How to Access Non-Traditional Investments: Best Practices for Employee Benefits Prefunding

By nature, credit unions are people centric. From the members to the staff to the community, credit unions represent a mission to serve their stakeholders. The NCUA offers two specific solutions to help institutions achieve this mission: Employee benefits prefunding (EBPF) and charitable donation accounts. These non-traditional investment portfolios are intended to help credit unions fund expenses associated with non-monetary compensation and charitable giving. With access to investments outside traditional 703 constraints, credit unions can tap into high quality assets that historically have generated returns in closer alignment with rising expenses on employee benefits and help support financial commitments to the community.

Employee Benefits Prefunding Regulations

Section 12 CFR § 701.19 of the federal code defines the ability of credit unions to invest in assets otherwise restricted by section 703 for the direct purpose of offsetting expenses associated with current or potential obligations under an employee benefit plan or defined benefit plan. Essentially, a credit union can invest in non-703 permissible fixed income and equity securities, among other assets, with the explicit purpose of generating income to pay for non-monetary compensation expenses. The most common of these expenses are medical insurance and qualified retirement packages such as 401(k) plans. Other benefits, which are becoming more common in modern compensation packages, include tuition reimbursement, childcare reimbursement and travel stipends, among others.

While the regulations themselves are relatively broad and do not directly limit concentration or asset allocation, the NCUA’s Examiner Guide sheds more light on the safeguards expected for these types of portfolios. Three key areas for governance include:

• Direct Relationship Requirement;
• Expanded Examination Scope; and
• Pre-Purchase Analysis.

Prefunding Best Practices

The Direct Relationship Requirement indicates that the return of the investment portfolio is reasonably related to the expense and cannot exceed the benefit obligation. Essentially, this means that your portfolio can only be as large as necessary to extinguish the qualifying expense, and that the assets within the portfolio must generate a return profile that aligns reasonably well with the liability. This last consideration can be interpreted as the element that limits investment in assets with erratic return profiles. It is rare that institutions consider such assets given the significant risk profile, but worth noting when determining your investment strategy. For context, most credit unions prefer to invest just outside the scope of 703 permissibility in high quality liquid assets, such as corporate debt, asset backed securities and equity instruments.

In determining appropriate size, there is a common misconception that credit unions are limited to 25% of net worth. While not a hard limit on concentration, this is a threshold that when exceeded triggers added regulatory scrutiny, known as Expanded Examination Scope. Once the aggregate assets tied to prefunding benefits expense exceed this threshold, expect more oversight and questioning related to governance and risk management. This expanded review is at the discretion of examiners for portfolios totaling less than 25% of net worth. In discussion with regulators, there is a stronger preference for a right-sized risk profile rather than a limited balance sheet footprint. The concern over capping portfolio size is that institutions would likely increase exposure to more risky assets to generate a higher expected rate of return and similar dollar return relative to a larger, less risky portfolio, creating a misalignment with the institution’s risk appetite or ability to manage such risks.

Similar to core investments, your employee benefits prefunding portfolio must have appropriate procedures for pre-purchase analysis, due diligence and risk monitoring. This specific requirement will be dependent upon the portfolio approach you select. The most common approaches include:

• Securities portfolio (discretionary or non-discretionary);
• Mutual funds;
• Credit union-owned life insurance (CUOLI); and
• Alternative insurance products, like stable value annuities.

If building a non-discretionary securities portfolio, your institution will be required to prepare or obtain adequate pre-purchase reporting and ongoing monitoring for each security within the portfolio. Under the discretionary approach, the due diligence obligation shifts to review of the asset manager, ensuring that they follow appropriate protocols when purchasing securities and keep within defined risk policies when managing the portfolio. General account insurance policies have less transparency into the underlying investments of the policy and therefore due diligence on the insurer and any other involved parties is emphasized. Separate account insurance policies offer greater control over investment mandates but restrict the policy owner’s ability to influence security selection. As such, a similar approach to adequate due diligence of insurer and affiliated parties (including the asset manager) is critical.

Evaluating EBPF Approaches

Different approaches to EBPF portfolios can have drastically different accounting treatments, cost structures, investment mandate flexibility, transparency and liquidity profiles. A general comparison of the approaches is detailed in the table below.

Brittany Rollek is Managing Director of Client Experience for the Dallas-based ALM First Financial Advisors.