Split-dollar is a unique and popular life insurance strategy that can benefit both a key employee and their employer. Over the years we have learned, amidst multiple regulatory and market environment changes, that one thing is for sure. There is no ‘one-size fits all’ template for split-dollar arrangements.
However, in the decades we have spent designing and administering split-dollar, we have consistently found about eight design features that are key in the success of a split-dollar plan. These features not only help with compliance, but meaningfully contribute to achieving a sustainable, tax friendly and resilient plan regardless of market conditions or organizational leadership changes at the employer. After all, many of these plans are intended to last long after employment terminates, and often will extend for the lifetime of the employee.
First let’s focus on the overall design of the split-dollar plan. Certain features, if utilized, have proven time and again to benefit all parties.
1. Separation of Objectives
Split-dollar is an arrangement between two parties, often an employee and an employer, where the benefits and obligations of one or more life insurance policies are shared between the parties. As such, a split-dollar plan must always satisfy two masters, the obligation to both repay the employer and provide benefits to the employee. When ensuring that a split-dollar plan will stand the test of time, satisfying these competing objectives with independent and dedicated policies is key. This gives the employee an opportunity for more control over the policy designed to provide benefits, such as selecting investment options based on their goals and deciding how and when to access the policy’s value. A separate policy, protected from the employee’s activity and dedicated to the employer’s recovery, ensures the obligation to the employer is not compromised.
2. Sufficient Collateral Coverage
At its core, split-dollar is an arbitrage transaction. The plan’s assets must outperform the amount due to the employer in order for benefits to be available to the employee. Ensuring the plan has sufficient collateral coverage is critical to building a sustainable plan in a variety of marketing conditions. Poor planning in this area (and a lack of ‘what if’ type modeling) could result in a significant dilution of benefits to the employee and even adverse tax consequences if the plan becomes under collateralized due to market conditions. We further explore the importance of stress testing later when we discuss Expected Return assumptions.
3. Financial Statement Consideration
While employers often utilize split-dollar, at least in part, due to its favorable book treatment, many plans fall victim to poor design choices in an effort to minimize expenses to the employer. This often takes the form of a “full recourse” arrangement, whereby the employee is legally obligated to furnish the additional funds if the underlying assets are insufficient to meet the recovery amount. Unfortunately, many affected employees are either ill-informed of the consequences of this requirement, or would fail to prove their wherewithal to make such a payment if the need arose. This presents employees and their employers with both a tenuous compliance problem, and a potential for hard feelings and conflict after the employment relationship has terminated. Instead, the parties should consider use of “early cash value” riders available on most insurance products. Such riders provide at or near 100% of the premium value making funding a split-dollar plan a virtually neutral balance sheet transaction. This substantially lessens the obligation of the employee, or can eliminate it entirely utilizing a non-recourse arrangement where the organization will simply mark to market the value of the underlying assets.
4. Employee Death Benefit Allocation
We dedicate our recommendation of the following two features under the “good faith” category of designing an attractive and thoughtful split-dollar plan for a key employee. The first is the determination of the employee’s portion of the Death Benefit. When an employer is deliberating how to provide benefits to its key employees it will often compare the attributes of split-dollar against that of a cash bonus or deferred compensation plan. In either of those instances, the employee would receive the supplemental compensation at a certain time and take the responsibility of turning those funds into a retirement portfolio. It is in this spirit that we always recommend a split-dollar plan have a death benefit allocation to the employee’s beneficiaries at least equal to any projected but uncollected benefits at the time of death. Meaning, had the employee taken their benefits in cash, their remaining portfolio would have passed to their beneficiaries at their untimely passing. Emulating this in a split-dollar design is often overlooked and is a great way to ensure an equitable share of the death benefit proceeds.
5. Planning for Tax Obligations
The second “good faith” design feature relates to planning for the employee’s tax burden as a result of the plan. Split-dollar plans often have some tax implications to the employee, the significance of which depends on how interest is treated under the plan, and if the plan utilizes any interest-bearing funding accounts. For example, some plans utilize a forgiven interest approach, where the employer forgives the interest on the plan each year, and the executive is responsible for the resulting imputed income on that forgiveness. Another example is use of a “Premium Deposit Account” whereby funds for future premiums are housed with the life insurance carrier. Interest earned on those premium deposit accounts are often includable in taxable income to the employee. Ideally, a well designed split-dollar plan ensures the employee is made whole on any tax burden generated under the plan.
Next, we explore how certain policy features can meaningfully contribute to the long-term health and success of a split-dollar plan.
6. Expected Return Rationale and Stress Testing
Split-dollar plans are almost always exposed to an element of rate of return risk. That is, the performance of the underlying policies is paramount to the plan’s ability to deliver the expected results to the parties. For years, many popular split-dollar insurance products enjoyed a great deal of flexibility with illustrative rate of return assumptions. Generally, it was in the hands of the advisors to determine an appropriate rate and educate their customers on the risks associated with the product. This proved problematic over the course of split-dollar history, where unrealistic rate of return assumptions and subpar market performance left certain plans in ruins.
Starting in 2015, the NAIC stepped in with a series of Actuarial Guidelines limiting an insurance carrier’s ability to illustrate above certain crediting rates. Regardless of the effectiveness or merits of the NAIC’s recent restrictions, there is an important lesson to be had resulting from the historical behavior in this area. Decision-makers and plan beneficiaries should ask their split-dollar administrators and/or advisors for rationale when assuming a specific rate of return. Then, explicitly ask for stress tests (reduced rate of return scenarios) to better understand the impact of lower rates of return on the split-dollar plan. This type of analysis will help ensure the initial design is properly collateralized in a variety of market scenarios, and help the employee understand the range of benefit outcomes possible in the event of “Black Swan” market returns. Further, stress tests should not only be considered during the plan design, but should be run periodically throughout the life of the plan as well.
7. Overloan Protection Rider
An Overloan Protection Rider is the easiest way to protect against an unintended policy lapse due to over-enthusiastic policy borrowing on the part of the employee. Frankly, we are of the opinion that split-dollar plans designed without this rider borderline on malpractice. As an employee enters retirement, a popular split-dollar strategy is to use accumulated cash values to supplement retirement income through a systematic program of withdrawals and loans. However, outstanding policy loans must eventually be paid back. Typically the employee pays the loan back upon death, netting the outstanding loan balance against death proceeds. However, if a policy is surrendered or lapses prior to death, the total outstanding loan balance is considered a distribution of account value at the time of termination and becomes taxable to the extent it exceeds the policy’s cost basis.
Unfortunately, the parade of horribles continue if that lapsed policy was associated with what is now likely an under-collateralized split-dollar plan. In this instance, the employee would now have an additional taxable event to the extent of the amount of the collateral shortfall.
An Overloan Protection Rider is typically a free rider that prevents policy lapse due to over-borrowing. Once the rider is exercised, the policy will enter a “Reduced Paid-up” status with a minimal guaranteed death benefit for the remainder of the employee’s lifetime. While this prevents the possibility of a lapse, the policy will no longer provide substantial death benefit coverage towards the employer’s recovery obligation. As a result, this should be utilized only as a last resort, and in consultation with your plan administrator.
It is the role of the administrator to monitor the plan for sufficient death benefit, among many other things. For this reason, we will conclude this article with a discussion surrounding the importance of proper plan administration, likely the most important feature to the success of a split-dollar plan.
8. Top Notch Third-Party Administration
Implementing a split-dollar plan is not a ‘set it and forget it’ endeavor. Arguably, third-party administration of a split-dollar plan is just as important as the design. Since the plan is often in effect for the life of the employee, the third-party administrator’s role must outlive that of the employer’s decision-makers who implemented the plan. In many circumstances, it can be especially helpful to have a third-party administrator liaise between an employee and their former employer after that employee has retired. Their role ensures that historical record-keeping and knowledge transfer occurs with new employer leadership, and the interests of the retired employee remain a priority.
Third-party administrators also assist with plan compliance, tax and other reporting requirements, and an annual assessment of plan performance. A top notch administrator will also actively monitor the economic environment and will guide the parties through opportunities to improve plan efficiency including refinancing the arrangement, a health rating reclassification, new product availability, and other policy and product options available.
While split-dollar is certainly not a “one-size-fits-all” transaction, the quality and experience of both the advisory firm designing the plan and the third-party administrator will make a significant difference in the plan’s outcome. We encourage employers and employees to consider their new and existing plans, and take action with trusted advisors if any of the critical and proven features described above are not being met. Contact TriscendNP to learn more.