Be Careful With COLI

Most of you are familiar with it. If you've ever been in corporate HR or Finance, someone has undoubtedly tried to sell it to you. It can look like the greatest thing since sliced bread, and frankly, before 1986, it probably was, but corporate-owned life insurance, commonly referred to as COLI, is not the be all and end all.

It has its uses. I have recommended in favor of it and I have recommended against it. But, understand that I have never sold it. I am not licensed to sell insurance products. I never have been. That makes me relatively agnostic to COLI. I don't make money from its sale. The work that I have done and do with respect to COLI is either analysis of its merits or performance, or helping a client unwind it if they decide they don't like it.

So, why am I writing this? While I have no insurance credentials, I do have a bunch of actuarial credentials. As such, I am held to a whole set of professional standards. They start with the Code of Conduct and include adherence to a set of Actuarial Standards of Practice (ASOPs). While adherence to all of this can feel annoying at times, I fully support that my profession has adopted this framework. If only all of the other professions that we deal with had as stringent a framework, in my opinion, the benefits world would be a more honest and straightforward place.

Let's go back to COLI. I looked at a COLI illustration this morning. It was based on a Variable Universal Life (VUL) product. Note the variable part. That means that the product invests typically in a mixture of equity and fixed income instruments, usually chosen (all or in part) by the policyholder. So, like a defined benefit trust or defined contribution account, it has a return of return that is closely linked to the rates of return on those instruments (there are often charges and or loads).

What was alarming? The cash value seemed to be building up really quickly. I did some analysis. The agent who produced those illustrations chose to assume a 10% rate of return inside the policy. I checked. That is legal in his state. It is in many states. But, as an actuary who has to make similar assumptions for defined benefit trusts, I would tell you that it's not reasonable. In fact, if I put in writing today in a Statement of Actuarial Opinion that a 10% rate were reasonable, I would expect to be reported to my profession's disciplinary body.

You know what, if you can get tax-favored asset build-up that has a geometric mean 10% long-term rate of return guaranteed, you should put all the money that you can afford to into the underlying instrument. And, you had better tell me about it so that I can invest in it as well. It's just not feasible, it's not reality, but it was in an illustration presented by an agent to a prospect.

So, the message is this. COLI has its uses. It has its purposes. But, the guy who has the goal of selling you COLI is not going to be unbiased, no matter how hard he tries to convince you. If you can do the analysis yourself, do it. Find out if the COLI product is, in fact, good for your company. If you can't, then find an unbiased third party to do it. And, if either you or a third party find that the illustrator thinks he can get you a 10% annual rate of return, run away from it as fast as you can.

Another Survey Says

The benefits community in the US loves surveys. Large consulting firms love to do surveys. Presumably, their clients like this information, or at least someone thinks they do. The benefits news consolidators (you know, the publications that scour the internet for benefits news for a daily newsletter) love to tell us about these survey results.

This is all good. Or, at least, this could all be good. These surveys, though, have their problems.

• Questions are often poorly worded
• Possible answers either cover too much territory or not enough territory
• Press releases summarizing survey results seem to disassociate cause and effect
• Survey populations may not be unbiased
• Surveys inevitably are constructed to produce the findings that the surveyors think should be produced

Questions are often poorly worded

This is a no-brainer, but the world at-large doesn't seem to mind. I saw a survey question recently (the group had not been bifurcated yet into people who liked versus those who disliked their consumer-driven health plan (CDHP)) that asked "What do you like best about your consumer-driven health plan?" The possible answers were something like:

     a. my quality of care is higher
     b. it costs me less
     c. I can choose my own physician
     d. it promotes a culture of wellness

My immediate reaction is to ask where is e: none of the above? Let's look at the possible answers. Anybody who says that their quality of care is higher under a CDHP must be hallucinating. What would make it higher? If you can choose your own physician, why would they provide better care when you are in a CDHP than they would under a traditional health plan?

If you say that it costs you less, I would ask you less than what. Yes, the premiums are lower than they would be in an HMO, for example. On the other hand, they are higher than they would be if you had no insurance at all. Isn't this like having a deductible on an automobile insurance policy? If you choose a higher deductible, your policy costs less. But, in the health care policy, you usually don't get to choose your deductible. And, in the case of high-deductible health plans (HDHP) which are typically the cornerstone of CDHPs, the deductible is typically higher than most people can effectively budget for.

If you say that you can choose your own physician under a CDHP, that is true, but can't you choose your own physician under any health plan? It's true that your care may not be covered by the plan, but for many people, if that is really the reason they are in a CDHP, I would say that they are quite misguided.

Do you really think that CDHPs promote a culture of wellness? If I were texting, I would reply "lol." According to a recent Aon Hewitt survey (oops, now I am citing a survey), 35% of participants in CDHPs are sacrificing medical care because they cannot afford their part of the cost under these plans and 28% are postponing it for financial reasons. FACT: that is not indicative of a culture of wellness.

Suppose I think the CDHP that I have been forced into just plain sucks. How do I answer this question?

Answers cover too much or not enough territory


In the last section, I managed to deal with answers that don't cover enough territory. Sometimes, they go the other way and cover too much.

I took a survey recently about automobiles. The survey asked me a series of questions. For each question, I was supposed to answer on a scale of 1-13, with 1 meaning I strongly disagreed and 13 meaning I strongly agreed. Come on, people, 1-13? Do they really think that ten minutes into a survey, I can rate things on that fine a scale. They asked me if I would consider buying a Lexus when I next purchase a vehicle. So, perhaps I went through a train of thought like this. Lexus makes a very good car. They are stylish, safe, high-performing, and dependable. They are also expensive. Would I consider buying one? Yes, I would probably consider it, but I really don't want to spend that much money on a car, so how strongly would I consider it? Hmm, is that a 5 or a 6 or a 7 or an 8 or a 9 or a 10? I don't know. If it was on a 1-5 scale, I could probably happily fill in the little button for a 3. But on a 1-13 scale, that would be equivalent to a 7 and I just don't know if I'm a 7 or not.

Press releases ignore cause and effect


I saw another survey (if I could find the actual survey again, I would cite it here) recently that said that fewer companies were funding (informally) their nonqualified deferred compensation (NQDC) plans. The headline said something about recent guidance on corporate-owned life insurance (COLI) being the reason for this. Hmm, the survey had no questions in it about why fewer companies were funding their NQDCs. And, further, I'm not sure what recent is, but I can't find any recent COLI guidance that would affect funding of NQDC plans. Perhaps the authors of the surevy had a bias?

Survey populations may not be unbiased


Suppose a large consulting firm does a survey. In my experience, they send the survey to a nice cross-section of large companies. Perhaps it looks something like the Fortune 200 plus all of that firms clients not in the Fortune 200 that generate at least $1 million in annual revenue for the firm. Of the companies surveyed, who do you think are the most likely to answer the survey? Could it be the consulting firm's large clients? Aren't they the ones most likely to actually open the survey? Who are least likely to answer the survey? Could it be the companies that have recently fired that large consulting firm?

Do you think that the results of this survey might be a little bit skewed? Do you care? I do.

Surveys inevitably are constructed to produce the findings that the surveyors think should be produced


Suppose you ran the health care consulting practice at a large consulting firm. Further suppose that you are a big proponent of consumerism. In fact, you have built your consulting firms health care consulting practice around CDHPs. You ask your survey group to do a survey around health care plans. You want to be able to make a bold statement in a press release that shows how wonderful CDHPs are and for all the reasons that you have been touting.

Do you think you will make sure that the questions have at least a small bias that will lead to your desired result? If the findings come back differently than you had hoped, do you think you will publish the results as is, or will you find a way to tweak the results? Will you tout the portion of the results that support your practice or will you be unbiased in how you release the survey results?

I don't need to answer those questions for you. You don't need to answer them either. We all know the reality.

These surveys ... they do have their problems.

Another Knife Stabs COLI

Most of us have heard of it -- corporate owned life insurance (COLI). In the 80s and part of the 90s, it was one of the ultimate gimmicks. It had great tax treatment and great accounting treatment, and yes, it often performed well. But, over time, COLI began to get a bad name. Battling for tops among the reasons were two: brokers of COLI products were making what were viewed by many as unconscionably large profits selling the product; and many companies were buying what was known in the pejorative as janitor's insurance. That is, they were buying life insurance policies on everyone down to the janitor to fund perquisites and benefits for top executives.

Well, over time, these benefits of COLI have eroded. Someone could write a book on just that, but that discussion is for a different day here. But, in the latest blow to COLI, the IRS has released Revenue Ruling 2011-9 . What, you may ask is this, and what does it do? It adds particular teeth to [Internal Revenue] Code Section 264(f). So? What in the world is Code Section 264(f) and why do you care? Be patient, dear reader.

Section 264 is entitled Certain Amounts Paid in Connection with Insurance Contracts. Subsection (f) deals with expensing certain related interest costs on a pro rata basis.

Here is why this matters.


As COLI laws have been tightened, companies that purchase COLI have become more and more concerned about having an insurable interest in the individuals on whom they purchase insurance. So, for example, if Microsoft purchases life insurance on Bill Gates, even the most cynical among us would probably argue that Microsoft does, in fact, have an insurable interest in his life. But, suppose instead, Microsoft purchased insurance on the life of Horatio Hornblower [Note: to the best of my knowledge, they have neither done this nor considered it]. Even the most fervent COLI supporters among us would likely argue that there is no insurable interest there.

Where this turns grayer is with regard to policies held on past employees, or when a policy on a past employee is exchanged for one on a current employee. I digress. Code Section 1035 generally allows a policyholder to exchange one bona fide policy for another without creating a taxable event. So, as the insurable interest rules have tightened, many companies have routinely exchanged policies on employees who have recently terminated for policies on employees who have recently joined. That sounds innocent enough, doesn't it?

Now, let's look at Section 264(f). It says that, in general, a portion of a taxpayer's interest deduction based on the ratio of the sum of the unborrowed cash values on life and annuity contracts it owns to the adjusted basis of all of the taxpayer's assets is disallowed. Notably, Section 264(f)(1) provides an exception for officers, directors, employees, and 20% owners at the time of policy issuance. So, if all of your COLI is held on the exempted group, you get your full interest deduction. Right?

Not so fast. There is a good chance that some of the policies that you hold on the exempted group were not originally held on the exempted group. In other words, some of these policies were acquired through the use of Section 1035 Exchanges. And, the exchanges were likely (a euphemism here for perhaps 100% certain) done after the original insureds were no longer in the exempted group.

According to this ruling, both new and old policies that were acquired through a 1035 exchange after the original insured was no longer in the exempted group are not exempted. This would say that an employer needs to contemplate the termination of an employee and perform the exchange prior to that employee's termination. I think most would say that this is not practical.

From a reality standpoint, here's what this does. When COLI no longer has its most favorable tax treatment, it becomes what is sometimes referred to as an underperforming asset.. According to the revenue ruling, if an exchange is not done on a timely basis, either the interest deduction goes away because of the untimely exchange or the company now holds a policy on an individual who is no longer exempted. What did Joseph Heller call his book: "Catch-22"?

What should companies do about this? Companies that hold COLI need to check all of their policies to see which ones no longer get them the presumed deduction. Then, they need to make decisions with regard to those policies to see if they should somehow unwind them and use the assets for other purposes. Worse yet, the stated proposal of the current administration is to take away the exemption in Code Section 264(f)(1).

We can help you wade through this mess.

But, as always, neither this author nor his employer provide tax, legal, or accounting advice. This can only be obtained from someone licensed to provide such counsel.

Risk Management Isn't Just for Qualified Retirement Plans

Do you work for a company that has an active risk management policy? Do you consult with companies that manage risks or should? Are you in a benefit plan that may or may not manage risks? Then, perhaps this is for you.

Much has been made of risk management in recent years. During the economic downturn that started sometime during Bush (43)'s second term (I'm not going to argue about specifically when it started) and that is still continuing (or is not depending on which "expert" you believe), every company that I am aware of talked about risk management in earnest. Some actively did something about, some just talked about it, but it became a buzzword (I'm sorry, but a buzzword can be more than one word in my blog).

Let's focus on employee benefit programs, both broad-based and executive. Most everyone out there does some sort of risk management in most of their welfare benefit plans. Their health care plans are often fully insured, or if not, they at least have some sort of stop-loss insurance in place. And, they know that they can increase the employee portion of cost-sharing next year. With regard to other welfare benefits, LTD plans are often fully insured, life insurance plans as well. Think about them, in virtually all of these plans, employers are pooling their risks.

Suppose we turn to retirement plans. I am going to look at them in four baskets:

• qualified defined benefit
• qualified defined contribution
• nonqualified defined contribution
• nonqualified defined benefit

Qualified DB

What a trendy topic to write about: risk. The word has been out for nearly 25 years now. Get out of defined benefit plans. Diligent readers (I'm sure I have at least one) will recall that I wrote several weeks back that certain DB plans (specifically cash balance) managed appropriately are less risky than 401(k) plans from the plan sponsor standpoint. Since nobody commented on this, can I presume that everyone who read it agreed with me? I;m not that foolish, but ...

In any event, anyone who deals with qualified plans has heard about risk management, LDI, and lots of other trendy terms. When I got into this business, more large companies than not sponsored DB plans, and extremely few did anything to manage their inherent risks. Now, only those who think that they are omniscient with regard to both interest rate movement and equity and fixed income prices do nothing.

Qualified DC

In my experience, very few companies even evaluate their risks here, but most companies have them. Consider these:

• Suppose an employer provides a matching contribution in their 401(k) plan and all of their communications to employees are successful. Then, employees will contribute more and employers will be on the hook for more matching contributions. Isn't this a risk? I think it is. How many companies forecast this under any, let alone many scenarios? Shouldn't they?
• Many private or closely held companies sponsor ESOPs. When a private company sponsors an ESOP, isn't there really only one way to pay out plan participants when they terminate with a vested benefit? And, isn't that to repurchase the shares? I know that there are some companies out there that perform (or have done for them) an assessment of their repurchase liability. For the ones, who don't, in my opinion, they are just rolling the dice.
• I've seen a lot of companies scrap their defined benefit plans in favor of a profit sharing plan. In doing so, they make an implicit promise to their employees (not all companies do this, but there are enough that do), that they will contribute at least some minimum percentage of pay to the plan on behalf of each employee. Suppose business is bad. Suppose there are no profits to support these profit sharing contributions. That's pretty risky. The old way of sponsoring a profit sharing plan, basing contributions on and sharing profits, is probably more prudent. 

Nonqualified plans

Why don't employers (as a group) manage their risks in these plans? Are the obligations too small to worry about? Is it because they are just executive plans and since they may not get ERISA protection, they are not worthy of risk management? Is it because they don't know how? Is it because they have never thought about it?

Let's go back a few years, say to some point before 1986 (there were sweeping changes to tax laws including the treatment of certain life insurance products). Nonqualified plans were much smaller than they are now. But the promises made in many of them were just plain silly. 

I'm aware of one former Fortune 100 company (the company no longer exists due to acquisitions, but its particular identity is irrelevant) that promised a return in excess of 20% annually in its NQDC plan. They funded the plan using COLI, and they could point to broker illustrations that showed that all was taken care of. [pause for me to laugh out loud] I'm sure that there were other companies out there that did similar things. Remember that whoever it was that designed the plan (internally) was going to benefit from that large rate of return. If they were at the level that they were involved in the design, they were probably at least 40 years old at the time and they were smart enough to know that it doesn't take too many years at a guaranteed 20+% rate of return to build up a pretty good nest egg. And, they also knew if they thought about it that the risks that they created for the company wouldn't become really apparent until after they had become a wealthy retiree.

Why didn't this company manage this risk better? They were using the same mentality that many others have used in a retirement plan investment context -- that of total return. And, their assumptions were overly optimistic.

I'm going to make a bold statement (it's not really so bold, but teeing it up this way gets your attention better). Whether it be on a micro basis (at the plan level) or on a macro basis (at the enterprise level), it is critical that companies manage their nonqualified risks. This means that it is incumbent upon them to set aside assets to appropriately manage those risks (whatever that means to the particular company). While it may seem prudent to make the play that, on average, minimizes financial accounting costs, this is often wrong. While it may seem prudent to take the position that managing cash flow, in a way that on average, minimizes that cash flow, this is often wrong.

I'm going to attempt something drastic here. I'm going to try to insert a graphic in this blog (people over the age of 50 should generally not resort to such technological indulgences).

Tell me, in this matrix, which risk do you really want to take additional steps to actively manage? If I ask people (limited to ones that I consider to pretty intelligent), they assume that this is a trick question. Of course, they want to focus on the northeast corner -- the one with high risk and high likelihood. Think about it. Aren't these the risks that they are already very actively managing? With regard to these risks, companies tend to be fully insured, fully hedged, or at least fully something. They don't let these risks go unwatched. They know that they could bring down the company.

Does anyone remember what happened to BP in the Gulf of Mexico a few months ago? The likelihood of that event was small, but the downside risk was immense. Similarly, does anyone remember the performance of assets and liabilities together during the 10-year period that just recently ended? We had about 4 years of "left  tail events during that 10 year period (the left tail in a normal distribution is where you usually find the low probability, but very poor outcome events). In other words, 40% of the time, we had an outcome that models said would occur less than 5% of the time. What went wrong?

I could go on and on about what went wrong in terms of bad models, bad laws, bad accounting rules and the like, but that's not the point. The point is that not enough companies prepared for this low-probability event. Now, risk management in pension plans is all the rage (at least for companies that still sponsor pension plans). As time goes by and the rich get richer (they do, don't they?) nonqualified liabilities grow rapidly. And, as those liabilities grow, companies are actively managing the risks attendant to those plans, right?

WRONG!

Some have looked at this carefully, but you can probably count that list of some pretty darn quickly. Am I suggesting that companies formally fund their nonqualified obligations in a secular trust? Probably not, the tax rules usually don't work. Am I suggesting that they fund in a rabbi trust? Maybe, perhaps more than maybe. Am I suggesting that they somehow evaluate their low probability, high magnitude risks in their nonqualified plans and then quickly take reasonable steps to ensure that those risks will not get in the way of the successful operation of their company?

With due credit to Rowan and Martin's Laugh-In, you bet your bippy I am.

Do it now, and do it right, and if you're not sure how, let me help you do it.