non-investment firm and subsidiary of Arthur J. Gallagher & Co., is a licensed insurance agency that does business in California as “Gallagher Benefit Services of California Insurance Services” and in Massachusetts as “Gallagher Benefit Insurance Services.”
