Is CU Position Riskier Than That of Banks?
Credit unions are not-for profit organizations operating in a for-profit world. Credit unions must offer compensation and benefit programs to their employees that compete with their banking counterparts. They must also invest prudently to assure the emerging benefit liability is adequately covered by appropriate investment vehicles.
In comparing the ways that credit unions fund their benefit programs to the ways in which banks cover the same kinds of liabilities, a question arises: Are credit unions taking riskier positions than banks in funding employee and officer benefits costs?
This is a legitimate question given that the Federal Reserve, the Office of the Comptroller of Currency and the FDIC have taken the position that banks must fund these programs with "bank eligible" investments. Simply stated, a bank eligible security is a debt instrument that is rated investment grade, or the credit equivalent of investment grade. If credit unions are placing employee benefit investment funding in less than investment grade instruments, then it seems the answer is "yes," they are taking riskier positions than banks.
This then begs the next questions:
• What do credit unions consider appropriate funding investments for benefit liabilities?
• Under what authority are credit unions investing in these assets?
There are several sources of authority that would lead a credit union to redeploy investment portfolio assets into other positions:
1) The "normal" credit union investment rules are spelled out in NCUA Rules Section 703. The exceptions to Section 703 are found in Section 701.19, which states that a federal credit union can invest in an "otherwise impermissible" investment so long as the investment directly relates to the credit union's employee benefit obligation. This opens the door to looking at investments that may provide a better return than "permissible" investments.
2) NCUA recognizes a credit union's need to competitively compensate employees. Therefore, NCUA allows for benefits such as pension plans, 401(k) plans, health insurance, cafeteria plans, executive benefits, etc., to be "informally funded" (asset/liability matching) with these "otherwise impermissible" investments
Emerging Gains & Allocations
3) NCUA issued Legal Opinion Letter 03-0512 in February 2004, which recognized the efficiency of pooling benefit expenses, existing liabilities and potential liabilities, and then matching those with emerging gains on pooled funding assets. Thus, as long as there are benefit costs existing or on the horizon, emerging gains from assets can be allocated to fund them.
4) In NCUA Opinion Letter 04-0453, issued in November of 2004, the cost of funds was recognized as a legitimate part of the cost of benefits. This meant that a CU could recover not only the cost of its benefits, but also the cost of the funding and cost of funds on both.
5) In 2006, the NCUA issued NCUA Legal Opinion Letter 06-0406. Under this authority a federally insured, state-chartered credit union (FISCU) can invest in a mutual fund as the underlying investment for a 457(f) plan.
In addition to the authority granted by the NCUA, credit unions must consider the current environment in evaluating the best investment options. Many credit unions have relatively low loan-to-share ratios and the funds that are not loaned out are not doing much better than an annualized 23 BPs at the Fed. Some CUs have even offered members cash for withdrawing deposits. The cost to process a new loan hasn't decreased, but interest income has, resulting in lower loan spreads and dismal net revenue results.
In evaluating investment alternatives, CFOs may perceive that investing in equities presents a hypothetical higher return, with a corresponding improvement in the financial statements. But this perceived increased return comes at a price-higher risk and higher volatility.
NCUA Legal Opinion 06-0406 states that credit unions can place benefit funding assets in mutual funds; many credit unions have concluded that the allowance of mutual funds means that those mutual funds may, themselves, invest in equity securities. Based on this logic, several vendors of funding investment products have recommended and sold investments in equities of all types.
Obviously, those credit unions that took this funding approach saw dramatic fluctuations in value and earnings from 2008 to 2010. Regrettably, those credit unions may now be chasing not only the benefit costs, but also the lost investment earnings and principal.
The most common way that credit unions ended up in equity positions was through a variable insurance policy or variable annuity that invests in equities. These products have electable "underlying separate accounts." These separate accounts operate similar to a mutual fund. Beyond fixed accounts and bond accounts, these products can contain equities that range from large caps to small caps, and from blue chips to penny stocks. This gives rise to the potential for tremendous market volatility.
Other Important Considerations
While this discussion is focused on what investment vehicles are allowable, a credit union board must also consider what investment vehicles are prudent. Many credit unions have their own experiences of investing in annuities with underlying separate accounts in equities for the purpose of funding retirement benefits, only to find that the investment was underwater when it was time for a payment. This leaves everyone dissatisfied with the outcome-the exec, the board, and members.
Rather than asking if credit unions are taking bigger risks than banks in funding their employee benefit obligations, perhaps a better question is, "What level of risk does a CU have to take in order to recover the cost of its benefits, funding investment and a cost of funds, and does the risk allow for a prudent investment strategy?"
With low-risk investments of fixed accounts and investment grade bond accounts clearly allowed, without the worry of fluctuating markets, why take an unnecessary risk?
Kevin Mahan is principal of Executive Compensation Solutions.