By Ken Derks and Trey Deupree
The banking industry has been on a wild ride since March, when a large influx of liquidity began to flood balance sheets. Combined with significant rate cuts by the Federal Reserve, government programs such as the Paycheck Protection Program and individual pandemic-relief payments, banks have experienced a tremendous surge in deposits.
According to the FDIC, as of Sept. 30, 2020, interest-bearing balances averaged approximately 10 percent of total assets for all banks, with most of those dollars earning negligible returns. U.S. Treasury rates continue to hover at historic lows while the Fed has signaled its intent to hold the target range for the federal funds rate steady at zero to 0.25 percent.
Holding too much cash is taking its toll on banks’ net interest margins. According to the latest FDIC Quarterly Banking Profile, NIM fell to an historic low. With the majority of bank earnings coming from NIM, CFOs are challenged with evaluating alternatives to protect and grow earnings. Significant changes in market conditions, as we are currently experiencing, require changes in strategies—particularly in asset mix. Now may be an excellent time to consider adjusting your asset mix to include a larger allocation of bank-owned life insurance.
Advantages of BOLI
Despite the low interest rate environment, some of the top insurance carriers currently offer products with tax-equivalent yields in the 3 to 4 percent range, which many banks believe is very attractive compared to alternative investments. The tax-advantaged interest generated by a fixed-income BOLI policy is typically substantially higher than what a bank can earn on other investments with a similar risk profile, especially in the current rate environment.
In addition, BOLI activity has been driven by strong credit quality and leverage ($1 invested in BOLI typically returns $3 to $4 of tax-free death benefits). In compliance with regulatory guidelines, BOLI is used to offset and recover employee benefit costs, such as health care and 401(k) or other employee benefit expenses.
Many banks purchase BOLI to informally fund specific deferred compensation plans and/or to provide supplemental life insurance, which can be tailored to the individual participant. These nonqualified plans can be highly customized and are generally designed not as a retirement plan, but a plan to provide them with cash during their working years. For example, a plan could assume a bank’s top loan officers receive a contribution of 5 to 15 percent of salary annually. The deferred compensation earns interest, and the balance pays while employed and perhaps within three to five years. This popular strategy uses BOLI financing to attract, reward and retain younger, high performing mid-level officers.
For a properly structured plan, the bank purchases individual life insurance policies on a group of eligible employees; per IRC §101(j), each insured must provide written consent to be insured and be a highly compensated employee. This is commonly measured as the top 35 percent of bank employees by compensation. For example, if a bank had 60 employees, it would be able to acquire life insurance policies on up to 21 of the highest-paid employees.
When purchasing BOLI policies on ten or more eligible participants, the insurance companies often allow “guaranteed issue” underwriting, meaning the employees are not required to undergo a medical exam or have their medical and prescription records reviewed.
Regulatory guidance suggests a guideline aggregate BOLI capacity of no more than 25 percent of capital. Historically, most banks have excess capacity to purchase BOLI as they have remained below the 25 percent of total capital guideline, establishing internal guidelines at or below the regulatory level. Banks should continue to evaluate their BOLI capacity as a percentage of capital, as their capital levels change over time.
For example, a bank that has achieved positive capital growth over the past three years and currently has additional BOLI capacity of $17 million, which corresponds to 19 percent of BOLI to total capital concentration but has in previous years assumed a target BOLI concentration of 21 percent. If the bank would attain the 21 percent target, this would assume an additional $8 million of new BOLI, which at 3.72 percent tax equivalent yield would improve the bottom line by $235,000. Again, the small increase in percentage from 19 to 21 percent results in $8 million of investment opportunity.
According to FDIC data as of Sept. 30, 2020, the cash surrender value of BOLI policies held by U.S. banks grew to $182.2 billion, up from $176.5 billion reported one year earlier. Sixty-six percent of all U.S. banks have recorded BOLI on the Call Report, and 72 percent of all U.S. banks with assets over $100 million and 77 percent over $250 million have BOLI on their Call Reports. As banks cope with market and economic challenges associated with COVID-19, anticipating next steps to improve or protect profitability will become increasingly important.
Ken Derks and Trey Deupree are consultants with NFP Executive Benefits, which ABA endorses for executive and board benefits consulting, administration of BOLI and nonqualified benefit plans, BOLI portfolio solution and BOLI risk assessment. To learn more, contact Ken Derks at [email protected] or Trey Deupree at [email protected]. Ken Derks and Trey Deupree are registered representatives with Kestra Investment Services, LLC. Investor disclosures.