This article by Jordan Smith, JD, LLM was originally published on WealthManagement.com.
In August 2016, the University of Michigan began what has now become a trend when they offered a split-dollar life insurance arrangement to head football coach Jim Harbaugh as an alternative to deferred compensation. Other schools have since followed in Michigan’s footsteps: Clemson, for Dabo Swinney; LSU, for Ed Orgeron; and South Carolina, for women’s basketball coach Dawn Staley. While Michigan’s basketball team finished the 2019-2020 season with a solid but unremarkable record of 19-12 under new head coach Juwan Howard, cooling off (due, in part, to injuries) after an unexpectedly hot 8-1 start that included wins over Gonzaga and North Carolina, Howard has quietly compiled the #4 recruiting class in the country (#1 in the Big Ten). He seems poised to pick up where John Beilein left off and have Michigan contending for national titles on an annual basis for years to come. Like Michigan did with Harbaugh at the completion of his first season as head coach, now is the time for Michigan to enter into a split-dollar life insurance arrangement with Coach Howard.
The Benefits of Split-Dollar Life Insurance
For those unfamiliar with split-dollar life insurance arrangements: This is a program where an employer agrees to loan dollars to an employee (generally over a period of 7 years) that are invested in a cash accumulation life insurance policy. Unlike a traditional life insurance policy, however, where the goal is to pay the lowest premium for the highest amount of death benefit, the policies used in these programs do the opposite and pay the highest premium for the lowest amount of death benefit. This approach minimizes policy charges and allows the policy’s cash value to grow as rapidly as possible with the least amount of drag. At some point – either out of policy cash value during the employee’s lifetime, or out of the death benefit at the employee’s death, depending upon the structure of the agreement – the loan from the employer will be repaid. But in the meantime, policy cash value in excess of the loan balance can be accessed by the employee income tax-free to supplement cash flow in retirement. Think of the arrangement as analogous to the employer funding a Roth IRA for the benefit of the employee, with a potential death benefit as an added bonus.
“Every Day We Get Better, Or We Get Worse”
As legendary Michigan football coach Bo Schembechler preached, even successful programs always have room for improvement – and Michigan’s approach to split-dollar life insurance is no exception. In designing a new a split-dollar arrangement for Coach Howard, Michigan has the opportunity to upgrade the structure that was used for Coach Harbaugh in ways that would provide significant additional benefit to both the University and the Coach.
“Those Who Stay Will Be Champions”
One somewhat surprising element of Michigan’s split-dollar agreement with Harbaugh was that it did not include any penalty for leaving early and taking another coaching job somewhere else. While Harbaugh needs to be employed by Michigan at the time of each scheduled advance in order to receive that premium advance, the obligation to repay the earlier premiums is not accelerated in the event of his early departure from the University. Moreover, Harbaugh’s loan is non-interest bearing and non-recourse, so there is little incentive for him to remain with the school once all 7 premiums have been advanced. This time around, Michigan should structure Howard’s agreement so that the loan accelerates and becomes immediately due if he voluntarily leaves to coach elsewhere within a certain number of years. As a practical matter, the impact of this approach would be similar to a Buyout clause – simply raising the financial bar for deciding to leave. In addition, Michigan should consider having the loan bear interest at the minimum rate set by the IRS, rather than making the loan interest-free. The arrangement could be paired with a separate Retention Bonus Agreement that would pay Howard an additional bonus each year he remains with the school, in an amount sufficient to cover both the interest due on the loan and the tax on the bonus – so that the program would truly be cost-free to Howard for as long as he remains with the University.
Better Living Through Income Tax Efficiency
While Harbaugh’s split-dollar loan is “interest-free,” it is not “cost-free”. Each year, Harbaugh must pay tax on imputed income equal to the interest that Michigan would have charged him if the loan had borne interest at the minimum IRS rate. What’s worse: Harbaugh won’t know the full extent of his annual imputed income until all 7 advances have been made on the loan – because the imputed interest rate that is applied to each advance is determined by the rate in effect at the time the advance is made. Had Michigan loaned Harbaugh all $14 million up front in August 2016 (rather than advancing $2 million each year for 7 years), they could have locked in a 1.9% interest rate on the entire amount for the rest of Harbaugh’s life. (Had they gone this route, to be consistent with the other terms of the existing deal, Michigan could have clawed back a pro rata portion of the $14 million in the event that Harbaugh left before Year 7.) Instead, the rates in effect for installments 2-5 were 2.26%, 2.64%, 3.31%, and 2.08%, respectively – which amounts to almost $54,000 of additional imputed income that Harbaugh will now have to pay tax on each year (for the rest of his life) over and above the amount he would have recognized had the entire $14 million been advanced up front. With interest rates even lower today than they were in August 2016, if Michigan enters into a split-dollar agreement with Coach Howard in April 2020 and advances the amount of all 7 premiums up front, they can lock in an interest rate of only 1.44% for the rest of Howard’s life.
Putting a Better Product on the Court
Perhaps the most significant way that Michigan can improve upon the split-dollar program they entered into with Coach Harbaugh would be to use a better life insurance product this time around. Although details surrounding the insurance policy purchased by Harbaugh are not a matter of public record, reliable rumor has it that the product used was a Northwestern Mutual Whole Life policy. If that is the case, then Harbaugh is almost certain to be disappointed by the amount of cash flow (or lack thereof) that he will be able to squeeze out of that product in retirement without jeopardizing his ability to repay $14 million to Michigan from the residual death benefit. Back in the summer of 2016, when news of Harbaugh’s split-dollar arrangement become public, we at Schechter Wealth ran our own illustration for what we would have recommended (a maximum funded indexed universal life policy with a top-rated carrier), and projected that such a product would have enabled Harbaugh to borrow up to $1.4 million per year out of the policy, tax-free, every single year beginning at his age 65 (Year 13 of the policy) and continuing on through age 98 (while still maintaining a residual death benefit in excess of the required $14 million)! With a Northwestern Mutual Whole Life contract, Harbaugh won’t come anywhere close to being able to access that much cash – because of the slow cash build-up and the negative rate arbitrage on policy loans that are long-standing features of Northwestern Mutual products. But fortunately, Michigan has the opportunity for a do-over when it comes to Coach Howard’s split-dollar arrangement, and the indexed universal life products available on the market today are better than ever. Imagine (to pick just one of the many attractive options presently available) a product with cash growth based on an uncapped 1-year point-to-point performance of the S&P 500, protected by a 0% floor, that currently (as of late March 2020) offers a 120% participation rate on the upside, and assesses only a 2.5% annual asset charge. Although the insurance carrier has the ability to move the participation rate up or down, that is not any different from the ability of Whole Life carriers like Northwestern Mutual to move their dividend rate up or down – and the historical look-back for this indexed product (based on current specifications, after the asset charge) is several points higher than Northwestern Mutual’s current dividend rate. If Coach Howard is looking for strong future performance that would likely even eclipse what we projected back in 2016 for Coach Harbaugh, choosing an indexed product like the one described here should be a slam dunk.
“The Team, The Team, The Team”
While some might be inclined to view certain of the provisions described above through the lens of whether they benefit the University (the acceleration clause; charging minimum interest rather than making the loan interest-free) or the Coach (advancing all of the money up-front), such a focus is too narrow and loses sight of the motivation for entering into a split-dollar agreement in the first place. At its core, the purpose for a split-dollar insurance program is to promote the long-term retention of a key employee in a tax-efficient manner that provides more benefit to the employee than the relative cost to the employer. It’s not a zero-sum game – in fact, it’s quite the opposite: The program works best when the employee is able to receive the maximum benefit possible from the dollars that are provided, in exchange for expressing a long-term commitment to be part of the employer’s team. The University and the Coach are in this together, and for the split-dollar arrangement to achieve its intended purpose, they each need to get what they’re looking for out of it. To paraphrase the end of another famous Bo Schembechler quote: When the University and Coach Howard work together as a “team,” then when the whole season is over…it’s gonna be Michigan again. Michigan.