Jan 4, 2014

COLI Users: Time to Tune Up

Monitor Corporate-Owned Life Insurance Like Any Other Corporate Investment Or Risk Unnecessary Loss

Few corporate investments are so significant yet receive so little scrutiny as corporate-owned life insurance (COLI). Few corporate investments disappoint so often. Why is this?

COLI was a popular investment strategy in the 1990s and into the 2000s. But the tipping point was reached 2007, when use of COLI to fund nonqualified executive benefit liabilities began a steady decline. Today’s management is still attempting to understand what their predecessors purchased many years ago.

On Decline

According to a 2011 Mullin/TBG study mutual funds outpaced COLI by more than 10 percentage points (52.6% vs. 42.1%). This trend was also confirmed by a 2013 report, A Three-Step Approach to Nonqualified Plan Financing prepared by CAPTRUST, indicating 44 percent of companies fund plans with life insurance compared to 55 percent with mutual funds. One percent of companies leave plans unfunded.

OBSCURE COSTS

While at its core COLI is only life insurance, the subject of life insurance as a funding tool is quite complex, and its efficiencies are highly dependent on tax-laws and accounting advantages. Anecdotally, we know that companies find it difficult to understand the inherent costs in insurance policies; cost is not as transparent as with other corporate assets. Consequently, COLI investments are not managed as well as other corporate investments.

Hard-to-Get Information

Another thorn is the side of COLI users is how prickly it is to gather objective information about COLI programs: Brokers who sell the programs appear to hold the greatest knowledge yet they have an incentive to continue to sell more COLI, despite its decline in use.

Let’s back up a little and look at why companies informally fund their nonqualified (NQDC) plans to better understand why COLI is needed at all.

Informal Funding/Finance of Nonqualified Plans

The term “informal funding” describes the funding of a nonqualified benefit plan. You will also read the term informal financing. Informal funding represents the monies the sponsoring employer sets aside for the express purpose of satisfying obligations to participants who have elected to defer compensation; the contributions are usually the amounts deferred.

A nonqualified plan is an unfunded and unsecured contractual benefit obligation between a plan sponsor (employer) and participant (executive). In a nonqualified arrangement, when the participant defers income, the company (plan sponsor) records that amount as a liability on its balance sheet; this amount can get quite large over time.

To offset this liability, companies often choose to informally fund benefit obligations by setting assets aside. These assets provide the sponsor with liquidity to pay future benefits and some assurance to plan participants that they will receive their benefits. Assets used for this purpose are impacted by tax, accounting, financial statement, and expenses that are often the most costly aspect of operating a nonqualified plan. As you know, NQDC plans differ from qualified plans, which are formally funded.

HIGHER PROTECTION IN FORMAL FUNDING

In qualified plans, formal funding is required for 401(k plans) which must set aside contributions in a trust outside the reach of the company. These benefits are protected by ERISAS1 (Employer Retirement Income Security Act) and cannot be touched by the employer. Should the sponsoring employer become insolvent, creditors cannot make claims against monies in formally funded programs.

Nonqualified plans are informally funded when the plan sponsor decides to take some or all of the money deferred by the participant and invest it. This move helps to ensure that, when the time comes to pay out funds, those funds will be in place. The plan sponsor may invest in virtually any type of investment to accomplish this objective. The most common choices are mutual funds and COLI contracts owned by the sponsoring employer’s corporation.

Three Whys to Informally Fund NQDC Plans

There are three primary reasons why sponsoring employers elect to informally fund a nonqualified plan:

  • To provide a degree of benefit security to participants;
  • To match plan liabilities with a pool of assets; and
  • To mitigate P&L funding impact of the overall program

Like all financial instruments, there are advantages and disadvantages to COLI as a funding vehicle.

The following chart is a summary of the advantages and disadvantages of the three most popular funding options:

So, where do we go from here?

Advice on COLI

American corporations hold approximately $83 billion of cash value assets in COLI policies, a highly significant market. Typically, these companies seek out brokers and specialized firms to help evaluate their COLI assets. But the information is as hard to unearth as the body of Jimmy Hoffa. Providers are incentivized to sell you more COLI, not less. Full stop.

What’s more, broker incentives often recommend replacing existing policies with new contracts rather than restructure the current holdings. In most scenarios, the broker compares new policies with an existing portfolio, which is like comparing a gazelle to a zebra.

Most insurance companies will not pay new commissions on internal replacements or re-structuring of existing policies, so brokers illustrate other carriers to show vast improvement, based on illustrations chock full of assumptions. Most insurance companies, if given the half a chance, will clamor to “optimize” your existing COLI policies rather than see flee to another carrier.

What policy owners don’t see is new commissions, premium taxes and loads on the replacements; they are often hidden behind “enhancement riders” designed to spread the upfront loads over a seven to ten year period. The new policy provides enhanced cash values during this period, however, to receive the enhancement; the policy owner must surrender the contracts and possibly pay taxes on gains.

Hold Onto Existing COLI

The policies you currently hold have already been through the upfront sales charges, premium taxes and loads, so why exchange them for new contracts only to begin again to pay these loads?

In my opinion, COLI is a “buy and hold” informal funding strategy for companies. Your existing COLI can be a good asset to hold long term, to use in concert with other assets to informally fund your plan’s cash flows over the short term.

For those companies who are high tax payers, and willing and able to fund benefit liabilities out of their current cash flows and hold the asset (COLI policies) to the insured executive’s death, COLI is a viable asset. However, holding the best, optimally designed contracts is important. Because plan dynamics change, it is also important to make sure the policies are reviewed periodically and right sized.

In my next post, I want to share with you a process for financial modeling an optimal funding strategy that gives you a solid framework to grab better control of your COLI assets, as well as analyze other assets like mutual funds, ETFs and Total Return Swaps. Many of these assets are easier to administer, present full transparency, and match up with deferred compensation distributions.

To end this alert, please consider working with an independent advisor, one who does not sell COLI policies, one who can clarify your view of the entire cost structure, and show you how to optimize the policies you already own.

See you on the upside, Bill

Footnote:

1. The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans.