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.
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.