Series: Ask ALM
As many are aware, employee benefit costs continue to rise.
As is the case with any problem, putting it off, though probably the easiest approach, is dangerous. There are many ways to offset these expenses, and a prudent management team recognizes the need to address this issue and provide an appropriate response. Increasingly, that response is beginning to take the form of a securities portfolio.
Figure 1 illustrates the growth within this space for credit unions, with securities investments being the fastest-growing asset class since 2014. As of Q3 2017, investments to meet future benefit obligations represent over 10% of net worth for the entire industry. Traditional outlets such as insurance (split-dollar/other) still comprise the majority.
Section 701.19 of NCUA regulations outlines the regulations for pre-funding employee benefits. These benefits must be reasonable in kind and size, given the financial condition of the institution. However, the regulations reference the U.S. Code of Federal Regulations for definitions of permissible expenses. Thus, what is explicitly outlined as impermissible cannot be pre-funded. Examples include salaries, overtime pay, incentives, or holiday gifts.
Figure 2 highlights a few of the most common expenses that are permissible. Ultimately, these expenses will establish the legal basis for creating a pre-funded portfolio. More importantly, the creation of such a portfolio must be linked directly to the future obligations. Once established, the credit union has a legal basis for participation in otherwise impermissible asset classes. As a rule of thumb, portfolios in which the size exceeds 25% of net worth will receive “enhanced scrutiny”, but this is not a statutory limit; each portfolio will be judged with respect to balance sheet materiality.
So why should your institution choose a securities investment portfolio? For many years, insurance products have been a popular investment vehicle. This is particularly true in the banking industry, where these programs often carry substantial tax benefits. For credit unions, however, this tax benefit doesn’t exist, and often these investments can be complex, presenting an undue burden on management. Investing in these assets requires an understanding of the risks associated with the product. In particular, a credit union must be comfortable with potentially higher compliance and legal risk when compared to a securities portfolio.
Choosing a securities portfolio provides a greater degree of control, as it pertains to investment mandates and overall portfolio construction. Partnering with an asset manager allows the credit union to maximize returns while reducing fees – an added benefit. Overall, the simplicity, transparency, and control afforded by a securities portfolio grants the depository greater freedom than institutional life insurance, which often are fairly illiquid.
Formulating a proper portfolio strategy should not be overlooked when constructing a pre-funded securities portfolio. This includes determining a desired risk tolerance, expected return, investment objective, and benchmark against which the institution can evaluate performance. It is important to assess risk tolerance with respect to both return and interest rates, as the underlying assets of the portfolio affect both earnings and capital-at-risk. Identifying a strategy that aligns with institutional goals and overall balance sheet management can provide the greatest benefit to the depository.
Also vital to this process is understanding the accounting treatment these investments will receive, particularly as it pertains to equities. For example, a more risk-averse institution may elect to avoid any equity exposure to eliminate mark-to-market treatment of their portfolio. Additional considerations in strategy formulation include determining return objectives, liquidity requirements, time horizon, or any other specific investment restrictions.
The need to manage employee costs will only increase in the coming years, as the burden continues to swell and weigh down institutions across the country. While there are many paths to take, creating pre-funded securities portfolios is an intelligent approach.
