In Nonqualified Benefit Plans, One Size Does Not Fit All

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Employers have long struggled with the ability to attract, retain and reward key talent at their company.

Government limits and restrictions on the amount that employees and employers may contribute toward qualified retirement plans such as a 401(k) leave many highly compensated executives without enough retirement income to sustain their current standard of living.

A supplemental executive retirement plan (SERP) is a defined benefit and a great way to solve both governmental limits and the ability to attract, retain and reward talent. SERPs are typically designed to make up for a retirement income shortfall, because executives at most companies tend to be in their late 40s and 50s.

But when consultants design SERPs solely for retirement income — because the decision-makers are concerned about retirement — they often make the mistake of designing a plan that fails its primary goal: attracting, retaining and rewarding key talent.

Consider the following: Executive A is 57, married with no children. He is maxing out his company’s 401(k) plan but still has not saved enough for retirement. His employer wants to reward him for his 15 years of service and keep him for another 10 years until his retirement. Putting a SERP in place that promises to pay him 40% of his final pay for 15 years will accomplish the employer’s goal because he is only 10 years from retirement and concerned about it.

Now let’s take a look at his successor in training. Executive B is 40 years old, married and has three kids, ages 4, 6 and 8. He is contributing very little to his 401(k). His employer wants to retain him to succeed Executive A. The employer offers him the same SERP that will pay him 40% of final pay at retirement. Three years go by, and Executive B leaves the company for a higher paying job. The plan failed the employer’s goal because to most 40-year-olds, short-term incentives are king. Promising a benefit 27 years down the road does little to retain an executive in the short term.

That is where many consultants and employers make mistakes during the design process. They don’t ask themselves: If they were in a similar stage in life as the executive, what would matter most? They also fail to ask the executives being considered what’s important to them. Many employers and executives hesitate to answer honestly. That’s where a consultant can be invaluable during the planning process. Asking the important questions to establish goals is key to making a plan work effectively.

Once the bank has a good understanding of what is important to top talent, they can design a plan to accomplish the goals. Plans can pay out benefits at certain pre-set dates or life events while still employed to accomplish goals other than retirement. Here are a few examples:

  • Lump sum in 5 years for mission work.
  • Four annual payments starting in 10 years to help pay for college.
  • Lump sum at age 50 to buy a boat.

Consider the following alternative benefit design for Executive B and its value to him. Executive B is 40 years old. He is married with three children, ages 4, 6 and 8. After being interviewed, he is most concerned about paying for his children’s college. Therefore, instead of offering him a SERP that pays out at retirement, his employer offers him a SERP that allows the executive to receive some payments while still employed.

This plan allows Executive B to direct up to half of the employer contribution into a short term or “college funding” bucket. This bucket will start paying in 10 years, when his oldest child starts college. The other half of the contribution goes into a “retirement” bucket. This is set aside for supplemental retirement income.

Will this accomplish the employer’s goal? It definitely has a better chance. This two-bucket approach is of great value to Executive B, because it addresses his immediate need to save for college and also starts to build a retirement account.

Using alternative approaches to the traditional design of focusing on retirement is more important than ever. Employer can accomplish their goals using a nonqualified plan, as long as they remember that “one size does not always fit all.”

Insurance services provided through NFP Executive Benefits, LLC. (NFP EB), a subsidiary of NFP Corp. (NFP). Doing business in California as NFP Executive Benefits & Insurance Agency, LLC. (License #OH86767). Securities offered through Kestra Investment Services, LLC, member FINRA/SIPC. Kestra Investment Services, LLC is not affiliated with NFP or NFP EB.
Investor Disclosures: https://bit.ly/KF-Disclosures

Keeping Pace with Wages After Corporate Tax Cuts

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compensation-4-12-18.pngSince the reduction of the corporate tax rate from 35 to 21 percent, 64 banks nationwide have raised their minimum salaries to $15 per hour or given bonuses that range from $500-1,500, or both.

This number has increased by 50 percent since Jan. 1. Some have increased their 401(k) matching contributions. Some have made significant donations to nonprofit organizations in their communities.

Companies in the market at-large with whom financial institutions often compete for frontline talent are increasing their starting wage. For example, Target has announced it will raise its salaries to $15 per hour by 2020. Apple has announced it will reinvest $350 billion and add 20,000 jobs in the U.S. over the next five years. Companies with freed up capital are investing in the war for talent and in their communities.

All of this has caused concern for community banks and credit unions as they wrestle with whether they should follow suit and raise pay to $15 an hour. Here are our suggestions:

  • Know the market rate for wages. This requires examining external data and internal equity by a professional who is not bound to internal politics and long-term relationships between incumbents. You may need a midpoint that is 10 percent above the market as a competitive advantage.
  • Have a compensation philosophy and salary administration guidelines. Audit against those standards for consistency. If the next administration reduces the tax advantage, you would not need a knee-jerk reaction to adjust.
  • Don’t overpay for inexperienced new hires. We strongly recommend new employees with little or no background receive a starting salary of approximately 85 percent of the midpoint for most jobs and 90 percent of midpoint for “hot jobs.”
  • Develop a salary increase process that ensures that pay levels are getting to their midpoint in a reasonable period of time. Non-exempt employees with three years of experience in their job would have a pay level at 100 percent of the midpoint. Exempt employees with five years of experience in their job would get to their midpoint in five years. (This is where most salary administration programs fall down.)
  • Pay for Performance. The average salary increase differential by performance is 2 percent. If the difference between a high performer and an average performer is 1 percent, you are not differentiating the salary increase significantly enough to “pay for performance.”

When I review the pay levels of clients that have contacted us about an appropriate response to the market, it is easily to determine they were inconsistently applying their own salary administration guidelines. This should have been an obvious step even before the tax cut incented companies to offer more competitive pay.

If your competitive advantage is your people, then the war for talent is growing more heated. Have a well thought out compensation plan. Get out of the guessing game. Live up to your plan consistently. Update your salary ranges annually. Reevaluate and commit to your compensation strategies.

Use Compensation Plans to Tackle a Talent Shortage

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Can you believe it’s been 10 years since the global financial crisis? As you’ll no doubt recall, what was originally a localized mortgage crisis spiraled into a full-blown liquidity crisis and economic recession. As a result, Congress passed unprecedented regulatory reform, largely in the form of the Dodd-Frank Act, the impact of which is still being felt today.

Significant executive compensation and corporate governance regulatory requirements now require the full attention of senior management and directors. At the same time, shareholders continue to apply pressure on management to deliver strong financial performance. These challenges often seem overwhelming, while the industry also faces a shortage of the talent needed to deliver higher performance. As members of the Baby Boomer generation retire over the coming years, banks are challenged to fill key positions.

Today, many banks are just trading people, particularly among lenders with sizable portfolios. Many would argue the war for talent is more intense than ever. According to Bank Director’s 2017 Compensation Survey, retaining key talent is a top concern.

surey-chart.png

To address this challenge, many banks have expanded their compensation program to include nonqualified benefit plans as well as link a significant portion of total compensation to the achievement of the bank’s strategic goals. Boards are focusing more on strategy, and providing incentives to satisfy both the bank’s year-to-year budget and its long-term strategic plan.

For example, if the strategic plan indicates an expectation that the bank will significantly increase its market share over a three-year period, compared to competition, then executive compensation should be based in part upon achieving that goal.

Achieving Strategic Goals
There are other compensation programs available to help a bank retain talented employees.

According to Federal Deposit Insurance Corp. call report data and internal company research, nonqualified plans, such as supplemental executive retirement plans (SERPs) and deferred compensation plans, are widely used and are particularly important in community banks, where equity or equity-related plans such as stock options, restricted stock, phantom stock and stock appreciation plans are typically not used. These plans can enhance retirement benefits, and can be powerful tools to attract and retain key employees. “Forfeiture” provisions (also called “golden handcuffs”) encourage employees to stay with their present bank instead of leaving to work for a competitor.

SERPs
SERPs can restore benefits lost under qualified plans because of Internal Revenue Code limits. Regulatory rules restrict the amount that can be contributed to tax-deferred plans, like a 401(k). A common rule of thumb is that retirees will need 70 to 80 percent of their final pre-retirement income to maintain their standard of living during retirement. Highly compensated employees may only be able to replace 30 to 50 percent of their salary with qualified plans, creating a retirement income gap.

retirement-income-gap.png

To offset this gap, banks often pay annual benefits for 10 to 20 years after the individual retires, with 15 years being the most common. SERPs can have lengthy vesting schedules, particularly where the bank wishes to reinforce retention of executive talent.

Deferred Compensation Plans
We have also seen an increasing number of banks implement performance-based deferred compensation plans in lieu of stock plans. Defined as either a specific dollar amount or percentage of salary, bank contributions may be based on the achievement of measurable results such as loan growth, increased profitability and reduced problem assets. Typically, the annual contributions vest over 3 to 5 years, but could be longer.

While deferred compensation plans have historically been linked to retirement benefits, we see younger officers are often finding more value in cash distributions that occur before retirement age.

To attract and retain millennials in particular, more employers are expanding their benefit programs by offering a resource to help employees pay off their student loans. According to a survey commissioned by the communications firm Padilla, more than 63 percent of millennials have $10,000 or more in student debt. Deferred compensation plans can also be extended to millennials to help pay for a child’s college tuition or purchase a home. Because these shorter-term deferred compensation plans do not pay out if the officer leaves the bank, it provides a strong incentive for the officer to stay longer term.

Banks must compete with all types of organizations for talent, and future success depends on their ability to attract and retain key executives. The use of nonqualified plans, when properly chosen and correctly designed, can make a major impact on enhancing long-term shareholder value.

Insurance services provided by Equias Alliance, LLC, a subsidiary of NFP Corp. (NFP). Services offered through Kestra Investment Services, LLC (Kestra IS), member of FINRA/SIPC. Kestra IS is not affiliated with Equias Alliance, LLC or NFP.

Addressing Gaps in Executive Disability Coverage

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Risk continues to be an important issue for the banking industry. But what about the personal risk facing a bank’s valued executive? How should personal risks be addressed within a banker’s executive compensation plan and more specifically, what is the impact to the compensation plan if the executive becomes permanently disabled?

The Income Replacement Problem
Group long-term disability (LTD) plans provide excellent coverage for most workers, but leave gaps for highly compensated employees (HCEs). This is due to limitations on the amount of base salary covered, and the lack of coverage for bonuses, stock-based compensation and retirement plan contributions, including 401(k) plans and nonqualified plans such as supplemental executive retirement plans (SERPs). As a result, HCEs often end up with only 30 to 50 percent of their earnings protected, while most broad-based employees achieve more significant income protection. The following chart, which is an example, provides an illustration.

Title Base Salary Base Total Annual Compensation Total Monthly Compensation Monthly Group LTD* % Comp. Replaced
CEO $200,000 $150,000 $350,000 $29,167 $10,000 34%
SVP $175,000 $100,000 $275,000 $22,917 $8,750 38%
VP $100,000 $30,000 $130,000 $10,833 $5,000 46%
AVP $75,000 $15,000 $90,000 $7,500 $3,750 50%
Manager $50,000 $5,000 $55,000 $4,583 $2,500 55%

*60 percent of base salary to a maximum of $10,000 monthly benefit

Many HCEs are unaware of this potentially significant loss in earnings should they become disabled.

As another complication, retirement plans stop being funded when a disability occurs. For example, an HCE no longer contributes to the 401(k), and therefore no longer receives the matching company contribution. If the HCE has a nonqualified plan like a SERP, the plan normally provides for vesting in the accrued liability at the time of disability but does not provide additional credits to the account after the disability occurs. With a drastically reduced monthly income, it is difficult, if not impossible, to save for retirement.

While it can be an uncomfortable topic, and most people do not think it will happen to them, the fact is that disabilities do occur. But bankers are in the risk mitigation business: Once they understand this risk, they typically want to do something about it.

An Integrated Solution
Combining group LTD coverage with individual disability coverage provides the executive with a solid, well-thought out plan that can solve the gap in coverage, help attract and retain top talent, and keep the bank’s costs in check. By using company-sponsored individual policies rather than retail individual policies, the policies can be issued on a guaranteed issue basis and at a significant discount. Furthermore, the premiums are fixed, and the policies are portable and can’t be cancelled. Below is an example:

Title Total Monthly Compensation Monthly Group LTD* Individual Disability Income Total Disability Income % Comp. Replaced
CEO $29,167 $10,000 $11,875 $21,875 75%
Sr. VP $22,917 $8,750 $8,438 $17,188 75%
VP $10,833 $5,000 $3,125 $8,125 75%
AVP $7,500 $3,750 $1,875 $5,625 75%
Manager $4,583 $2,500 $938 $3,438 75%

The policies can be offered on a voluntary basis, and paid for by the employee or by the company. If company-paid, many banks invest in bank-owned life insurance (BOLI) as a way to offset and recover the cost, while others feel the expense is not that significant. In either case, it is well worth the expense as another tool to attract and retain top talent.

The shortfall in income replacement is a real problem for higher income earners should they become disabled. With the recent decrease in corporate tax rates, now would be a great time to explore solving this issue. Corporate-sponsored individual disability programs, when integrated with a group disability program, can protect HCEs from this risk in a cost-efficient manner for the employee and the company, while also providing one more important element in the ongoing desire of the bank to attract and retain key officers.

Reward Key Officers with a 401(k) Look-Alike Plan

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compensation-6-15-17.pngCompensation is one of the most effective tools in motivating executives to higher levels of performance. However, in today’s market, the compensation committee and the board have a variety of alternative compensation approaches to select from to most effectively attract, motivate and retain executive talent. Banks are seeking maximum performance from executives while executives are seeking income and, especially, retirement security.

Although most banks do a fully satisfactory job retaining solid performers by paying competitive salaries and bonuses, they are uncertain what to do when it comes to providing something truly special for their top executives while, at the same time, prudently managing expenses to protect the interests of shareholders.

Saving for Retirement
According to the trade association the Insured Retirement Institute, baby boomers are turning age 65 at a pace of roughly 10,000 per day, and if you’re a baby boomer who is fast approaching retirement, you might be wondering if you’re on target with your retirement savings goals.

Compounding the problem are IRS rules requiring no discrimination in favor of higher paid employees. Amounts that can be contributed to qualified retirement plans, such as 401(k) plans, are subject to statutory limits. The 2017 maximum pre-tax contribution is $18,000, with a catch-up contribution limit for employees aged 50 or older of an additional at $6,000. Therefore, qualified benefit plans do not fully meet the financial needs of executives because of their low limit on annual deferrals.

Today, financial planners, advisors, and consultants all seem to agree that retirees should plan for replacing 60 percent to 80 percent of preretirement income during the retirement period. While the right income-replacement ratio is highly dependent on a number of factors, most bank executives will not reach this level without help from nonqualified benefit plans.

401(k) Look-Alike Plan
One way banks can address these limitations is by offering a 401(k) look-alike plan. This nonqualified deferred compensation plan allows a select group of executives to make voluntary deferrals on a pre-tax basis with a matching contribution from the bank. Interest may also be credited to the executives account. Executives defer paying income taxes on money contributed now until retirement, a time when they may be in a lower tax bracket.

By tying the matching contributions to performance benchmarks, such as department and individual criteria, the executive is motivated to achieve higher results. When such plans are properly designed, if the shareholders do well, so will the executives. Note: As with any incentive-based compensation, matching contributions to the 401(k) look-alike plan should not provide executives with incentives to take imprudent risks that are not consistent with the long-term health of the bank.

Deferring income into nonqualified plans does have its disadvantages. For the bank, nonqualified plans—unlike their qualified counterparts—are not favored by a current tax deduction. The tax deduction is delayed until the officer receives the benefit.

There is also risk because nonqualified plans need to remain unfunded to achieve the desired tax deferral. A nonqualified plan must remain just a promise to pay a retirement benefit. It is a liability on the bank’s books and nothing more. In the event of bankruptcy or company takeover, executives in the plan stand to lose some or all of the money in the nonqualified plan.

Summary
Knowing that retirement security is a primary concern of your executives, it may be time for your bank to rethink its approach to executive compensation. By adding a 401(k) look-alike plan, the ability to attract and retain talented executives will be greatly enhanced.

What Are the Best Ways to Fund Your Retirement Plans for Executives and Directors?

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retirement-plan-4-20-16.pngNonqualified deferred compensation (NQDC) plans continue to be important tools to help banks attract, reward and retain top talent in key leadership positions. In order to retain their critical tax deferral benefits, such plans must remain unfunded. For tax purposes, a plan is “funded” when assets have been unconditionally and irrevocably transferred for the sole benefit of plan participants. Formal funding of qualified plans, such as a 401(k), does not subject the participants to immediate taxation—participants can defer taxes until they actually receive such income. However, qualified plans have limitations on the level of benefits that can be provided and these limits can lead to substantial shortfalls in expected retirement income for executives and other highly compensated persons. NQDC plans came about specifically to help offset those shortfalls.

The restrictions on funding NQDC plans leads plan sponsors to search for solutions to finance or economically offset the costs of providing enhanced benefits to NQDC plan participants. When you hear someone refer to “funding a NQDC plan,” this is what they mean. Economic, or informal, funding means that the bank acquires and owns the particular asset of that funding method and that at all times such assets are subject to the claims of the bank’s creditors. Our objective for this article is to review and compare the financial statement impact of various methods for economically funding such plans. In our examples we use a Supplemental Executive Retirement Plan (SERP) and the following funding methods: 1) unfunded; 2) bank-owned annuity contract; 3) bank-owned life insurance (BOLI); 4) a 30-year, A-rated corporate bond; and 5) a 30-year, bank-qualified municipal bond. The same investment allocation and same cost of money were used in scenarios two through five.

  1. Unfunded
    A benefit plan is implemented and no specific assets are earmarked to generate income to offset the expenses. The bank accrues an accounting reserve for the benefit liability as required under GAAP and makes payments out of general cash flows. This method is simple and has often been used when the bank does not have additional BOLI capacity.
  2. Bank-Owned Annuity Contract
    The bank purchases a fixed annuity contract (variable annuities are not a permissible purchase for banks) on the lives of the plan participants. While the primary advantage of purchasing an annuity is that the cash inflows from annuity payments can be set to match the cash outflows for benefit payments, because corporate-owned annuities do not enjoy the tax deferral benefits of individually owned annuities, there is a mismatch of income taxation (annuity) with income tax deductions (benefit payments). Fixed annuity contracts with a guaranteed lifetime withdrawal benefit provide a specified annual payment amount commencing when the executive reaches a certain age (usually tied to retirement). Payments are made for the life of the annuitant. Fixed annuity contracts generally do not respond to movements in interest rates.
  3. Bank-Owned Life Insurance (BOLI)
    The bank purchases institutionally priced life insurance policies on eligible insureds to generate tax-effective, non-interest income to offset and recover the cost of the benefit plan. When properly structured and held to maturity, earnings on BOLI policies remain tax-free, eliminating the tax mismatch issue. The tax-free nature of BOLI earnings often allows the bank to exceed the yields on taxable investments on a tax-equivalent basis. Top BOLI carriers structure their products so that they do respond to market rate movements, albeit on a lagging basis.
  4. 30-Year, A-Rated Corporate Bond
    A 30-year, A-rated corporate bond is a simple and transparent investment vehicle. Because investment earnings are taxable as earned, and benefit payments are not deductible until paid, the tax mismatch is the primary disadvantage. Corporate bonds do respond to market rate movements, leading to potential volatility in market values.
  5. 30-Year, Bank-Qualified Municipal Bond
    A 30-year, bank-qualified municipal bond is similar to a 30-year corporate bond except the earnings are tax free.

In summary, key to the funding analysis is evaluating the best investment for the bank that will mitigate the impact of the plan expenses and liabilities on the bank’s financial statements with bank-eligible investments. The following table summarizes the projected net financial statement impact of the five methods discussed above in both today’s interest rate environment as well as the projected impact in a rising rate environment. As you can see, BOLI and a 30-year bank-qualified municipal bond offer some of the better ways of funding the plan over time.

Funding Your NonQualifed Deferred Compensation Plan

  Projected Life of Plan Net Income(Expense)*
Method of Funding Today’s Rate Environment Rising Rate Environment
Unfunded $(772,439) $(772,439)
Bank-Owned Annuity Contract $(164,229) $(439,597)
Bank-Owned Life Insurance (BOLI) $190,369 $1,598,371
30-Year A Rated Corporate Bond $(114,989) $(235,872)
30-Year Bank-Qualified Municipal Bond $221,007 $701,441

*Based on $500,000 single premium investment. Current rates are as of March 2016. For more detailed information as well as the relevant assumptions used, please contact David Shoemaker at [email protected] or 901-754-4924.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

How Will New Fiduciary Rules Impact the Bank?

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fiduciary-rules-4-13-16.pngThe new fiduciary rules from the Department of Labor stand to impact a huge number of banks, as more employees will fall under “fiduciary” standards that will change the way they do business. Boards should be asking questions now about how the revised rules will affect their banks, especially if they have wealth management or trust departments or subsidiaries, which are likely to see the greatest impact.

The Department of Labor, which has rule-making authority for ERISA, the Employee Retirement Income Security Act of 1974, last week expanded the definition of fiduciary to include a wider variety of people who give advice on retirement accounts. The rules don’t apply to non-retirement accounts. Although some employees may already be fiduciaries and familiar with the rules, others may be encountering them for the first time. There also could be an impact on certain fee-generating products such as the sale of proprietary funds and variable annuities, and boards should ask questions of the bank’s senior management to assess the effect on their bank. “Over the next several months, we will find out what the impact is,” says Andrew Strimaitis, a partner at the law firm Barack Ferrazzano in Chicago.

The rules go into effect a year from now, April 2017, with some requirements delayed until January, 2018.

Saying outdated rules didn’t protect Americans as their retirement savings increasingly move away from employer-provided pensions and into self-directed individual retirement accounts (IRAs) and 401(k)s, the labor department said Americans were too often exposed to conflicted advice that moves them into high-fee products that benefit advisors more than clients. The labor department estimated Americans would save $40 billion over 10 years under the new rules. “While many investment advisers acted in their customers’ best interest, not everyone was legally obligated to do so,’’ the labor department said. “Instead, the broken regulatory system had allowed misaligned incentives to steer customers into investments that have higher fees or lower returns—costing some middle-class families tens of thousands of dollars of their retirement savings.”

What’s Changed?
Any investment advisor who handles retirement accounts becomes a fiduciary and has to comply with ERISA standards, which means providing impartial advice and not accepting payments that represent a conflict of interest, according to the department of labor. The industry has been concerned that the new rules would eliminate the possibility of brokers making commissions on trades or fees for selling insurance, or prohibit certain products such as a bank’s proprietary funds, or even variable rate annuities. But none of those products were ruled out, and neither are commissions. Instead, there is a “best interest contract exemption” that allows brokers and other advisors to continue their compensation practices and to sell products such as proprietary funds as long as they promise to put their clients’ best interest first, pay “reasonable” compensation to advisors and disclose all conflicts and fees.

What’s the Impact?
There will be new compliance costs associated with the rule. Analysts at the investment bank Keefe, Bruyette & Woods estimated that Morgan Stanley, as an example, could face a two-year implementation cost of $2,500 per financial advisor, plus about $600 yearly per advisor after that for on-going compliance, based on calculations from the trade group SIFMA, the Securities Industry and Financial Markets Association. The costs could potentially push some banks with marginally profitable asset managers to sell or outsource their compliance, and many of them already do the latter. Some think the rule could have far-reaching effects in terms of changing the types of products advisors are willing to sell, because of the uncertain liability. “It is fundamentally changing the way a bank will interact with the typical IRA client,’’ says Richard Arenburg, a partner at the law firm Bryan Cave LLP in Atlanta. Customers can sue advisors who don’t represent their best interests. Recommending products that benefit the advisor when lower-cost or more appropriate products are available could be a bad idea. “To continue to recommend funds where it is questionable whether they are in the best interest of consumers, you will have a tougher road to hoe to avoid liability,’’ Arenburg says. Some banks may react by limiting the number of advisors who handle retirement accounts such as IRAs. “I think you’re going to see consolidation definitely,’’ says Strimaitis. “People are going to have larger operations to make the compliance costs worth it.”

Boards should review the impact on the bank periodically, says Nancy Reich, an executive director with accounting and advisory firm Ernst & Young LLP. What’s the impact on the business model? What changes to its policies and procedures is the firm considering to address the impact?

Managing the BOLI Risk

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Bank-owned life insurance (BOLI) is a popular investment asset that can be used as an added benefit for key executives. For example, a portion of the death benefit may be allocated to the executive. The returns can be used to offset employee expenses such as health care or 401(k) plans. The percentage of U.S. banks holding BOLI continues to grow year after year. The percentage increased from 53.4 percent in 2012 to 56.4 percent in 2013, says David Shoemaker, a principal at BOLI provider Equias Alliance. He talked to Bank Director magazine recently about market trends and what boards should know about risk management of BOLI plans.

Why are banks buying BOLI today?
BOLI continues to offer a higher after-tax yield than most other investments of similar risk and duration. The extra income boosts capital and can aid growth or provide higher shareholder dividends. In a standard general account or hybrid separate account BOLI product, there are no mark-to-market adjustments on the bank’s books. BOLI interest rates are variable and will generally follow changes in market rates (but on a lagging basis), making them more advantageous than fixed-income products in a rising interest rate environment.

What are the risks that a bank should pay attention to?
As part of its annual risk assessment review, the bank should review the current and long-term performance of BOLI as well as the financial condition of the carriers. BOLI regulations going back to 2004 state that banks should perform their own analysis and not just rely on ratings. The Dodd-Frank Act highlighted the importance of this as well.

What impact will Basel III have on BOLI?
Basel III will not have any impact on general account BOLI policies, which are backed by the credit of the insurance company and carry a minimum interest guarantee and a risk weighting of 100 percent. However, hybrid separate account policies, which are also backed by the insurance company, offer additional benefits such as multiple investment accounts that are legally protected from creditors of the carrier. Typically, these policies are assigned risk-weights as low as 20 percent or as high as 100 percent. Under Basel III, our understanding is the bank has the option to evaluate each security in the portfolio individually, which would be a time consuming and expensive task, or may save time and money and simply risk weight the BOLI asset at 100 percent.

What are the responsibilities of the board when it comes to risk management of the bank’s BOLI program?
It is the responsibility of management and the board to make sure there is proper oversight of the BOLI program. The bank should have a BOLI policy that details the bank’s purchase limits for one carrier and for all carriers in aggregate. The policy should outline the processes for performing the pre-purchase due diligence as well as the ongoing risk assessment reviews. The board should have a reasonable understanding of how BOLI works and the risk factors associated with it, including credit and liquidity risk. If the bank owns a variable separate account product, additional due diligence should be performed since it is a more complex product.

Regulators are worried about the risk posed to banks by third-party vendors. How does this impact banks with BOLI?
One of the key messages in the regulatory guidance is that banks should adopt risk management processes commensurate with the level of risk and complexity of the third-party relationship. With regard to BOLI and non-qualified benefit plan design and administration, I believe banks will move increasingly to providers that offer a high level of technical support, including CPAs, attorneys and analysts, and that have significant internal support systems to aid in designing and servicing non-qualified benefit plans as well as BOLI. Companies will want to deal with providers that have internal controls independently tested and certified with a report known as Service Organization Control (SOC) 1 Type 2, through the American Institute of Certified Public Accountants’ SSAE 16 standards.

David Shoemaker is a registered representative of, and securities are offered through, ProEquities Inc., a Registered Broker/Dealer, and member of FINRA and SIPC. Equias Alliance is independent of ProEquities Inc.

Should our 401(k) Get Married?

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CCR_2-8-13.pngRetirement plans are viewed by many bank boards as necessary to retain employees and keep up with the competition. Costs are weighed against benefits, real and perceived. How should private banks and holding companies view their 401(k) while looking to minimize costs and maximize benefits?  One way is to marry the 401(k) provisions with employee stock ownership provisions in a single plan: a 401(k) + Employee Stock Ownership Plan or KSOP.

Should a Retirement Plan Own Closely-Held Shares?

The ability to purchase shares in a closely-held bank or bank holding company using the company’s tax-deductible contributions and dividends does not mean that it is universally the right thing to do.  First, no employee money should be used to purchase stock—funding will be entirely with employer-directed dollars. Efforts to structure programs using employee money to buy private stock are fraught with fiduciary and legal concerns (remember Enron?). Four major strategic considerations in using a qualified plan to purchase shares are:

  1. Is there a need to buy shares back?
  2. Will the required independent valuation of the shares reflect a fair market value acceptable to sellers?
  3. Will the tax favors and incentives of employees having beneficial ownership in some shares in the company warrant the costs?
  4. Does the company have the discretionary earnings to make such purchases, even on an untaxed basis, given the need for capital?

If the conclusion is that the tax-exempt private stock market is appealing, how does the KSOP work?

Key KSOP Operational Features 

A KSOP is a single plan document defining the two major components: 1) The employee savings deferrals making up the employee-directed accounts, and 2) The company contributions and dividends comprising the employer-directed accounts.

All the customary 401(k) features for employees can be retained—i.e. vesting, distribution rules, hardship loans, array of investment choices, daily valuation etc. for the employee directed money. The employer money can now be used to make contributions in cash or stock to the plan, with features of the company stock accounts now reflecting ESOP rules.

For example, if the employer match is made in the form of stock, the matching shares are allocated to all plan participants who participate in the deferral program. This is often done by employers wanting high employee participation. Rules restrict benefits that skew heavily to highly compensated individuals, and this broad participation can allow the more highly-compensated employees to defer more because it allows the firm to pass non-discrimination tests required for these plans.

The usual mechanism of a safe harbor 401(k) plan requires immediate 100 percent vesting of all contributions and employer matching contributions. Contributions can be matched at 3 percent of pay, or dollar for dollar up to 3 percent and then 50 percent on the next 2 percent of pay. The match goes to even non-participating employees.  

We have seen non-safe-harbor matches made with stock to avoid these rules and still provide sufficient incentives for broad participation.

Four Basic Pros:

  1. The company sponsors a single plan, which for companies with more than 100 employees requiring plan audits, reduces the cost to a single audit.
  2. The company can make matching non-cash contributions in the form of stock.
  3. The company can use cash accumulated in the employer-directed accounts to buy shares from any source—even newly-issued stock for capitalization purposes.
  4. As opposed to separate administration of two plans (often by different vendors), the consolidation of the process in a single plan can simplify management of the retirement plan.

Three Basic Cons:

  1. With often different rules for the ESOP and 401(k) components of one plan, care must be taken to avoid participant confusion.
  2. An independent valuation of the employer stock is required—something done annually, as opposed to the typical 401(k) daily valuation platform, which can also be a source of misunderstanding.
  3. The stock will incur an obligation for the company to repurchase shares for cash in the future.

Conclusion

Banks and bank holding companies needing a controlled market for their shares and reduced retirement plan costs, while retaining or improving employee retirement benefits, should consider a marriage allowed in the tax code between 401(k)s and ESOPs. Yes, there are complications, but the IRS will get its pound of flesh, either in complexity or dollars. Choose wisely.