The Struggle Is Real: Pre-Funding for 21st Century Healthcare Costs

There’s an old saying that “a rising tide lifts all boats,” but when we talk about the costs of health care, benefits and retention packages for employees, the ever-increasing expenses are making it difficult for credit unions just to tread water. The National Conference of State Legislatures estimates that the cost of family coverage rose 5% in 2018 and offsetting these increases has become even more difficult with recent accounting changes.

Benefits pre-funding, to summarize, is any account that a credit union establishes under NCUA Part 701.19(c) to offset the costs of their “employee benefit plans.” The regulation allows credit unions to step outside their normal permissible investments to achieve higher returns, so long as the investment is deemed “reasonable given the [federal credit union’s] size, financial condition and the duties of the employees.”

701.19(c) grants credit unions a very broad mandate: It refers to 29 U.S. Code 1002(3), which defines an “employee welfare benefit plan” to include any medical or insurance coverage, tuition reimbursement, vacation funds and a whole lot more (like your weekly pizza party – maybe not, but credit unions have a celebrated history of taking care of their people, and this regulation actively encourages it).

It’s a regulation credit unions are wise to leverage because it allows them greater return potential, as well as diversification out of interest rate sensitive bonds. Provided that they focus on quality and are not chasing the highest yields available, a diversified portfolio including equities and other otherwise impermissible investments can provide consistent returns and yield greater than regular investments. It is a sadly underutilized tool in any credit union’s arsenal.

Recent developments, however, are forcing advisors to think outside the box when it comes to pre-funding plans. The market climate we are in, for example, is a tricky one. At the tail end of a 10-year bull market in stocks, no one is entirely positive what direction is next for the markets, and interest rates spent most of last year climbing up a slow hill toward 3.25%, only to slide right down over the last four months. The rally has been a nice positive for bond investors in the short term, but over the long-term, continued low interest rates will keep returns suppressed.

Volatility and uncertainty is not a new phenomenon, however, and even with the market growing complacent a decade after the recession, it is easy, conceptually, to understand that low yields mean reduced income for any credit union that invests in bonds. What has made 2019 such an interesting and challenging year in the pre-funding world is an accounting change that has largely flown under the radar until the start of the year: ASU 2016-01.

The Financial Accounting Standards Board issued ASU 2016-01 as an update to GAAP, which changes the way “equity securities” are recorded. The change went into effect for credit unions on Jan. 1, and it, essentially, eliminates available for sale (AFS) accounting for stocks, ETFs and mutual funds. Even if a mutual fund owns 100% government bonds, FASB defines the share the credit union owns as an equity, and it requires these securities to be recorded using the new “fair value through net income” method.

For simplicity’s sake, this new method is very similar to trading, although there are a few differences on the debits and credits level. The credit union records the monthly market value change of a given security as income, not just the dividends or interest paid out. This means there are no more unrealized or realized gains for these securities, but rather that the investment’s total return over a given month determines the income booked from it. This is a big shift from the previous method, and it means that the old strategy of focusing on investment yield at the expense of quality has become an even riskier option, because a market value decline can negate or even outweigh the income produced. This, in turn, forces a credit union to reevaluate whether its funding levels are enough to meet its goals, since the “income” produced is more variable.

FASB did, notably, exempt individual bond positions from the new accounting standard. Bonds, including corporate issues, can still be recorded as AFS, and that can make an allocation to investment grade corporates and taxable municipal bonds, for example, even more attractive to credit unions. The trade-off, however, is that the accounting is trickier than it is for stocks, due to amortization, accretion and accrued interest.

As the market changes, and becomes faster paced and more competitive, most credit unions have been hunting for ways to increase their noninterest income. Executives can’t just snap their fingers and make loan growth happen, so the typical solutions are to increase fees or lower underwriting standards to drive business, both of which have their own drawbacks. Even with its challenges, pre-funding remains a great option for credit unions looking to improve their income statements without taking on undue amounts of risk on their balance sheets. With a little forethought and the right team of advisors, any credit union can set up a high-quality pre-funding plan and help give themselves a little more breathing room at the end of the year. To get started, keep these three simple principles in mind:

• Diversification: This doesn’t mean buy four different mutual funds that all invest the same way. Build a smart, conservative allocation, paying attention to the various types of risk. If you’re using mutual funds and ETFs, understand what their holdings are and how they fit in with the rest of the investments.
• Focus on Total Return: Don’t sacrifice quality to get an unsustainable dividend, because a market pullback of 20% can wipe out an entire quarter’s worth of gains now. Instead, focus on downside protection, earnings quality and sustainability to achieve the consistency to meet investment goals over the long term.
• Quantify the Credit Union’s Goals: Run an analysis for the credit union that looks at all the costs of the various employee welfare benefit programs. Discuss, possibly with an advisor, what a reasonable return expectation is and how much risk the credit union is willing to take on. Determine a total funding amount and start smaller than that – a pre-funding plan doesn’t need to be bundled into life insurance or some other product, so the credit union can start small and add to the plan freely. Save all the emails and notes from meetings to present to your auditors upon request.

These three bits of advice will get a credit union executive well on their way to creating an effective pre-funding program that will help their credit union knock it out of the park in terms of income and stay well ahead of the pack in terms of investment performance.

Fernando Arrue is Portfolio Administrator for Elite Capital Management Group, LLC. He can be reached at 203-699-9662 or fernando.arrue@elitecapgroup.com.