Aug 8, 2014

The Costly Trap: Cash Value Enhancement Riders in COLI Policies

What you don’t know about enhancement riders could hurt you.

Few corporate investments are so significant yet receive so little scrutiny as corporate-owned life insurance (COLI). What’s more, few corporate investments have been as disappointing. Here’s why:

  • Management must reconstruct and understand their predecessor’s COLI purchase from the past.
  • Life insurance is a complex product, dependent on tax laws, and accounting advantages.
  • Insurance policy costs, unlike other corporate assets, are not transparent.
  • Insurance companies enjoy broad discretion to change expenses and loads for existing programs, often without notice.
  • COLI investments are not managed as well as other corporate investments.
  • Brokers often recommend replacing existing policies with new contracts, rather than restructure current holdings, due to attractive incentives (more on this later).
  • It’s almost impossible to obtain objective information on COLI programs: COLI salespeople hold onto their unique product knowledge, in part, because they are incentivized to keep selling additional COLI, even though COLI usage is on the decline.

Although in decline, COLI is still used by many organizations to informally fund their nonqualified deferred compensation plans (NQDCs). Before we discuss potential pitfalls, let’s examine why companies informally fund NQDC plans in the first place.

INFORMAL FUNDING/FINANCE OF NONQUALIFIED PLANS

The term “Informal funding” or “financing” describes the funding of a nonqualified benefit plan. Monies of the sponsoring employer are set aside for the express purpose of satisfying obligations to plan participants who have elected to defer compensation, also known as contributions.

In effect, a nonqualified plan is an unfunded and unsecured contractual benefit obligation between a plan sponsor (employer) and participant (executive). This obligation differs from a qualified plan which is formally funded. In a nonqualified arrangement, when the participant defers income, the plan sponsor records that amount as a liability on its balance sheet. This amount can grow considerably large over time.

In order to offset this deferral liability, companies often choose to informally fund these obligations by setting assets aside. These assets provide the plan sponsor with liquidity to pay future benefits, as well as some assurance to plan participants that they will receive their benefits.

Assets used for this purpose are affected by tax, accounting, financial statement, and expenses. Plan expenses are often the most costly aspect of operating a nonqualified plan.

In formal funding, as required for a company’s 401(k), the plan sponsor sets aside contributions in a trust― outside the reach of the company. These contributory benefits are protected by ERISA (Employee Retirement Income Security Act) and cannot be touched by the employer. Should the plan sponsor-employer become insolvent, creditors cannot make claims against formally funded programs.

Again, nonqualified plans are regarded as informally funded when the plan sponsor-employer decides to take some or all of the money deferred by plan participants in order to invest and grow the deferrals to ensure that when the time comes for pay-outs, the funds will be available. The plan sponsor-employer may invest in virtually any type of financial instrument to accomplish this objective. To date, the most common choices are mutual funds and COLI contracts, owned by the sponsor-employer’s corporation.

REASONS FOR INFORMALLY FUNDING NQDC PLANS

Plan sponsors choose to informally fund a nonqualified plan for three reasons:

  • 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.

The following chart summarizes the advantages and disadvantages of these three rationales:

While the focus of this post is COLI and its enhancement rider, when designing proper funding, you should look at all assets classes. The optimal strategy incorporates a blend of assets aligned to company objectives. Let’s now discuss in detail COLI and the enhancement rider.

ACCOUNTING FOR COLI—USE OF CASH VALUE ENHANCEMENT RIDER

The Financial Accounting Standards Board (FASB) Technical Bulletin 85-4 (FTB 85-4) makes the accounting of life insurance straight forward. FTB 85-4 requires “the amount that could be realized under the insurance contract (cash value) as of the date of the statement of financial position should be reported as an asset. So as an example, if the premium paid was $1 million, and the cash surrender value is $960,000, the corporation purchasing the policy must expense the $40,000 difference as insurance expense.

Insurance companies continually look for additional benefits to help distinguish their products in the marketplace. In most financial modeling, mutual funds will look better to a company over the first five to seven years of purchase.

To reduce policy expenses in the early years, insurance companies created a cash value enhancement rider. This rider increases the cash surrender value of a policy in the early years, mostly for accounting purposes. It is primarily designed for COLI and bank- owned life insurance (BOLI) to improve a company’s P&L statement.

This enhancement rider benefit (usually available at no additional charge) allows the surrender charges to be adjusted, increasing the cash surrender value, if the policy is “surrendered” during the first few years (usually four to seven years). Note: The rider must be selected when the policy is issued.

The enhanced cash value is only paid upon surrender of the policy. If the corporation wants to do a 1035 tax-free exchange to another product (that would defer taxes on surrender), the enhancement is not paid. Once a policy is four or five years old, most of the upfront loads are already paid. That’s why, it is not to the benefit of the policyholder to surrender the contracts.

When a broker adds this rider to a policy to enhance the company’s P&L, he’s allowed to take higher commissions. Risk of commission chargeback could occur, if the policy is surrendered. The broker could achieve the same accounting results by increasing the cash value and reducing the commission expense of the policy. Most brokers use enhancement riders to maximize commission income.

POTENTIAL FOR ABUSE IN REPLACEMENTS

Abuse may arise in the policy replacement process. A broker may suggest to you to replace existing COLI policies with “new, more efficient” contracts. But you’ve already paid a substantial upfront cost on your existing policies. Add to this the possibility that the group of executives on whom you took out the policies is much older or no longer with your company.

The broker will be sure to make the new illustration appear competitive by adding the enhancement rider, which disguises the true cash value. If this action happens to you, make sure your broker shows you illustrations with maximum cash value, and without the cash value enhancement so you can see the true impact. In addition, you should have the product illustrated at various assumed earnings rates, with and without the enhancement rider. Finally, ask him or her to provide you with full disclosure of compensation earned.

The following chart shows the cash surrender value at 0% and 7% assumed returns and the impact of the enhancement. It represents a hypothetical illustration of a 45-year old executive with $100,000 of premiums paid for seven years.

As you can see, for the first seven years, the enhancement improves the cash value on the company books. However, as I stated before, the only way to get the enhancement is to surrender the policies. With some enhancements, corporations can take a hit with accounting charges when the enhancement burns off, particularly if the policies are performing below the enhancement’s returns.

Once COLI policies are between five and seven years, every company should right-size these policies to maximize their value, not replace them. To right size, you can adjust the death benefits to cash value versus premium projections, and lower expenses in the policies.

A new technology system, called The Optimizer™ , can right-size existing contracts at substantial savings. The Optimizer™ runs thousands of iterations per policy to maximize their value. Before you replace a contract, speak with the existing insurance carrier and request they use The Optimizer™ to right-size. It will save you new premium taxes, loads and commissions.

While the enhancement rider helps the P&L, it is there to improve the early year accounting by disguising the true cash value. In our example above, in year one, with an assumed 7 percent return, the real return in the first year is -3.7 percent due to policy loads versus 7 percent with the enhancement. As you can see, once the cash and enhancement are equal (year 7), the true return on investment is 4.7 percent for both.

TAKEAWAY MESSAGE

Whichever your situation, analyzing a COLI purchase for the first time or considering the replacement of existing COLI with new policies, I urge you carefully to evaluate the real cost of the cash value enhancement.

To be certain you’ve not overlooked an important element in the analysis, do yourself a service and turn to an independent third party to help you with the evaluation.

Jun 5, 2014

Is There a Free Lunch in Executive Compensation?

Proposals for low or no cost funding of nonqualified executive benefit plans continue to proliferate.

If there existed a list of truisms with which almost all financial executives could agree, the list would include: “Pension plans are expensive” and “Cash value life insurance is a poor investment.”

Top management regularly finds stacks of plan proposals on their desks intended to provide substantial retirement income and wealth accumulation benefits (via deferred compensation) for highly compensated executives, always with the caveat “little or no cost to shareholders.”

How do the makers of these proposals expect to fund these plans? Corporate-owned life insurance (COLI)? What are the underlying costs? Usually little, if anything. If not entirely a free lunch, it’s awful close.

For context, let me share several design styles of executive benefit plans:

  • Consider a voluntary nonqualified deferred compensation (NQDC) plan, which allowed executives to defer compensation over and above the company’s 401(k) plan limits set at $17,500 in 2014. The executives received 14 similar investment fund choices. Design-wise, the plan carried no cost to the company, even after an allowance for the time value of money.
  • In another “performance base” plan, the company made annual contributions between two and eight percent of the executive’s annual cash compensation, based on return on equity (ROE) set by the company. This plan, like the deferred compensation plan, allowed the executive to invest the company contributions into a family of mutual fund type investments. Plan design carried no costs, other than expected cost of money.
  • And finally, a supplemental executive retirement plan (SERP) provides a benefit equal to the executive’s average final five years of income. COLI is used to recover the after-tax cost plus company’s cost of money.

APPEAL LIES IN TAX DEFERRED WEALTH ACCUMULATION BENEFITS

The principal appeal of these plans, and others like them, lies in the tax-deferred wealth accumulation. Executives are rightly concerned about the government limitations of qualified pension plans and their inability to tax defer dollars for later retirement.

The limits governing contributions to a 401(k) plan make it only marginally valuable to highly compensated executives. They cannot accumulate adequate retirement savings solely as a percentage of their annual compensation solely through their 401(k).

To address this inequity of government limitations, as well as provide a valuable executive compensation benefit, companies began to offer savings plans considered “nonqualified,” which refers to their exemption from ERISA’s* requirements for qualified plans. Since these programs do not have to meet ERISA or other technical requirements applicable to broad-based retirement plans, they can focus narrowly on an employer-defined top management group.

DECEPTIVELY ATTRACTIVE?

When the above advantages blend with the extremely low cost represented, the attraction can seem overwhelming. Skeptical financial executives ask how it’s possible to provide significant benefits for executives since plans allow the insurance company to earn a profit on the funding policies, as well as marketing and program administration which makes a profit on its investment. Low cost? Everyone seems to win, and nobody pays.

Further, the executive knows the broad-based pension and other employee benefits are expensive, and he is also mindful of the reputation of cash-value life insurance as a poor investment. How is it all possible?

Determining the answers require an intriguing inquiry into perceptions of cost in funded employee benefit programs, and into the economics of buying COLI policies as an investment rather than for traditional insurance protection motives.

DEFERRAL ELECTION AND INFORMAL FUNDING

In a typical deferral plan, employees are given the option to defer a portion of their annual cash incentive pay, their base salary, or both. Make elections sufficiently in advance of the time the payment is otherwise due; then, you conform with IRC 409A and avoid current taxation. The amounts deferred and interest earned records as a liability by the company on its books. In order to offset this liability, companies often choose to “informally” fund their NQDC plans by using the cash from the executive’s deferrals.

Formal funding, as required with qualified plans such as the 401(k), occurs when a company sets the money or investment vehicles outside of its general assets. In other words, the company can’t touch the monies earmarked for payout under the plan. Should the company become insolvent, creditors cannot make claims against monies in formally funded programs.

Nonqualified plans are informally funded when a company sponsoring such plan decides to take some or all of the money it receives through the executive’s deferrals and invest it to help ensure that when the time comes to pay out funds, those funds will be in place. A company may invest in a wide range of instruments to accomplish this goal, but the most common choices are mutual funds and COLI.

COLI VERSATILITY

COLI products are quite prevalent among the Fortune 1000 because of the tax advantages they provide to the corporation. Typically, policy cash value invests in mutual fund investments, similar to your 401(k) plan. A company can allocate the cash value among these accounts to mirror employee elections under the deferral plan. Furthermore, the allocation can be changed and rebalanced without triggering realized gains. Any investment gains, dividends or interest earned within a COLI insurance contract (held until maturity/death of the insured) remain tax free to the company. On the other hand, if the company funded with mutual funds, most gains would be taxable.

SIMPLE MATH OF INFORMAL FUNDING

As mentioned earlier, the two methods most often used to informally fund deferred compensation liabilities are mutual funds and COLI contracts. Tax-paying status and cash-flow timing drives a company’s decision on which method to select.

Companies that do not pay taxes due to loss carry-forwards or NOLs (Net Operating Losses) almost always informally use mutual funds to fund their NQDC plans. The gains from mutual fund investments are taxable, but since the company isn’t a taxpayer, those gains do nothing to increase the company’s liability.

However, if the company is a tax-paying entity, then COLI should be considered for at least a portion of the funding. Gains that result from investments inside of an insurance contract, owned by the corporation and held until maturity (death of the insured), accrue tax-free to the company. There are costs associated with purchasing a COLI contract and a portion of those costs provide a death benefit. The executive participating in the plan becomes the insured; the beneficiary is a company (or a trust) that owns the policy.

The math is simple: The company needs to weigh the cost of the COLI against the cost of paying taxes on the mutual fund gains. Chart I compares the difference in long-term net after tax return for a mutual fund with the return for COLI invested in the same fund. In this example, the return (net of management fees) is 7.0 percent.

With mutual funds, the investment earnings are taxed as realized. Some of the taxation can be deferred by using passive index funds or by qualifying the funds as a hedging transaction; however, gains eventually are realized when the funds are liquidated to pay benefits. In the example, the annualized after-tax rate of return with mutual funds is 5.03 percent compared with COLI expected return through death (assumed age 85) of 6.37 percent.

As you can see, COLI has a clear advantage due to the favorable tax treatment, even despite any slippage due to expense charges for insurance. Nine percent of the gain on COLI was used to pay insurance cost verses 28 percent of the gain from mutual funds for taxes. When you adjust the return to 4 percent, COLI insurance costs are 16 percent compared to mutual funds still at 28 percent.

COLI VS. MUTUAL FUNDING/INVESTING SCENARIO SUMMARY EXEC AGE 45

Numbers in the above chart are hypothetical and should not be relied on for making an investment decision. Mutual funds and COLI have the same net investment rate in each scenario (you should review management fees in your analysis). Mutual fund assumptions: 7:00% return, 2:00% in ordinary dividends, 4:00% in capital gain dividends. 10% rebalancing per year, 70% dividend exclusion.

STRESS TEST YOUR COLI CONTRACTS

As we discussed above, COLI is advantageous when a company is in a tax-paying position and when it can use its own cash to fund benefits. Any COLI analysis should include stress testing. A number of factors can influence the returns from COLI contracts:

  • Company tax rate
  • Investment returns from the mutual funds (separate accounts) in COLI
  • The company’s cost of capital
  • The level of premium vs. executive deferrals
  • How the company funds the benefits (out of cash flow or policy)

What’s more, a company should consider the trade-off between tax efficiency and liquidly. When a company pays benefits out of current cash, while holding the COLI until the insured’s death (assumed age 85 in our example), it could find itself with excess funding.

Also, executive deferrals normally are not level as we illustrated, causing a mismatch with COLI funding.

Chart 2 below illustrates the funding mismatch when COLI premiums equal annual deferrals. Here we used the exact amount of executive deferrals to pay premiums on the policies (this is how the majority of companies fund their plans). Most brokers will write a policy to accept the full premium ($100,000 in our example) and never adjust the policies or consider split funding with mutual funds.

Funding mismatch is a common problem and is the reason COLI policies don’t perform to the original illustrations the broker provided. Using our example in Chart I, based on the deferrals and premiums in Chart 2, 21 percent of the return will be lost to insurance charges verses 28 percent to taxes in mutual funds. This differential makes mutual funds seem more attractive.

To avoid this mismatch, COLI is best used as a funding vehicle for a plan with continued growth or to be used in concert with other asset classes. You need to make sure your policies are always optimized to take advantage of the benefits provided from COLI.

Do not replace existing contracts with new policies. If a broker suggests this, it should be a big red flag. You need to find an independent advisor to analyze the suggested replacement or work directly with the carrier being replaced to give them a final chance to “right size” the policies. Replacing will cost you, even though the broker’s illustration will say differently.

PERCEPTION OF COLI AS A BAD INVESTMENT

Unfortunately, COLI comes in many shapes and sizes. Various forms of COLI have had some negative press. Today’s generation of COLI represents a highly sophisticated, competitively priced contract allows a company to choose investment managers of separate-account mutual funds whose strategies more closely match a company’s liabilities.

Prevalence studies show a decline in COLI usage mainly due to the need to examine other assets to fund the company’s future benefit obligations. Many companies simply do not have the time or expertise to do such an examination.

Benefit Funding Group utilizes a proprietary Optimizer™ technology process created by American Financial Services. Optimizer analyzes various funding alternatives and blends the assets to meet the company’s funding objectives. This process is an excellent due-diligence tool.

Of course, COLI purchases also should follow best practices. U.S. Reprehensive Thomas M. Reynolds, R-NY helped introduce H.R. 2251, the COLI Best Practice Act of 2005 in the U.S. House of Representatives, which helps to reform the use of COLI. The legislation preserves COLI as a valuable tool for employers seeking to fund employee benefits. Most firms consulting on COLI follow these best practices, however, many do not look at coordinating them with other assets to optimize the funding of these plans.

NET TAKEAWAY

As we know, there is no such thing as a free lunch. Because executive benefit plans empower organizations to attract and retain talented employees, those who contribute to corporate growth, some cost is clearly justified. Fortunately, COLI and other funding assets can help lower that overall cost.

Don’t forget, you need to use a proven process to ensure optimal funding that reflects company objectives and applicable assumptions.

See you on the upside, Bill