Split-Dollar is an effective – and increasingly popular – tool credit unions use to attract, retain, and reward key senior-level talent. While the concept itself dates to the 1950s, this is a unique era for Split-Dollar, one that is testing the framework that has worked so well for decades. A prolonged and historically low-interest rate environment that gave way to sudden and rapidly rising rates had a significant impact on plans.
A credit union now must consider the design of the underlying life insurance product, its sensitivity to reductions in policy arbitrage, and their advisor’s approach to mitigating high-interest rate risk. Seekers of new Split-Dollar plans should gauge the impact on capital requirements and the experience of their chosen plan administrator before making important decisions.
Historical Context
Basically, Split-Dollar is an arbitrage transaction. The growth of an insurance policy that surpasses the required principal and interest owed to the sponsoring organization can be utilized, often tax free, for an employee’s retirement benefits. 2003 IRS regulations governing these plans brought clarity for administration and compliance and gave insurance carriers and Split-Dollar practitioners the guidelines needed to build effective and specialized products for the supplemental executive benefit space. Also, for the first time sponsoring organizations had to charge interest at the prevailing fair market rate (Applicable Federal Rate or AFR) on plan payments.
What followed was Indexed Universal Life Insurance (IUL), a flexible cash value-oriented life insurance product with earnings (subject to cap and floor rates) based on the performance of a major market index such as the S&P 500. IUL offered principal protection and an attractive growth cap rate opportunity above prevailing interest rates and quickly became the product of choice in the retail and executive benefit space.
For over a decade, credit unions and their key executives enjoyed the fruits of IUL in a bull market with a slow but steady decline in general interest rates, keeping Split-Dollar attractive and affordable. Until recently.
Low-interest rates may reduce what a plan must achieve to satisfy repayment to the sponsoring organization, but prolonged low rates also put downward pressure on cap rates, an important driver in long-term performance. The lower the cap rate, the lower the earnings opportunity in a given year. Low-interest rates also put pressure on products such as Whole Life, another popular choice for Split-Dollar. Whole Life products receive dividends based on the insurance carrier’s overall portfolio performance.
As interest rates remained low, Split-Dollar was not adversely impacted by a decline in cap rates. But the sharp increase in general interest rates in late 2022 occurred with little to no change in IUL cap rates. Not surprising, since carriers are generally invested in long-term bonds, but while carriers are (and will continue to be) slow to respond with increases in cap rates, the arbitrage opportunity narrows. This poses awkward challenges.
Existing Split-Dollar Plans
If you placed a Split-Dollar plan prior to late 2022, the interest rate (obligation to the sponsoring organization) may be partially or completely locked in. So the high AFR environment will not impact the amount due to the organization. However, rising interest rates are likely to put other pressures on the policies within your arrangement. The rate the carrier charges on policy loans is likely increasing while cap rates on your policy are at all-time lows. If you are currently receiving distributions, or plan to retire soon, this “squeeze” can reduce forecasted benefits. This problem is often amplified in a one-policy Split-Dollar design, where the sponsoring organization’s obligation and the participant’s benefits battle each other in the confines of a single policy.
If you have an existing Split-Dollar plan and are within five years of retirement (or currently accessing benefits) be sure you are educated and aware of the impact of the current rate environment on your plan. Do not access benefits without assessing the effects of those actions on a current illustration. It may also pay to hire a disinterested third party (other than your current Split-Dollar vendor) to conduct an unbiased evaluation. With your retirement at stake, an extra set of eyes can mean a real difference.
New Split-Dollar Plans
For new plans, the current environment doesn’t mean they are not viable. But your vendor must have the experience and flexibility to deviate from traditional designs and not require a tremendous amount of capital from your organization. That can be a challenge for credit unions experiencing liquidity issues. Vendors should explain the various ways interest can be treated, the options of insurance products and carriers, and other design elements to manage the capital requirement. Stress testing conducted before purchase is vital, so all parties understand the sensitivity of results and the conditions determining success or failure.
