Risks Associated with Employee Benefit Programs and Investments that Fund Them
Providing employee benefits can subject a credit union to a number of risks. Credit unions accept a certain level of risk in providing employee benefits and investing to fund them, and need to manage the risk. The risks associated with employee benefits and investments that fund them include:
- Credit risk
- Interest rate risk
- Liquidity risk
- Transactional/operational risk
- Compliance risk
- Strategic risk
- Reputation risk
There are benefit plans in which the risks associated with the investments are borne entirely by the plan beneficiary. For example, investments in a 457(b) plan for a senior executive typically do not pose financial risk to the credit union, because the executive bears the investment performance risk and the credit union expenses the funding of the account as compensation. Similarly, some deferred compensation plans have risk that is self-directed and borne by the employee. Employee plan investments in which the risk is borne entirely by the plan beneficiary are not considered an investment risk exposure for the credit union.
All purchasers of investments are exposed to credit risk. With insurance, this risk arises from an insurance carrier’s contractual obligation to pay claims and, if applicable, any CSV, less any applicable surrender charges, upon the surrender of the policy. Credit-sensitive investments are generally subject to price risk if the investment’s credit profile worsens or if credit spreads widen.When evaluating credit risk, exam staff should consider credit quality and excessive concentrations in single obligors.
Credit risk exposure also occurs with defined benefit plans, also known as pension plans. Imprudent investment management of a defined benefit plan can result in underfunding and risk to a credit union.
Interest Rate Risk
Due to the interest rate risk inherent in many investments for employee benefits, it is particularly important for exam staff to confirm that management fully understands how these products expose a credit union to interest rate risk before purchasing the investment. Interest rate risk associated with these products is primarily a function of investment cashflows.
Interest rate risk can also result in price risk. A credit union should be aware of these risks before it purchases any investments for employee benefits and ensure the investments are appropriately modeled in NEV and NII simulations.
Liabilities associated with employee benefits can be difficult to model in NEV and NII simulations. Assumptions for these liabilities should be reasonable and supportable in a credit union’s NEV and NII simulations.
The purchase of investments for employee benefits can negatively affect a credit union’s liquidity position, both because insurance or other investments may be one of the less liquid assets on a credit union’s balance sheet, and because credit unions normally fund investments by drawing down liquid assets.A credit union may need to surrender or borrow against an insurance product to access the CSV of a policy. Credit unions should consider the exit costs for any investment when assessing liquidity.
Credit unions can mitigate liquidity risk by identifying the potential illiquid nature of investments for employee benefits before making a purchase, and ensuring that the credit union has the long-term financial flexibility to hold the asset in accordance with its expected use. For insurance, a credit union may not receive any cash flow from a life insurance policy until a death benefit is paid. The inability to hold a life insurance policy until the death of an insured party (at which point death benefits can be collected) may compromise the value of such investments.
Credit unions should review insurance contracts to quantify surrender charges and ensure they are consistent with any statements or marketing materials that state the products are 100 percent liquid without surrender charges.
This risk can arise due to the wide variety and complexity of life insurance products and other investment products, and associated accounting standards. Credit unions with more than $10 million in assets must follow GAAP. (See 12 U.S.C. § 741.6(b), Consistency with GAAP)
The NCUA has encountered instances in which a credit union had material income restatements due to improper accounting. Credit unions should be aware that some assets used to fund employee benefits will have an immediate negative impact to earnings when purchased, and should consider the impact of this on financial statements.
Credit unions should be aware of the impact of any long-term employment or post-employment obligations made to employees. Future employee benefit obligations committed to by contractual agreements or collective bargaining may require an actuarial analysis to determine the value of the liability that may need to be recorded on a credit union’s balance sheet. Credit unions may need to hire a vendor to perform this analysis.
Accounting for assets and liabilities for employee benefits, particularly insurance, can pose the risk for restatement of the financial statements if improperly accounted for. It is important that credit unions understand the unique accounting aspects of investments for employee benefits, both pre- and post-purchase.
Credit unions should establish a tracking process for former employees that are insured to provide an alert in the event of a mortality event that triggers a claim payment.
Credit unions need to be aware that they may be subject to the ERISAand other regulations based on the benefits they offer. Fiduciaries for qualified defined benefit plans must ensure that the plans are managed in a manner consistent with ERISA. Credit unions can mitigate the potential for compliance risk by seeking the advice of counsel on legal and regulatory issues.
With employee benefits, strategic risk may arise when a credit union commits to excessive or unaffordable employee benefits that materially impact future income. Credit unions should be aware of the potential negative impact that employee benefits commitments may have on future hiring plans or potential merger opportunities. Insurance products may have substantial price risk if terminated prematurely.
Credit unions should also consider the earnings volatility that investments for employee benefits can cause if changes in value flow through the income statement. Earnings volatility is a greater concern in credit unions that have low net worth.
While reputation risk arises from virtually all credit union products and services, it is particularly prevalent in employee benefits and investments for employee benefits. This is due to potential perceptions associated with a credit union’s compensation to senior executives and potential earnings shocks resulting from financial statement restatements. For example, a credit union with high executive benefits and a poor financial performance (such as low or negative earnings, or depressed or declining net worth) has an elevated reputation risk.
Last updated September 25, 2017