A credit union executive benefit is often designed as a 457(f) plan. While there are alternatives to a 457(f) approach for which funding may be mandated (such as collateral assignment split dollar), a 457(f) type of benefit does not have to be "funded." This article focuses on the reasons a credit union may or may not decide to fund a 457(f) plan.
A 457(f) plan provides benefit payments at pre-specified date(s). A benefit payment typically is predicated on the executive working until the date of distribution. Because of taxation rules, the plan typically provides that the executive will forfeit future unpaid benefits if she/he voluntarily terminates employment prior to distribution. The plan may provide payouts in the event of disability, change of control, involuntary termination or death. To get a grasp on funding we will consider a normal retirement situation.
Plan provisions dictate how a benefit accrues. The benefit must be incrementally expensed on the credit union's income statement and fully expensed on the balance sheet by the time it is payable. The amount that is expensed each year is the annual "cost" of the benefit.
Some plans provide that the benefit is the growth of the funding asset and the principal (and maybe some return) comes back to the credit union. This type of benefit requires the purchase of a funding vehicle. There are reasons this benefit may not be a good idea, and for all non-investment related benefits we ask:
To Fund Or Not To Fund?
All investments discussed for funding a 457(f) plan are owned by the credit union. Funding serves two purposes: (1) create gains each year that mitigate benefit charges, and (2) provide cost recovery to the credit union, either in whole or in part.
Cost recovery means the return, at some point of: (1) monies used for paying benefits; (2) monies used to buy investments to fund the plan; and (3) the time value of money, or lost opportunity costs, for the use of monies for both benefits and funding.
To illustrate cost recovery, consider an example of a lump sum payable in 10 years of $1,000,000. Assume a credit union purchases an investment right now for $2,000,000 with a fixed annual rate of return of 5%. In 10 years that investment will be worth $3,257,789. The credit union would receive back $2,000,000 for the investment cost, $1,000,000 for the benefit payment, and $257,789 for the time value of money. The net investment earnings would result in an annual return of about 1.22%.
Funding Vehicles
There are many choices to consider, such as various types of life insurance and associated strategies, annuities, a brokerage account or mutual funds. Life insurance with cash values can provide for some extra features such as a death benefit and managed money. Understanding life insurance can be a daunting task and figuring out if a proposal is good or bad for a credit union requires professional unbiased help. There are always tradeoffs and nothing is without risk or cost.
When is it in the credit union's best interest to purchase funding instruments? The answer to this starts by considering several financial factors of the credit union such as loan-to-share ratio, net worth, CAMEL rating and cost of money. Next consider the risk elements of a potential funding investment and how those match up with the credit union's investment policies for other impermissible investments (which these funding vehicles are). For some state-chartered credit unions, the state regulators will have to give their blessing in advance.
In addition, you should ask if the projected return on the program favorably compares with the cost of money for the credit union. In other words, is the credit union better off using its money to do the business of being a credit union or should it invest in the proposed funding vehicles?
There are many choices of funding vehicles out there being marketed to credit unions for funding executive benefits. The fiduciary responsibility a director takes on by joining a board requires guidance and education. Only then can the answer to this article's title be answered.
Kevin Mahan is president of CUBED, an executive benefits consultancy for credit unions. He can be reached at 626-486-0161,
