Not-for-Profit Organizations

Attract, Retain and Reward Top Performers

How Can Your Tax-Exempt Organization…

• Structure benefit packages for key executives that help them maximize their after-tax income?
• Attract top-flight management level talent that may be working in the private sector?
• Provide incentives for selected executives that encourage tenure with the organization?
• Provide retirement benefits commensurate with executive pay?
• Create management benefit packages that motivate long-term performance?
• Upgrade management benefits without jeopardizing the tax-preferred status of your organization’s qualified pension plan?

Defining The Need

Qualified pension plans and social security provide little incentive for talented executives to improve the financial performance of tax-exempt organizations, or to even remain with your organization. In fact, qualified plan benefits can be an incentive for executives to leave, because of early vesting and full portability.

Qualified plans simply do not provide top executives with retirement benefits that are in line with their pre-retirement compensation levels or with their contribution to the economic success of the organization. Qualified plans provide too little benefit for too many people.

Tax-exempt organizations are competing with tax-paying companies for executive talent. Total compensation packages of tax-exempts must be competitive with those offered by all employers, and not limited by geography or tax status.

The provisions of Internal Revenue Code §457 can significantly limit benefits offered to executives. Additionally, because of qualified plan and social security caps, higher paid executives will typically retire at 30% - 50% of their pay, far below the 70% - 90% range of final salary that your lower-paid employees can expect to receive in retirement (“Income Replacement in Retirement” by Robert D. Lebenson, MSPA; published by the ASPA National Retirement Income Policy Committee, © 1994.)

Because of this disparity and the heightened competition for talented managers, many tax-exempt organizations are following in the footsteps of tax-paying companies by creating supplemental benefit plans for their top executives.

A Well Designed Supplemental Benefit Plan Can…

• Provide additional post-retirement income for selected executives.
• Provide sufficient cash to executives upon retirement to meet the income tax liability issues associated with IRC §457(f) benefit plans.
• Provide retirement benefits to executives of your organization that are comparable to your tax-paying peers and competitors.
• Establish performance benchmarks that must be attained before supplemental benefits are awarded.
• Require continued employment for executives to reap benefits (“Golden Handcuffs”).
• Avoid ERISA restrictions on participation, funding, vesting and reporting.
• Replace benefits lost when an executive leaves a previous employer to work for your organization.
• Protect executives from the risk of change of control.

For the Tax-exempt Organization:

Remain competitive in the market for talented executives who can make a difference for your organization.

For the Executive:

Achieve greater retirement security as a reward for superior performance.

The “Plus” In Serp-Plus-457™

Efficient financing of benefits (1) provides your organization with the cash wherewithal to pay benefits when they become due, including the income tax liabilities of the executives; (2) establishes favorable accounting to minimize, and ultimately offset, the impact on your bottom-line; and (3) provides recovery of 100% of the executive benefit liabilities, including a factor for the cost of money as well as the financing cost itself.

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Use of Company-Owned Life Insurance (COLI)

Why finance the benefit promise?

• Pre-funding makes sound economic sense for the organization.
• Provides a measure of security for the executives, especially when combined with a Rabbi (Grantor) Trust.
• Rationally builds an asset to offset the benefit liability.
• Optimizes the cash flow impact of benefit payments to executives once they retire.

Why does COLI make sense?

• COLI can provide funding wherewithal, giving the organization another source of cash to pay benefits when they become due.
• COLI can be structured to provide a pre-retirement survivor benefit to executives on a tax-advantaged basis, in addition to providing cost recovery for the organization both pre- and post-retirement.
• COLI is self-completing, providing cash through death proceeds upon the death of each insured executive.
• COLI can provide a very favorable accounting treatment under FAS TB 85-4 to offset accounting for the benefit liability.
• COLI can be structured to provide recovery of the cost of benefits, cost of the financing itself (COLI premiums), and a factor for the use of cash.

Why not buy term and invest the difference?

• Term insurance has no cash value.
• Term insurance cannot provide any favorable accounting to offset the benefit liability.
• Term insurance cannot be economically structured to provide tax-advantaged pre-retirement survivor benefits.
• Term insurance cannot provide for self-completion nor cost recovery, since it cannot be economically purchased past retirement age, when the likelihood of mortality is the greatest.

COLI and SERP-PLUS-457™

• Insurability is of no concern since the COLI is used to create a pool only on insurable participants.
• Level face amounts are purchased through aggregate funding to minimize carrier underwriting issues.
• Pre-retirement split dollar arrangements are used to confer tax advantages on executives.

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Frequently Asked Questions about Purchases by Not-for-Profits of Company-Owned Life Insurance (COLI)

Q: Why do not-for-profits institute COLI programs?

A: Primarily to finance employee benefit plan expenses and increase net income. For example, not-for-profits have substantial costs for medical, group life, and other basic insurance as well as qualified and nonqualified benefit plan expenses that can be financed with Company–Owned Life Insurance (COLI). The reasons not-for-profits use COLI include:

• COLI matches the long-term nature of benefit plan expenses.
• COLI assets can be matched with benefit liabilities to offset the impact on earnings created by the benefit expenses.
• Use of COLI to fund benefits is a self-completing program.
• COLI can be structured so that the not-for-profit funds its benefits obligations and recovers its premium cost as well.
• COLI death benefits or cash value assets are available to pay pre-retirement survivor benefits.
• COLI provides important indemnification for the loss of one or more key executive (key person life insurance).

Q: Do many employers have COLI plans today?

A: Many not-for-profits, including some of the country’s largest, are using COLI to fund benefit obligations. For-profit companies also use COLI in this way. Based on industry surveys from 1999, 68% of the Fortune 1000 companies finance SERP obligations with COLI programs; and of the 50 top banks and thrift institutions in the United States, 43 have implemented COLI programs.

Q: How does COLI work?

A: The not-for-profit purchases insurance on lives of a group of employees. The insureds usually include a group of highly compensated or key management employees, for example, assistant directors and above.

The not-for-profit pays the premium(s) and owns the cash value of the policies. The not-for-profit is also the beneficiary of the insurance. The insured employees do not receive any of the insurance benefits directly, nor do they pay any of the premiums. The coverage does not replace nor interfere with any other insurance provided by the not-for-profit (e.g., group-term life insurance).

The COLI policies produce financial statement income for the not-for-profit as the cash value increases exceed the premiums paid. The income earned may be higher than the return available on other alternative investments.

Q: Do the policies actually fund the benefits like a pension plan funds retirement benefits?

A: No. The policies are part of the general assets of the not-for-profit. Properly stated, the insurance informally finances the cost of the benefits. The policies are often placed in a grantor trust (generally a “rabbi” trust), which is an asset of the not-for-profit, or they may be held by the not-for-profit directly and not otherwise segregated.

Q: What are the different types of COLI policies?

A: Two basic types are characterized as:

1. General Account COLI – These credit a fixed interest rate annually to each policy. The interest rate is based on the expected return of the investment assets purchased by the insurance company less a margin for expenses. These assets are held in the general account of the insurance carrier. Either a “new money” approach or a “portfolio” approach (both described later) is used to determine credited interest rates. General Account COLI policies provide minimum annual interest guarantees in addition to full book value (cash value) guarantees and asset default protection.
2. Separate Account COLI – The interest rate credited to a Separate Account COLI policy is a variable yield that is based on the return on the underlying policy assets less a margin for expenses. These assets are selected by the not-for-profit and are held in separate accounts of the insurance company. The separate account assets are sheltered from the general creditors of the insurance company in the unlikely event of the insurance company’s insolvency. Unlike a General Account contract, the cash values of a Separate Account contract will fluctuate with the market value of the underlying assets and are fully subject to the risk of asset default. The fluctuations of asset values have a direct impact on the purchaser’s balance sheet and income statement, since the cash value represents the book value of the life insurance contract. Some carriers employ a hedge strategy to smooth the annual returns.

Q: Is one type of COLI policy better than another?

A: The answer depends on a not-for-profit’s desire to participate in selecting the investment mix of the funds underlying the COLI policy values. If the not-for-profit does not want the burden of selecting the investment mix and accepting the risks associated with the investment results, General Account COLI is preferable. There are no investment decisions for the not-for-profit to make, and it will have the underlying protection of a minimum interest guarantee. On the other hand, if the not-for-profit is comfortable that it can select an investment mix likely to outperform the investment results of the insurance carrier’s general account and is willing to accept full risk for investment results, the Separate Account COLI policy may be preferable. Some not-for-profits split their coverage so that a portion of the not-for-profit’s contributions is allocated to each type of policy.

Q: What are the differences between a “New Money” rate product and a “Portfolio” rate product?

A: “New Money” and “Portfolio” describe the two philosophies or methods used by insurance companies in setting credited rates on their insurance policies. A New Money philosophy credits each policy with an interest rate based on assets available specifically at the time of purchase. These assets are tracked and determine the future interest of each specific case. A Portfolio approach is based on a pooling philosophy. The insurer pools all its assets and all its policies and determines a rate for all policyholders regardless of when the policies were purchased. While the New Money policies are more responsive to changes in interest rates than the Portfolio policies, ultimately the performance will be similar.

Q: If this were an opportunity for a not-for-profit to make more money and finance benefit expenses at the same time, why wouldn’t every not-for-profit do it?

A: Every not-for-profit should buy COLI if it has these characteristics:

1. It has reasonable liquidity.
2. It has employee benefit liabilities.

MAKING A COLI PLAN WORK

Q: Do the insurance policies have to be placed into a separate account or trust?

A: No, the policies always remain part of the general assets of the not-for-profit. For administrative or other reasons, the not-for-profit may choose to implement a grantor trust to own and hold the policies.

Q: Does the not-for-profit keep the coverage when the insured employees terminate or retire?

A: Yes. The coverage on each individual insured is carried as part of an aggregate COLI pool. To make sure death benefits are collected on retired employees on a timely basis, we track all covered employees in COLI pools administered by NYLEX Benefits via the Social Security System. At present, we have over 200,000 employees that we track for our clients. When the retired employee dies we access information via the Social Security System to file the death claim with the carrier.

Q: What has been employee reaction to the plans?

A: Very favorable. Keep in mind, the coverage does not cost the employees anything. It makes the employer more financially viable and it is a plan that has been implemented by many of the country’s largest and most reputable not-for-profits and regular corporations. While an employee cannot be forced to be covered within the COLI pool, our experience is that well in excess of 90% do participate.

Q: Do the employees receive any of the cash benefits from COLI?

A: Generally, no. However, some not-for-profits provide some additional death benefits to insured COLI participants by allocating a stated portion of the proceeds for the benefit of the participant’s designated beneficiaries.

Q: How long does it take to implement a COLI arrangement?

A: Normally 2 to 3 months from start to finish.

COLI FINANCIAL IMPACT

Q: Will COLI have an impact on a not-for-profit’s financial performance?

A: COLI will favorably impact a not-for-profit’s financial performance by creating higher net income to offset the benefit expense. The result is an increase in earnings.

Q: Are COLI premiums a charge to earnings?

A: To the extent that COLI premiums result in cash surrender value, the not-for profit is treated as having purchased an asset. COLI premiums (except for the recognition of any early surrender charges) require a cash flow outlay, but over time enhance earnings.

Q: What are the current earnings rates of COLI?

A: The rate of return is a function of the type of policy purchased and the interest crediting approach (“New Money” vs. “Portfolio) for a General Account COLI arrangement, and is based on the investment results of the separate accounts in a Separate Account COLI arrangement. Common structural elements are:

• All policies will have a rate based on the expected performance of the underlying assets in a General Account arrangement and based on the actual performance of the underlying assets in a Separate Account arrangement, less, in either arrangement, a margin for carrier expenses.
• Product expenses will be similar.
• Each carrier incurs approximately the same charges for premium tax, general administration, the federal Deferred Acquisition Cost (DAC) tax, and expected mortality and investment expense.

Therefore, the return is primarily a function of the assets supporting the COLI arrangement. When reviewing a COLI purchase, NYLEX Benefits will help the not-for-profit understand the underlying investment philosophy and be comfortable that the philosophy can support the interest rates being illustrated over the long term.

Q: Is COLI liquid?

A: Yes. COLI policies allow the not-for-profit to borrow against the cash value, and the policies can be surrendered at any time and the cash value will be paid to the not-for-profit. In very large COLI programs, some carriers may require a 4 to 5 year surrender period to allow them to gradually wind down their investment in the arrangement.

Q: What happens if the coverage is surrendered?

A: The carrier pays the not-for-profit the cash surrender value of the policies.

Q: If the insurance had to be surrendered in the future, is COLI still a good deal?

A: Yes. The investment yield is still attractive.

Q. What is the credit risk of a COLI program?

A: Before any COLI purchase, the not-for-profit should carefully review (with our help) the financial strength of each proposed carrier, as well as its track record in the market. Regardless of product type, the financial strength and reputation of a carrier is critical to the future viability and credibility of a COLI program. Separate account products minimize the credit risk in the event the carrier becomes insolvent as the assets are protected in a separate account. However, insolvency is an infrequent event.

Q: How does the COLI insurance carrier make money?

A: The carrier recovers expenses and makes a profit on the difference between the income and outflow from the product. The majority of income is from the interest earned on the assets backing the policies.

Q: How does the COLI insurance carrier recover expenses incurred and what do they include?

A: Most carriers recover expenses through an interest margin. Some carriers may also charge an administrative fee, costs of insurance for mortality and even a front-end load. These recoveries may be in different proportions between products but in total they need to recover the same basic expenses regardless of the type of product. The expenses that a carrier must cover include: state premium tax; federal DAC tax; marketing expenses; interest credited to cash value (in a General Account product); administrative costs; death benefits; profit; and Risk-Based Capital (RBC). The RBC cost component varies significantly between products. The Separate Account policies will have lower RBC as the risks for market value accounting, minimum interest guarantees and asset defaults are passed on to the policyholder under this product.

Q: What happens if the COLI insurance carrier has financial trouble?

A: In such a situation, the coverage may be transferred to another carrier via an IRC Section 1035 tax-free exchange.

Q: What is the effect of a policyholder merger on COLI plans?

A: Merger and acquisition activity has no direct impact on the COLI plan performance. However, for an acquiring not-for-profit, the COLI from the acquisition should be a beneficial addition to its existing portfolio. It will be reviewed in terms of concentration and credit for the newly merged entity. For the not-for-profit being acquired, COLI is an attractive balance sheet asset and will enhance the net worth and earnings results.

COLI ACCOUNTING TREATMENT

Q: How is the income earned and recorded?

A: The not-for-profit earns income in a COLI arrangement from two sources. The first is from the growth of the cash value of the policy. While the full cash value works for the not-for-profit, the not-for-profit records as an asset the cash surrender value (the full cash value less any applicable surrender charges in the event the contract is surrendered in the year being recorded). The cash value increases each year as the insurance carrier credits interest or as the separate account increases in value. The second source of income comes from the insurance proceeds paid to the not-for-profit as each insured employee dies. The accounting treatment for a typical COLI plan can be summarized as follows:

• COLI purchase is reflected as an OTHER ASSET.
• Earnings (increases to cash surrender value) will be recorded as a credit to an income account (OTHER INCOME).
• Receipt of the net-at-risk portion of death proceeds is also reflected as a credit to an income account (OTHER INCOME).

Q: How does the balance sheet change with the purchase of COLI?

A: The not-for-profit will normally use funds generated through cash flow to purchase COLI. Since both are assets, there is no initial charge to the balance sheet (other than the possible recognition of an early year COLI surrender charge). However, since COLI may earn a rate of return that may be higher than other similar type investments, the income statement will show additional income, which translates into increased surplus.

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