The purpose of this letter is to provide supervisory guidance on the expectations for a corporate credit union (corporate) providing employee benefits1 in accordance with § 701.19 (opens new window)2 of NCUA’s Rules and Regulations entitled Benefits for Employees of Federal Credit Unions.
§ 701.19(c) (opens new window) provides corporates investment authority that would otherwise be impermissible as long as the investment is directly related to the credit union's obligation or potential obligation under an employee benefit plan, and the credit union holds the investment only for as long as it has an actual or potential obligation under the employee benefit plan. The supplementary investment authority allows for investments which may be riskier and more complex than otherwise permissible. Employee benefit funding investments may range from subordinated securities to insurance products which may include Split Dollar Life Insurance.
NCUA expects a corporate to prudently incorporate all investments made under this authority into its risk management program. All investments must comply with the operating requirements set forth in § 704.6 (opens new window)3 Credit risk management, § 704.8 (opens new window)4 Asset and liability management, and § 704.9 (opens new window)5 Liquidity management to ensure a corporate is not exposed to excessive market risk. Investments made under this supplementary authority must adhere to the tests and criteria for evaluating investments and investment transactions set forth in Part 7046 to ensure a corporate understands the risks, rewards and unique characteristics of each investment.
Direct Relationship Requirement
The direct relationship requirement is the legal basis on which NCUA permits corporates to make otherwise impermissible investments to fund employee benefits. A corporate must illustrate that the investment is directly related to the corporate’s funding obligation under an employee benefit plan and it is not investing for its own account. Additionally, investments may only be held for as long as a corporate has an obligation under the employee benefit plan. Demonstrating a direct relationship suggests that benefits be in place prior to completing an investment transaction and that the expected income does not exceed the projected costs of benefits (plus reasonable recovery costs) for employees. In order to reasonably satisfy the direct relationship requirement corporates should also be able to illustrate an investment’s predictable rate of return7, provide the stated or expected maturity, and generate an approximation of future cash flows. If a corporate cannot demonstrate a direct relationship between the employees benefit obligation and the investment funding the obligation, it must take action to bring the investment into compliance or divest of the original investment. Under §704.10 (opens new window)8, any corporate in possession of an investment that fails to meet a requirement of Part 704 must, within 30 calendar days of identifying the failure, report the failed investment to its board of directors, supervisory committee and the Director of the Office of National Examinations and Supervision (ONES). Investments failing to meet Part 704 also require the submission of an investment action plan to the Director of ONES. Additionally, NCUA can object to an investment based on the investment’s reasonableness in relation to the corporate’s size, complexity, and financial condition.
Risk Management Processes Commensurate with Investment Risks
A corporate should ensure its risk management program incorporates the risk associated with all financial assets on its balance sheet irrespective of any accounting classifications. Due diligence on investments should increase in accordance with the risk and complexity of a financial asset. Proper due diligence requires that a corporate identify and monitor changes in an investment’s quality and structure particularly in light of an investment’s impact on expected income and net worth. For example, investments funding employee benefits should be reflected in issuer concentration limits set forth in §704.6 (opens new window)9 and included in net economic value (NEV) and other tests required by §704.8 (opens new window)10 including weighted average life (WAL) and adjusted WAL requirements.
When incorporating employee benefit plan investments into regulatory required operating calculations and analysis, methodologies may be straightforward, or alternatively complex depending on the specific type of benefit plan investment held by a corporate. Among other aspects, a corporate’s approach must take into consideration unique characteristics of the investment that could have an adverse effect on the corporate’s financial outlook. For example, the value of premiums paid towards a split-dollar agreement may exceed the policy’s cash value during the initial years. Withdrawals or cash values upon cancellation may also result in significant surrender charges. In these instances, the substantial risk of forfeiture may not be appropriate for corporate’s focused on restoring net worth.
A corporate should also illustrate its understanding of the full array of risk an investment poses. This is necessary to implement appropriate risk management processes and limits that will ensure the balance sheet does not incur unwarranted risk. Additionally, NCUA will review employee benefit investments during the supervisory process and can object to an investment on suitability and risks concerns.
Investments without Stated Features
In some cases, investments used to fund employee benefit plans may take the form of life insurance plans and open ended investment funds (i.e. mutual funds, ETF’s, insurance policies and annuities). These types of investments may not always carry a defined “maturity date,” and for corporates, are likely to carry higher levels of credit, market, and interest rate risk than permissible investments. In the case of mutual fund investments, the corporate should “look through” the investment into the fund itself to determine the duration and WAL of the underlying investments of the fund to assign WAL and duration for interest rate and liquidity risk analysis.
Assigning an estimated WAL for an investment will be challenging for investments with no stated maturity, WAL, duration target, or readily available estimates of future cash flows. In these cases the corporate should develop supportable estimates of key attributes in order to measure and monitor the interest rate and liquidity risk associated with holding the investment over the life of the employee benefit plan. While there is no specific “best practice” for estimating WAL and duration for these types of investments, reasonable and supportable assumptions and estimates can be developed by looking directly at the terms and conditions of both the investment and the benefit plan being funded to identify the holding period, maturity, and asset amortization to calculate the WAL and valuation of the investment.
Employee Benefit Plan Examples
To illustrate the concepts above, the following examples and commentary are provided:
Assume a corporate purchases an insurance or annuity type investment that does not have a stated maturity date or readily available estimate of future cash flows that can be used to determine the WAL and duration of the investment.
In this instance, a corporate may forecast the time the benefit plan will be outstanding by utilizing an actuarial life table. The investment’s maturity and cash-flow assumptions can subsequently be used to determine its WAL. Regardless of its approach, a corporate should document its methodology and all analysis supporting its investment assumptions.
A corporate has a defined benefit plan that requires a future compensation payments to eligible employees at retirement based on accumulated service and the level of salary expected. The current accumulated benefit obligation of $250,000 is estimated to increase substantially in approximately 10 years to $500,000. In order to help fund the future expenses from its qualified retirement plan the corporate has created a new employee benefit portfolio (EBP). The corporate deposits $800,000 in the EBP at its inception. The EBP will be placed in an investment fund with a 6.5% annual return. The EBP is projected to grow to approximately $1,500,000 over the following 10 years.
In this example, the corporate has failed to demonstrate meeting the direct relationship requirement between the employee benefit obligation and the investment chosen to fund it. The contractual returns for the corporate’s EBP indicate that its $800,000 investment is sufficient to fund and recover reasonable costs for an obligation of $700,000 in 10 years which exceeds the projected costs of employee benefits by $200,000. Accordingly, the agency’s position is that the corporate’s investment, in excess of that amount needed to return $500,000 in approximately ten years, is for the corporate’s own account and not directly related to its employee benefit obligation.
A corporate has a Section 457(f) plan as a way of retaining executives with supplemental retirement benefits. Assets are invested as determined by the executives, but all assets are owned by the corporate until distributed to employees. The plan includes otherwise-impermissible investments. The corporate reports its WAL to address market factors that may materially impact the corporates NEV as part of its asset and liability management policy. The WAL reported does not include investments held within the corporates 457(f) plan.
In this example, the corporate has failed to properly incorporate its employee benefit plan into its risk management program and is not fully identifying and monitoring the market risk on its balance sheet. The additional investment authority granted does not relieve the corporate from monitoring and reporting the investment risk held in its 457(f). All investments owned by the corporate in its 457(f) plan should be reflected in the corporate’s risk exposure levels and appropriately incorporated into its risk management program.
While NCUA has not adopted specific limits for capital or retained earnings at risk for employee benefit plan investments, a corporate should give consideration to the additional risk being acquired in relation to Tier 1 capital and retained earnings. Corporate boards of directors should fully understand the structure and risks associated with these investments, and their potential ability to impair retained earnings and Tier 1 capital. As part of the examination and supervisory process, NCUA expects a corporate’s board and management to demonstrate that appropriate pre-purchase analysis was conducted and the corporate gained a thorough understanding of the investment’s structure, its short and long-term cash flows, and the potential affects to retained earnings and capital at the various stages of the investment’s life-cycle. Prudent risk management suggests corporates establish risk limits when evaluating the reasonableness of an otherwise impermissible investment product both individually by instrument, and in totality as a percentage of both retained earnings and Tier 1 Capital.
In summary, a corporate’s risk management program must be commensurate with the risk held on its balance sheet. Corporates have the authority to purchase investments otherwise impermissible if those investments meet the direct relationship requirement and are intended to fund an employee benefit obligation. In these cases, the corporate may not invest for its own purposes and the investments may only be held for as long as the corporate has an obligation under the retirement or benefit plan. Regardless of what kind of investment plan is used, a corporate must ensure that the type and amount of employee benefits it offers are reasonable given its size, financial condition, strength of retained earnings and Tier 1 capital, and the duties of its employees. The additional investment authority granted to corporates does not relieve the corporate from monitoring and reporting risk on the balance sheet in accordance with Part 704 (opens new window)11 of NCUA’s Rules and Regulations as well as reporting these investments in accordance with GAAP. In cases where investment attributes are not clearly defined, corporates should employ reasonable and supportable estimates and methodologies to ensure that otherwise impermissible investments are included in risk management measures in accordance with §§704.6 (opens new window)12, 704.8 (opens new window)13, and 704.9 (opens new window)14 of the NCUA Rules and Regulations. And lastly, NCUA can object, during the supervisory process, to an investment due to reasonableness and risk concerns.
If you have any questions, please contact your district examiner or the Office of National Examinations and Supervision at ONESMail@ncua.gov
Scott A. Hunt
Office of National Examinations and Supervision
cc: State Supervisors
1U.S. Bureau of Labor Statistics defines employee benefits as any non-wage compensation a credit union provides an employee.
212 C.F.R. § 701.19.
3Id. § 704.6.
4Id. § 704.8.
5Id. § 704.9.
6Id. Part 704.
7This may imply investments with fixed-income characteristics unless the benefit funded is tied to the returns of the investments. For example, a 457(b) plan where the executive chooses an equity investment option.
812 C.F.R. § 704.10.
9Id. § 704.6.
10Id. § 704.8.
1112 C.F.R. Part 704.
12Id. § 704.6.
13Id. § 704.8.
14Id. § 704.9.