Speaker 1 0:00

And so the, the build-out there, again, it can take a number of different forms , um, especially the , the pre-funded benefits portfolio. We see , uh, like you mentioned the bullied and product, which is again, kind of the banking sphere of this, this conversation, but for credit unions, the Cooley , or the CU Oli , um , type products, it's one form of creating

Speaker 2 0:31

Welcome

Speaker 3 0:31

Everyone to the 12th episode of in your best interest and ALM first podcast, a show that will explore common depository challenges, give you an insider's view of the latest market trends and share stories and insights from industry leaders. I'm your host, Mike Ehnes Weiler . We took a little break to start the year, but just like major league baseball. We are back in full swing in the fourth quarter of last year, we discussed some of the themes we thought we would see heading into 2021. Since that time we've had the vaccine rollout, additional stimulus, a yield curve, steepening more surge deposits and depositories continued margin and earnings pressure, and a whole lot more. The theme that started back then, and I'm still hearing is how do I deploy this excess cash? And give me some ideas to improve our margins. Today, we are joined by Brittany Rolla . Our first repeat guest , I asked Brittany to join us because she works so closely with a wide variety of depositories as their clients and believe she has some great insights to share. Brittany is a director in alien first advisory services department and joining the firm in 2013 as a director for the firm, Brittany is primarily responsible for the client's management team to customize and implement actionable and effective ALM and investment strategies to enhance client performance.

Speaker 2 2:16

Thank you for joining us again, Brittany.

Speaker 1 2:18

Thank you, Mike. Always a pleasure to chat with you.

Speaker 3 2:22

No. When we met last October, we talked about the challenges facing depositories and some of the best practices being deployed. My goal for today is to talk about what, if anything has changed since then and dig a little deeper into some of the successful strategies for improving net interest margins, liquidity, excess liquidity still seems to be an issue as well as how much, if any, should depositories deploy. I know it's not a one size fits all answer, and I don't want to touch too much on the regulatory need for liquidity, stress testing and those kinds of things today, but focus more on profitability. So let's just dive in what is driving your client discussion these days?

Speaker 1 3:03

Yeah, it's definitely all stemming from this very challenging operating environment. You know , you've got depositories which are flushed with deposits because of fiscal stimulus. The fact that folks are still relatively kind of on lockdown, haven't been spending as usual , um, and combine that with relatively low loan demand and additionally, a pretty historically low rate environment and that squeezing margins across the board and definitely creating some earnings struggles. Um, and so most of the client conversations really are surrounding those themes and those ideas. And how do we enhance margins? How do we stabilize those margins, stop the bleed. Um, and also it really increased the bottom line returns and earnings for, for the institution. So, you know, some of the things that we've definitely been talking about and, and some, some common themes and areas that institutions are looking to try and maybe get outside of their usual box things like exploring FinTech partnerships to really supplement the in-house lending activities, reach a broader audience and try to regain some of that loan demand. Um, that has been relatively anemic through the pandemic thus far , um, below the line income strategies . So trying to , to boost what they can to generate some ancillary income, whether that be through again, ramping up mortgage origination and selling mortgages to , to generate some gains on sale. Um, but also as well, other strategies with , uh, selling ancillary services and , um, investment services and things like that for depositors that's, that's another area of discussion and probably one of the biggest ones , um , that we're seeing, especially right now, as we kind of continue to, to work through this environment is non-traditional investment portfolios. And those are , uh , things like employee , um, pre-funded benefits, portfolios, CDA, or charitable donation accounts that are specifically targeted to offset a benefit expense or charitable activity expense. Um, which again is , is so associated within this environment, within the institutions that we work with, the, you know , community bank space, the credit union space in particular, where again, they're generally they're purpose or mission driven , um , institutions where they , they want to add stakeholder value wherever they can. And these types of portfolios, it's a, it's a great way to be able to supplement and support those initiatives and internal activities.

Speaker 3 5:31

Those, and those are great ideas, you know, so let's touch on that a little bit more. So, as you mentioned, one of the avenues that your clients are that we're hearing from depositories that they're exploring more these days is that, you know, on the bank side, it seems like they're getting a lot more pitches for Boley , um, which, which makes sense to some degree , um, because of the tax advantage that that brings. Um , but there's, there's, I know there's different kinds of bullies. There's a separately managed bully in the taxable or in the general fund type bully, as well as on the credit union side, like you mentioned those typically non permissible, seven Oh three assets for employee benefit pre-funding and charitable donation accounts. Can you maybe just compare and contrast those or explain in a little more detail , um, perhaps for some of the uninitiated as to what those things are and kind of pros and cons of those?

Speaker 1 6:23

Yeah, absolutely. So a pre-funded benefits portfolio and a CDA portfolio for the credit union space is essentially the ability to work outside of the traditional regulations and build an investment portfolio , uh, which again, can take a variety of different forms in order to generate returns earmarked for these specific purposes, like funding non-monetary comp related expenses , um, and charitable giving, which is associated with a permissible charitable organization. And so the, the build-out there, again, it can take a number of different forms , um, especially the , the pre-funded benefits portfolio. We see , uh, like you mentioned, the, the bully and product, which is again, kind of the banking , um , sphere of this, this conversation, but for credit unions, the coli or the CU Oli , um, type products, it's one form of creating, again, this , uh, this investment vehicle to be able to generate returns to ultimately offset pre-fund benefit IX , um , the , the non-monetary comp related expense. So that's one, one type of vehicle that exists within this framework. Um, and even within that, you've got some, some breakdowns , um , between a general account type of structure where essentially you're just putting money into an insure , um, and they are generating and, and , um , crediting you a return within their, their managed asset base. And then you have a separate account, which ultimately has a bit more control , um , there for the investors themselves defining where the assets are going, what the risk profile looks like. So again, kind of some added breakdowns just within that type of product alone. Um, and then you have outside of that kind of insurance , um , type landscape, you have things like mutual funds , um, which can be used again to , to get outside of your traditional seven Oh three permissible asset classes. Uh, again, a lot of those mutual funds that we, we see what we're institutions are tapping into those again, have some equity exposure associated with them. Um, but you can also go the route of, even outside of all that you can go into a specifically managed securities portfolio , uh, which again, it's like almost think of it kind of a , um , the same as your investment portfolio, but again, it's managed with the exp the , the ability to have exposure to assets, which are outside of those 700 , three permissible asset classes. So you'd have an asset manager and an asset allocation across various sectors, things like corporate bonds , um, equities as well. Uh, so there's a lot of ways that you can build out these types of portfolios and each of these different forms of these portfolios can have some pros and cons , uh , depending on the risk appetite of the institution, the preferences for volatility in the earnings statement. There's, there's definitely things to consider a lot of things to consider when evaluating what makes the most sense for institutions as they're looking to develop and , um, essentially establish these types of portfolios on the balance sheet.

Speaker 3 9:44

So that was a good, good explanation. And so let me just summarize, so bullying makes sense for banks because of the tax benefits , um, it's , it's accounting friendly. Um, you can tie it into some additional executive benefit programs, that kind of thing, but on the, but they're there, you have to differentiate that between a general account and a separately managed account. Um, cause I know a lot of times they have poor liquidity. Um, they're , they're not very transparent. Um, there's higher fees , um , that are kind of baked in that the institution never sees, but on the, on the credit union side, because there is no tax advantage , um, it seems like a lot of these programs are just a black box. There's a , you know , a teaser rate almost. Um, and then, you know, that that crediting rate applies over time. But given that there's, there is for liquidity, it is a more complex legal structure. It is less transparent at the end of the day, there are higher fees that are baked in , um, because without that tax advantage, there are better ways for credit unions to earn higher income or get higher returns without having to go down that path. Summarize it .

Speaker 1 10:58

That's absolutely correct. I would agree those that's actually what we would say are kind of some of the biggest factors and red flags to be looking for when you're evaluating these different types of programs and also evaluating what you may already have on your balance sheet, right? There's, there's already some exposure within the credit union industry to these insurance type products like Holi . Um, and you know, when we talked through the value of those types of programs, again, you know, it was something that was, was relatively common, especially because it kinda came from that bully space , um, where again, there was that tax advantage for banks, but in the credit union space, like you said, there's, there's other ways to get it done. That may be much more valuable to the institution without having those factors of the high fees and costs structures. And then also as well, that black box idea, like you mentioned, you know, institutions should very much so no what type of risk they are taking on within these types of portfolios. And it's can be very difficult to really understand that and wrap your hands around it when you're in these general account coli type , um, type products. And so we definitely see an advantage and a stronger value of having a much more transparent approach to building out these types of portfolios , um, and having a securities portfolio where again, it can be tailored and customized directly to the needs of the institution. What is the risk tolerance, the risk preference of the institution? What are the return targets? You know, what is the expense that you're trying to extinguish or minimize , um, through the creation of these types of portfolios? So, you know, that those are definitely key components in what we talk through when we evaluate these different types of programs and, you know, the red flags ultimately that we're looking for and , uh, you know, trying to maybe create better solutions to still tackle that ultimate need.

Speaker 3 12:58

Yeah. And that that's great. So I love that you brought up this idea of red flags as you've worked with your clients who maybe have had some of these programs in place. Do you have a couple of examples that you can specifically cite? What, you know, when you, when you're evaluating a program that one of your clients was either looking at or currently has, what are the, you know, do you have a checklist in your mind of, Hey, there's three or four things that I specifically want to understand about this program , um, before I can opine on it?

Speaker 1 13:29

Yeah, absolutely. So first is knowing again, kind of what type of format the institution has in , in the creation of those types of portfolios. And again, most common it is that we see these insurance type , um, programs and , uh, portfolios already being established. But again, a lot of institutions may be looking to move away from that, especially once you hear about the different types of, of portfolios and, and , um, you know, structures that can be used instead of that coli type product. Um, what a couple of things we , we really work through there is understanding what are the costs to manage. Um, so knowing where you may have layered costs. So again, generally coli products and bully products tend to be more expensive. Um, they generally carry higher management fees. Um, and again, you know, depending on how you structure the securities and , or rather the assets for that portfolio, there could be added and layered management fees going into that portfolio itself. You know, if you have a separately managed Tulia account, which again, you know, we probably say is maybe the better approach of a general account versus a separate account. Um, both because of the, the bank breakfasty treatment, you have a , a better , um, a better profile in a separately managed account. Those are not essentially assets that are co-mingled in that general fund, which again, if the, if the insurer was to , um , file bankruptcy, the assets again are , are lost. Um, but the, in that separately managed account, again, if you have not only the management fees of the coli itself, but then also have assets embedded within that portfolio that also incur additional management fees or expenses, things like mutual funds that just layers that cost in, which is ultimately reducing down the return for the institution. So that is definitely one red flag , um , that we see when we start opening up and kind of looking behind the curtain, if you will, on some of these products and portfolios and helping institutions understand that they are taking on much more cost associated with these portfolios than they probably realized , um, that they were, and that really eats into return. And again, may defeat , um, and work against the goals of , of the return that they're trying to generate. So that's definitely one thing. So look for layered management fees and really kind of where are all the costs adding up. Um, additionally again, you know, understanding the risk profile, so transparency within the portfolio, do you really know how much risk that you are taking on? And that becomes a really important question when looking to defend a portfolio and the size of a portfolio in an examined story framework , um, and examination framework. So when regulators come in and they want to understand, you know , okay, you've developed or grown this portfolio, maybe substantially , uh, you know, what is, what is your support and your defense behind it? And if an institution understands the risk profile and , and the anticipated or expected returns , um , for that portfolio, and can use that to justify the size of the portfolio, you're in a much better position from a regulatory standpoint as well. So definitely, you know, that transparency idea here , um, is, is very important and certainly something that again, can be a big red flag, if an institution, when you ask them about a portfolio that they already have on the balance sheet, they can't adequately explain that. Um, when, when talking about it, that's probably going to be a red flag of continuing to use that type of approach if you're looking to expand the program.

Speaker 3 17:16

Yep . That makes a whole lot of sense to me, Brittany. So let's, let's focus on the separately managed portfolios. Um, and you know, you talked a little bit about that, especially for credit unions, they can get into nine, seven Oh three permissible investments. Um, they can go down the credit spectrum. So talk a little bit about, you know, how can you achieve a better return profile? And then if I do have exposure to things like equity and I have a sensitivity, or my board does to income volatility, how do I tackle?

Speaker 1 17:50

Absolutely. So first, just like any investment portfolio, it's really, it's establishing a risk tolerance and a risk preference within an ALM framework. So when we, when we look at building out a separately managed , um, portfolio for pre-funded benefit accounts or, or a charitable donation account , um, the , the, the number one thing that we ask when we get into that process is what is the risk preference and risk tolerance of the institution. And certainly when you have an ALM framework and you're doing interest rate risk analysis, you'll have a gauge of how much interest rate, risk and sensitivity that you can take on given the structure of the balance sheet . But another layer to that conversation is like you mentioned how much earnings volatility are you willing to take on and potentially absorb and kind of stomach through the income statement on a month, over month basis, especially once you start layering in these more risky investments, like equity exposure. And again, some other asset classes that may have a much more volatile , um, return profile over the long run. And so when , when we talk through that with institutions, most of most institutions, again, probably don't have a, a really , um, you know, steel stomach when it comes to the income volatility, because an equity exposure, whether it be through a mutual fund or an ETF or specific stock holdings , uh , ultimately that is a Mark to market asset from an accounting perspective, that again will have monthly volatility and its value, and that will flow through the earning statement. And so when institutions hear that and see that generally speaking, there is some concern relative to taking on that degree of volatility. So again, that's where generally , uh, again, you know, the question then comes up, okay, if that is a concern, right? That's any kind of an accounting related concern associated with having that type of exposure yet, do we want the economic return and exposure of those asset classes and pretty much overwhelmingly, you know, we , we hear that institutions again. They want to seek those assets and, and , um, source those assets that ultimately will create that stronger return. They're looking to get outside of 703 permits philosophy classes because of that higher return profile over the long run. And so with that, you know, there's options like a stable value annuity, which we can use to essentially wrap a sub-component of, of the investment portfolio, like the equity exposure , uh, in order to stabilize the earnings profile to the institution, kind of circumvent essentially that Mark to market , um, type of accounting approach, but still have the exposure to those assets, which again, have generally stronger return profiles, but yet tend to be a function of , uh , a more risky or volatile return profile over time. So that's one way that institutions can, can use the idea of a separately managed portfolio, but kind of bringing in some of these characteristics of maybe the insurance products that might look and feel good initially , um, that are out there. But ultimately again, it's a very targeted application of an , an annuity wrap in order to create stability to that equity return , um , over time. So that's a great way to kind of work through those types of concerns and questions. And from there again, it's just deciding the mix and the right sizing of the portfolio, given the risk preferences of the institution and , and ultimately the expense obligation that is , uh , that we're trying to extinguish or trying to , to offset.

Speaker 3 21:42

Yep . I get it. And it makes sense. And if I get it, I'm sure all of our listeners will as will as well. Um, so, you know , let's , let's shift gears a little bit, you know, shame on me. We probably didn't define employee benefit pre-funding or her charitable donation accounts well enough. And I think that's okay, but, but giving, given all that's going on right now with, you know, with COVID and the political climate, you know, et cetera, it seems like a lot of our clients are community financial institutions seeking the strength, their community giving. So how does something like a charitable donation account play into this?

Speaker 1 22:18

Absolutely. So charitable donation account is , um, essentially those, the investment portfolio itself, or this component of the balance sheet is ultimately earmarked to generate returns, which the majority of the returns are at least 51% of the returns has to be distributed back to a qualifying five Oh one C3 charitable organization over a five-year time horizon. So it's very, very specific in the way that this works for credit unions and what they can build out. Um, the, the cap is 5% of net worth. So again, it's a relatively small component of the balance sheet overall, but again, you are essentially allowed to invest outside of permissible , um, asset classes in the seven Oh three regs and have expanded investment authority to be able to, again, generate a stronger return to supplement and support that charitable giving. So it's a really, I think, a compelling , um, use of a lot of the excess cash that institutions have today, which may be historically, we haven't had the ability to tap into and specifically earmark for this purpose. Uh , especially again, because like you mentioned, institutions are trying to expand that , uh, stakeholder value and give more back to the community and these targeted portfolios, which are fully permissible, according to the regs , it really allows institutions to do more of , of what they set out to do, which is again, to provide stronger community value. Um, and so ultimately, you know, the , the nice part here is that institutions don't have to give up earnings to invest back into the community. They can basically build these portfolios to generate stronger returns and supplement that give back, and you may actually be able to , uh, provide stronger, give back in your community and to different charitable organizations then you would have otherwise. Um, so I think it's a, it's a really great way , um, for institutions again, who have known and planned charitable expense and want to be more involved , um, with this type of giving, this is a great way to basically take a portion of the balance sheet and, and identify it specifically to generate return for that purpose.

Speaker 3 24:33

So let me just throw out a hypothetical illustrative example to paint the picture. So my core bond portfolio, again, hypothetically earns two and a half percent by investing in different types of assets, maybe extending the duration, doing things I do outside of my normal core bond portfolio. I can earn a re rate of return again, hypothetically of 5%. So I can still earn my base kind of core portfolio rate, but then all of that excess, at least 51% of it, I can use your Mark towards some kind of charitable giving or, you know, give back to my community, that type of a thing.

Speaker 1 25:15

That's absolutely correct.

Speaker 3 25:18

Awesome. So I know we're butting up against the clock here a little bit. So I, and I've seen, and I've heard from, from clients and prospects that they're getting all kinds of proposals right now, all this excess liquidity, obviously every, you know, every kind of provider out there is trying to capitalize on that, which makes a whole lot of sense. And so if I'm an institution and I'm seeing these different types of proposals, whether it's BOLI, coli, separately, managed accounts , um, you know, equity-based mutual funds, whatever it is, how should I be evaluating these types of proposals?

Speaker 1 25:53

So first, no , no , whether or not you need the tax advantage again, if you're a credit union, you probably don't need that tax advantage associated with a coli type of product. Uh , if you're a bank again, a bully might make a lot of sense , uh , given again that th that tax advantage associated with that form of a portfolio , uh , outside of that, understand the fees, know what you're getting into with costs. Um , and again, how the return is being generated. How much control do you have over the asset allocation over the risk profile, and how does that fit into the context of the balance sheet, the risk , um, the risk tolerance and preferences and the return objectives, and also ask about, again, the historical returns, of course, that's not necessarily going to be indicative of the future returns, of course, but it will help the institution to understand the potential volatility, what that profile has looked like over time, and again, help the institution really determine what makes the most sense giving the , given those risk and return targets for the institution overall.

Speaker 3 27:00

Awesome. Any, any last thoughts as we wrap up here, Brittany?

Speaker 1 27:04

Absolutely. So, you know, again, I think the biggest, the biggest theme and, and what we want institutions to take away from these types of conversations is that there is definitely a value add associated with being able to take some of this excess cash sitting on the balance sheet today and invest into a pre-funded benefits portfolio or a CDA portfolio. There's a diversification to the balance sheet, there's diversification to the drivers of return. And again, generally speaking, being able to get outside of those seven Oh three permissible investments allows institutions to be able to add assets to the balance sheet, which generally will return a higher return over time , um, to support all of these initiatives. Um , that again, really, I think go hand in hand with the idea of , of a credit union and an also as well, you know, community banks. Um , the, the biggest thing in the way that I like to put this, this is really the intersection of the purpose of the institution and the mission of the institution and performance. You know, it's about driving stronger stakeholder value in every way possible. And this is one of those areas that I think it it's , uh , a it's a more low hanging fruit type of idea because of the excess cash on the balance sheet, which we haven't always necessarily had. It's a great way to, again, be able to say, okay, given the low rate environment, given that squeeze on net interest margin and the pressure on ultimate returns, we still want to be able to provide all the stakeholder value back. And this is a , uh , completely permissible way to do it and to drive stronger returns. Not only right now, but again, over the long run.

Speaker 3 28:48

Well, I always enjoy sitting down and chatting with you. Thank you so much, Brittany, for joining us today, it was very enlightening and hopefully you'll be our first three , Pete .

Speaker 1 28:58

Well, thank you. It's always a pleasure.

Speaker 3 29:08

I want to thank you again, Brittany, for taking time to chat with us on maximizing profitability in this environment. At the end of each episode, I'd like to take a moment and let you know some of the additional resources we have available. Alun first has a robust webinar schedule. So be sure to visit our website for more details on these, as well as additional educational offerings, you can also visit our resource center for recorded webinars articles, and more as always stay safe, stay healthy, and thank you for listening to in best interest and ALM first podcast.

Speaker 4 29:45

The content in this podcast is provided for informational purposes and should not be relied upon as recommendations or financial planning advice. We encourage you to seek personalized advice from qualified professionals regarding all investment decisions. Current and future holdings are subject to risk . Past performance is no guarantee of future results on cash should not be copied, distributed, published, or reproduced in whole, or in part information presented here. And it's for discussion and illustrative purposes only, and is not a recommendation or an offer or solicitation to buy or sell any securities. The views and opinions expressed by the alien first financial advisor speaker. So are their own. As of the date of the recording, any such use are subject to change at any time based upon market or other conditions. And Alun first financial advisers. Disclaims any responsibility to update such views. These use should not be relied on as investment advice and because investment decisions are based on numerous factors may not be relied on as an indication of trading intent on behalf of any ALM first financial advisors in front of you , neither Alun first financial advisors , nor the speaker can be held responsible for any director, incidental loss and cured by applying any of the information offered . First financial advisors is an sec registered investment advisor with a fiduciary duty that requires it to act in the best interest of clients and place placing interest of clients before zone . However, registration as an investment advisor does not apply any level of skills .