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Other ERISA compliance matters: ERISA bonding requirements and compliance testing

10.28.21

Read this if you are a plan sponsor of employee benefit plans.

This article is the tenth in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with Employee Retirement Income Security Act (ERISA) requirements. You can read the previous articles here

ERISA bonding requirements

Generally, every fiduciary of a plan and every person who handles funds or other property of the plan must be bonded. ERISA's bonding requirements are intended to protect employee benefit plans from risk of loss due to fraud or dishonesty on the part of persons who handle plan funds or other property. ERISA refers to persons who handle funds or other property of an employee benefit plan as plan officials. A plan official must be bonded for at least 10% of the amount of funds he or she handles, subject to a minimum bond amount of $1,000 per plan with respect to which the plan official has handling functions. In most instances, the maximum bond amount that can be required under ERISA with respect to any one plan official is $500,000 per plan. If the plan holds employer securities, the maximum required bond amount increases to $1,000,000. The bond must be fixed or estimated at the beginning of the plan's reporting year; that is, as soon after the date when such year begins as the necessary information from the preceding reporting year can practicably be ascertained. The amount of the bond must be based on the highest amount of funds handled by the person in the preceding plan year. Bonds must be placed with a surety or reinsurer that is named on the Department of the Treasury's Listing of Approved Sureties, Department Circular 570.

The US Department of Labor Field Assistance Bulletin No. 2008-04 provides answers to a number of questions that have been raised concerning the bonding rules.

Compliance testing

The Internal Revenue Code requires retirement plans to undergo certain non-discrimination and compliance testing on an annual basis to ensure contributions or benefits do not discriminate in favor of highly compensated employees and contributions are not in excess of amounts prescribed by the Internal Revenue Service (IRS).

The tests the plan should perform varies based on the plan’s provisions. However, some of the more common tests for defined contribution plans are:

Actual Deferral Percentage (ADP) Test: This test ensures employee salary deferrals made to the plan do not disproportionately benefit highly compensated employees (HCEs). If this test is failed, the most common correction method is distributing excess contributions to HCEs in the amount necessary to make the test pass. Corrections should be made no later than two-and-a-half months following the close of the plan year to avoid a 10% excise tax. The final deadline is 12 months following the close of the plan year.

Actual Contribution Percentage (ACP) Test: This test ensures the matching and voluntary employer contributions made to the plan do not disproportionately benefit HCEs. If this test is failed, the most common correction method is removing excess contributions from HCE’s accounts in the amount necessary to make the test pass. These excess contributions do not leave the plan. Rather, they are transferred into the forfeiture account of the plan, typically to be used to pay plan expenses or fund future employer contributions. Corrections should be made no later than two-and-a-half months following the close of the plan year to avoid a 10% excise tax. The final deadline is 12 months following the close of the plan year.

416 Top Heavy Test: This test ensures key employees do not represent a disproportionate percentage of plan assets. If this test is failed, the most common correction method is to allocate a 3% top heavy minimum contribution to non-key participants (any participant that is not a key employee). Other employer contributions can be used to offset the 3% contribution. Corrections should be made no later than 12 months following the close of the plan year in which the plan is top heavy.

The ADP, ACP, and Top Heavy Tests can be forgone if the plan qualifies for safe harbor status. Also, 403(b) plans are not required to perform the ADP nor the top-heavy test.

410(b) Minimum Coverage Test: This test ensures each contribution made to the plan benefits a sufficient percentage of non-HCEs. This test is performed for each different contribution type offered within the plan. If this test is failed, the most common correction method is to retroactively amend the plan to benefit more non-HCEs until the test passes. Corrections should be made no later than nine-and-a-half months following the close of the plan year in which the failure occurred.

402(g) Elective Deferral Limit: Participants are limited in the amount of elective deferrals they may contribute to qualified plans and thus exclude from taxable income each calendar year. If a participant contributes in excess of this limit, the most common correction method is to distribute the excess contribution amount. In 2021, the 402(g) Elective Deferral Limit is $19,500. Corrections should be made no later than April 15th following the close of the calendar year during which the excess deferral was made.

415(c) Annual Addition Limit: Participants are also limited in the amount of total contributions that can be credited to their account each limitation year (usually the plan year). If a participant receives total contributions in excess of this limit, the most common correction method is to first distribute elective contributions in excess of the limit. If an excess still remains, employer contributions should then be transferred to the plan’s forfeiture account. In 2021, the 415(c) Annual Addition Limit is $58,000. Corrections should be made no later than nine-and-a-half months following the close of the limitation year in which the failure occurred.

ERISA bonding requirements and compliance testing, although not necessarily related, are two of the compliance matters we, as auditors, commonly look at during our audits. For ERISA bonding requirements, we review to make sure the plan had adequate coverage and the bond is with an approved surety. For compliance testing, we look to make sure the testing has been performed and failed tests, if any, have been appropriately and timely resolved. Plan fiduciaries are not alone in addressing these matters—insurance carriers can help guide plan management in finding a fidelity bond appropriate for their plan and third-party administrators will typically perform compliance testing on behalf of the plan and guide plan management through any necessary corrections. However, it is still important for plan fiduciaries to be aware of the overall purpose of the bonding requirements and the compliance tests and be familiar with the correction methods and deadlines.

If you would like more information, or have specific questions about your specific situation, please contact our Employee Benefits Audit team.

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IRS definition of a highly compensated employee

A highly compensated employee is an individual who:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
  • For the preceding year, received compensation from the business of more than $125,000 (if the preceding year is 2019 and $130,000 if the preceding year is 2020 or 2021), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation. 
Resource
IRS definition of a highly compensated employee

IRS key employee definition

According to the IRS, a key employee is any employee (including former or deceased employees), who at any time during the plan year was:

  • An officer making over $185,000 for 2021 and for 2020; ($180,000 for 2019, $175,000 for 2018, and $170,000 for 2015 through 2017);
  • A 5% owner of the business (a 5% owner is someone who owns more than 5% of the business), or
  • An employee owning more than 1% of the business and making over $150,000 for the plan year.
Resource
IRS definition of a key employee

Read this if you are a Chief Financial Officer at a financial institution. 

The mechanics of interest rate swaps

Interest rate swaps, a form of derivative, are a tool financial institutions can use to manage interest rate risk. In this form of derivative, as an example, the financial institution may hedge the interest rate risk on a pool of fixed rate loans by executing a derivative contract with a counterparty. The derivative contract indicates the financial institution will pay a fixed rate to the counterparty, while the counterparty will pay the financial institution a variable rate. These payments are typically made on a net settlement basis. Thus, the financial institution has effectively turned its fixed rate lending into variable rate lending.

This example is considered a hedge – since the financial institution is mitigating its interest rate risk, as opposed to a speculative transaction – where the financial institution assumes risk with the hope of commensurate reward.

1Original promissory notes
2Derivative contract between financial institution and counterparty

This type of transaction allows the financial institution to separate credit risk from interest rate risk. Borrowers often prefer fixed rate financing, since future cash flows are known. However, a financial institution may avoid lending to creditworthy borrowers that expose the financial institution to excessive interest rate risk. An interest rate swap may allow the financial institution to provide financing to the borrower without having to sell the loan to mitigate interest rate risk.

The accounting for interest rate swaps via hedge accounting

Derivatives are recorded at fair value with changes in fair value generally reported in earnings. Hedge accounting is optional and may help prevent earnings volatility due to changes in the fair value of the derivative. Hedge accounting varies depending on the type of hedge. In the case of an interest rate swap, the hedge may be a cash flow hedge or a fair value hedge. A cash flow hedge is one where the financial institution looks to mitigate risk from variable exposures (such as a swap that effectively hedges LIBOR-based trust preferred securities to a fixed rate). Conversely, a fair value hedge looks to mitigate risk from fixed exposures. A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment. 

The example above describes a fair value hedge, since the financial institution is mitigating its exposure to the change in fair value of the fixed rate loans (due to changes in market interest rates) by, in substance, converting its fixed position into a variable position. For fair value hedges, the derivative is recorded at fair value with any changes in fair value recorded through earnings. The hedged item is also adjusted to its fair value through earnings. Thus, to the extent changes in the fair value of the hedging instrument and hedged item offset one another, there is no net impact on earnings.

Cash flow hedges

For cash flow hedges, the derivative is also recorded at fair value; however, the effective portion of changes in fair value of the derivative (i.e., the portion that offsets changes in expected cash flows of the hedged item) is recorded in other comprehensive income (OCI) rather than earnings. These changes are then reclassified into earnings when the hedged item affects earnings. A hedge is considered effective if the changes in the cash flow or fair value of the hedged item and the hedging instrument offset each other. Historically, the ineffective portion of the hedge is immediately recorded through earnings. However, Accounting Standards Update (ASU) 2017-12: Derivatives and Hedging (Topic 815), which we discuss below, simplifies this rule by enabling all changes in fair value of the derivative, not just the effective portion, to be recorded in OCI). For a cash flow hedge, there is no effect on the accounting for the hedged item. 

Measuring the effectiveness of a hedge relationship can prove to be complicated, and may in some cases require statistical methods, such as regression analysis. However, for interest rate swaps only, generally accepted accounting principles (GAAP) provides a “shortcut” method. If all of the applicable conditions in paragraph 810-20-25-104 of the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (the “official” source of GAAP) are met, an entity may assume perfect effectiveness in a hedging relationship of interest rate risk involving a recognized interest-bearing asset or liability and an interest rate swap. Examples of some of the conditions are: 

  • The notional amount of the interest rate swap must match the principal amount of the interest-bearing asset or liability being hedged; and 
  • For fair value hedges only, the expiration date of the interest rate swap must match the maturity date of the interest-bearing asset or liability or, as amended by ASU 2017-12, the assumed maturity date if the hedged item is measured in accordance with paragraph 815-25-35-13B. Paragraph 815-25-35-13B indicates an entity may measure the change in the fair value of the hedged item attributable to interest rate risk using an assumed term that begins when the first hedged cash flow begins to accrue and ends when the last hedged cash flow is due and payable.

Although use of this approach may be considered a shortcut compared to traditional hedge effectiveness assessments, it can still be difficult to qualify for the shortcut method given the number of conditions that need to be met. The shortcut method is also very rigid – the specified conditions must be met exactly.

ASU 2017-12

In 2017, FASB issued ASU 2017-12 to improve the financial reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. For non-public business entities, ASU 2019-10 delayed the effective date of ASU 2017-12 to fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. For public business entities, the ASU is already in effect.

ASU 2017-12 makes several changes, which the FASB refers to as “targeted improvements”, to the accounting requirements for hedging activities. Two of these changes, which will likely be beneficial to many financial institutions, are partial-term hedging and use of the “last-of-layer” method. 

With the adoption of ASU 2017-12, institutions can measure the hedged item in a partial-term fair value hedge of interest rate risk (e.g., a swap whose term is shorter than that of the loan pool it hedges) by assuming the hedged item has a term that reflects only the designated cash flows being hedged (i.e., that only considers the portion of the term of the loans that corresponds with the term of the swap). Prior to ASU 2017-12, GAAP did not allow this methodology when calculating the change in the fair value of the hedged item attributable to interest rate risk. Thus, institutions would often experience a difference between changes in the fair value of the hedging instrument and the hedged item due to the difference in maturities, resulting in hedge ineffectiveness that was recognized in earnings. Under ASU 2017-12, as long as the termination date of the hedging instrument is on or prior to the maturity date of the hedged item (in this case the loans), partial-term hedging may be used for changes in fair value of the loans during the term of the swap.

Prior to ASU 2017-12, GAAP indicated that hedge accounting should generally be applied to specifically identified assets or liabilities or portions thereof. Therefore, prepayment risk at the individual asset or liability level must be considered. The result can be frequent dedesignation and redesignation of hedges since many hedging instruments do not allow for prepayment. The last-of-layer method introduced by ASU 2017-12 allows the entity to designate a portion of the principal balance of a loan pool that is not expected to be affected by prepayments, defaults, or other events affecting the timing and amount of cash flows, without necessarily identifying which loans (or portions thereof) in the pool are expected to remain outstanding during the term of the hedging instrument. Under this designation, prepayment risk is not incorporated into the measurement of the hedged item. So, similar to the partial-term fair value hedge provisions, the last-of-layer method provides added flexibility in matching terms between the hedging instrument and the hedged item.

In May 2021, FASB issued proposed ASU 2021-002, which would provide clarifying and additional guidance on the application of ASU 2017-12. Amongst other things, the proposed ASU would expand the last-of-layer method to allow multiple-layer hedges. As a result, the term “last-of-layer method” would be renamed “the portfolio layer method.” The portfolio layer method would allow the financial institution to establish tranches, or multiple layers, within its hedged loan pool based on, for example, contractual maturity dates. These various layers could then be paired with different hedging arrangements. Multiple layers also provide added flexibility in the event the financial institution needs to dedesignate a portion of the hedging relationship, which would be required if circumstances change such that the hedge is no longer highly effective.

Lastly, ASU 2017-12 also makes changes to the presentation of changes in fair value in the financial statements. Under ASU 2017-12, for fair value hedges, changes in fair value of the hedging instrument should be presented in the same income statement line that is used to present the earnings effect of the hedged item. (Previous GAAP did not specify a required presentation of the change in fair value of the hedging instrument.) For cash flow hedges, the ineffective portion of such hedges is no longer presented separately from the effective portion. Rather, the entire change in fair value of the hedging instrument is presented in other comprehensive income. These amounts are then reclassified to earnings in the same income statement line item that is used to present the earnings effect of the hedged item when the hedged item affects earnings. According to FASB, these changes are thought to make it easier for the user of the financial statements to understand the results and costs of an entity’s hedging program.

ASU 2017-12 appears to make hedging activities, and the resulting accounting, much more flexible while also reducing the complexity of reporting such transactions. While we have only provided a snapshot of what we believe to be some of the most relevant provisions of the ASU for financial institutions, we encourage you to read the ASU in its entirety to see if there are other provisions that may prove to be useful or applicable to your institution. Likewise, with adoption fast approaching, we encourage you to reach out to your auditors to start the discussion as to how this ASU may impact and/or provide additional opportunity for your financial institution.

For more information on ASU 2017-12, including a deeper dive on the proposed portfolio layer method, check out a recent webcast hosted by our colleagues at Stifel.


 

Article
ASU 2017-12 provides added flexibility to hedge accounting

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its second quarter 2021 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,951 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In second quarter 2021, this section included the financial information of 4,490 FDIC-insured community banks. BerryDunn’s key takeaways from the community bank section of the report are as follows:

  • There was a $1.9 billion increase in quarterly net income from a year prior despite continued net interest margin (NIM) compression. This increase was mainly due to higher net interest income and lower provision expenses. Net interest income had increased $1.4 billion due to 1) lower interest expense, 2) higher commercial and industrial (C&I) loan interest income, and 3) loan fees earned through the payoff and forgiveness of Paycheck Protection Program (PPP) loans. Provision expense decreased $2.3 billion from second quarter 2020. However, it remained positive at $46.1 million. For non-community banks, provision expense was negative $10.8 billion for second quarter 2021.
  • Quarterly NIM declined 26 basis points from second quarter 2020 to 3.25%. The average yield on earning assets fell 57 basis points to 3.57% while the average funding cost fell 31 basis points to 0.32%. Both of which are record lows.
  • Net operating revenue (net interest income plus non-interest income) increased by $1.6 billion from second quarter 2020, a 6.5% increase. This increase is attributable to higher revenue from service charges on deposit accounts (increased $134.8 million, or 23.5%, during the year ending second quarter 2021) and an increase in “all other noninterest income,” including, but not limited to, bankcard and credit card interchange fees, income and fees from wire transfers, and income and fees from automated teller machines (up $203.6 million, or 9.3%, during the year ending second quarter 2021).
  • Non-interest expense increased 7.8% from second quarter 2020. This increase was mainly attributable to salary and benefit expenses, which saw an increase of $688.2 million (7.8%). That being said, average assets per employee increased 8.4% from second quarter 2020. Non-interest expense as a percentage of average assets declined 18 basis points from second quarter 2020.
  • Noncurrent loan balances (loans 90 days or more past due or in nonaccrual status) declined by $894.6 million, or 7.1%, from first quarter 2021. The noncurrent rate improved 5 basis points to 0.68% from first quarter 2021.
  • The coverage ratio (allowance for loan and lease losses as a percentage of loans that are 90 days or more past due or in nonaccrual status) increased 39.8 percentage points year-over-year to 191.7%, a record high, due to declines in noncurrent loans. This ratio is well above the financial crisis average of 64.5%. The coverage ratio for community banks is 15.4 percentage points above the coverage ratio for non-community banks.
  • Eighty-eight community banks had adopted current expected credit loss (CECL) accounting as of second quarter. Community bank CECL adopters reported negative provision expense of $208.3 million in the second quarter compared to positive $254.5 million for community banks that have not yet adopted CECL.
  • Net charge-offs declined 8 basis points from second quarter 2020 to 0.05%. The net charge-off rate for consumer loans declined most among major loan categories, having decreased 51 basis points.
  • Trends in loans and leases showed a slight decrease from first quarter 2021, decreasing by 0.5%. This decrease was mainly seen in the C&I loan category, which was driven by a $38.3 billion decrease in PPP loan balances. The decrease in PPP loans was driven by the payoff and forgiveness of such loans. Despite the decrease in loans quarter-over-quarter, total loans and leases increased by $5.7 billion (0.3%) from second quarter 2020. The majority of growth was seen in commercial real estate portfolios (up $61.7 billion, or 8.9%), which helped to offset the decline in C&I, agricultural production, and 1-4 family mortgage loans during the year.
  • Two-thirds of community banks reported an increase in deposit volume during the second quarter. Growth in deposits above the insurance limit, $250,000, increased by $47.8 billion, or 4.7%, while alternative funding sources, such as brokered deposits, declined by $3.8 billion, or 6.7%, from first quarter 2021. 
  • The average community bank leverage ratio (CBLR) for the 1,789 banks that elected to use the CBLR framework was 11%.
  • The number of community banks declined by 38 to 4,490 from first quarter 2021. This change includes two new community banks, 12 banks transitioning from community to non-community banks, one bank transitioning from non-community to community bank, 27 community bank mergers or consolidations, and two community bank self-liquidations.

Second quarter 2021 was another strong quarter for community banks, as evidenced by the increase in year-over-year quarterly net income of 28.7% ($1.9 billion). However, tightening NIMs will force community banks to find creative ways to increase their NIM, grow their earning asset bases, or find ways to continue to increase non-interest income to maintain current net income levels. Some community banks have already started dedicating more time to non-traditional income streams, as evidenced by a 4.3% year-over-year increase in quarterly non-interest income. The importance of the efficiency ratio (non-interest expense as a percentage of total revenue) is also magnified as community banks attempt to manage their non-interest expenses in light of declining NIMs. Banks appear to be strongly focusing on non-interest expense management, as seen by the 18 basis point decline from second quarter 2020 in non-interest expense as a percentage of average assets, although inflated balance sheets may have something to do with the decrease in the percentage.

Furthermore, much uncertainty still exists. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain. And, payment deferrals have made some credit quality indicators, such as past due status, less reliable. Payment deferrals for many borrowers are coming to a halt. So, the true financial picture of these borrowers may start to come into focus. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important. This monitoring will become increasingly important as we transition into a post-pandemic economy. For seasonal borrowers, current indications, such as the most recent results from the Federal Reserve’s Beige Book, show that economic activity was relatively strong over the summer of 2021. However, supply chain pressures and labor shortages could put a damper on the uptick in economic activity for these borrowers, making a successful transition into the “off-season” months that much more important. 

Also, as offices start to open, employers will start to reassess their office needs. Many employers have either created or revised remote working policies due to changing employee behavior. If remote working schedules persist, whether it be full-time or hybrid, the demand for office space may decline, causing instability for commercial real estate borrowers. Recent inflation concerns have also created uncertainty surrounding future Federal Reserve monetary policy. If an increase in the federal funds target rate is used to combat inflation, community banks could see their NIMs in another transitory stage.

As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

Article
FDIC Issues its Second Quarter 2021 Quarterly Banking Profile

Read this if you are responsible for meeting your broker-dealer’s annual report filing requirement under Securities Exchange Act (SEA) Section 15.

In February, the US Securities and Exchange Commission (SEC) approved a 30-day extension for eligible broker-dealers to file their annual reports, effective immediately. Firms that meet the criteria should consider taking advantage of the filing extension. Here are a few details and tips to help broker-dealers understand more about the 30‑day extension.

SEA Section 15 filing extension background

Normally, each broker-dealer registered under Securities Exchange Act (SEA) Section 15 must file annual reports—including financial and compliance or exemption reports, along with those prepared by an independent accountant—no more than 60 days after the broker-dealer’s fiscal year ends. But in light of disruption caused by the COVID-19 pandemic, the Financial Industry Regulatory Authority (FINRA) requested that the SEC allow broker-dealers an extra 30 days to file their annual reports. The extension, FINRA argued, would allow broker-dealers more time to obtain audit services.

Criteria for broker-dealers eligible for the extension

To qualify for a filing extension of 30 calendar days, a broker-dealer must meet the following criteria:

  1. Was in compliance with 15c3-1 (Net Capital) as of its most recent fiscal year end and had total capital and allowable subordinated liabilities of less than $50 million,
  2. Is permitted to file an exemption report as part of its most recent fiscal year-end annual reports,
  3. Submits written notification to FINRA and the Securities Investor Protection Corporation (SIPC) of its intent to rely on this order on an ongoing basis for as long as it meets the conditions of the order, and
  4. Files the annual report electronically with the SEC using an appropriate process.

The extension does not apply to just this year alone. It is understood to be in effect on an ongoing basis.

How to notify FINRA of your intent to take advantage of the extension

Broker-dealers that meet the aforementioned conditions are required to notify FINRA of their intent to take advantage of the extension. FINRA advises eligible broker-dealers to send an email to their Risk Monitoring Analyst with a message structured according to the following template:

“My firm wishes to have an additional 30 calendar days for filing its annual report on an ongoing basis for as long as my firm meets the conditions set forth in the SEC Order of February 12, 2021, regarding additional time for filing annual reports under SEA Rule 17a-5.”

How to file electronically

In addition to notifying FINRA, those looking to benefit from the extension are required to file electronically. There are multiple ways to do so, but the most user-friendly and efficient avenue to electronic filing is through the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.

Using the EDGAR system, broker-dealers must upload only two attachments maximum. The EDGAR system offers two options for electronic filing:

  1. The broker-dealer could attach one document containing all the annual reports as a public document; or
  2. The broker-dealer could attach two documents to its submission: (1) a public document containing the statement of financial condition, the notes to the statement of financial condition and the accountant’s report which covers the statement of financial condition, and (2) a non-public document containing all the components of the annual reports.

Implications for annual filings

An upcoming filing deadline is a stressful event, especially for broker-dealers contending with the upheaval of the past 18 months. Fortunately, FINRA has advocated on their behalf, and the SEC has complied by offering a 30-day filing extension.

The extension provides broker-dealers excess time to review documents and schedule a session with their auditor. Auditors will likely appreciate the extension as well, as it allows them to serve their various clients over a longer period of time, alleviating some of the pressure traditionally associated with filing season.

For these reasons and more, broker-dealers who qualify are encouraged to take the steps required to benefit from this grace period. If you have questions or would like more information, please contact our broker-dealer consulting team. We're here to help.

Article
Eligible broker-dealers: Take advantage of SEC's 30-day filing extension

Read this if you have a blended workforce with both in-office employees and remote workers.

It is hard to believe it has been nearly a year and a half since we started our remote work journey. At the time, many thought the move to working remotely would be short term. Then, a couple of weeks turned into a month, a month into another month, another month into a year and, some employers are now finally considering re-opening their offices.

Back in April 2020, we provided some internal control challenges, and potential solutions, faced by working in a remote environment. These challenges included exercising appropriate tone at the top, maintaining appropriate segregation of duties, and ensuring timely review, amongst others. Although these challenges still exist, there are new considerations to address as we transition into (hopefully) a post-pandemic world.

Blended workforces

As we mentioned in that article, since people have now been forced to work in a remote environment, they will be more apt to continue to do so. For some employees, the perks of ditching that long commute outweighs the free coffee they receive in the office. Employers have a decision to make—do we allow our employees the option to continue to work from home or, do we require employees to work from the office, as was standard pre-pandemic? Now that employees have exhibited the ability to work from home efficiently and effectively, it may be difficult to move all employees back into the office. Requiring all employees to return to the office could result in employees seeking employment elsewhere, and the option to work remotely is a selling point for many recruiters. Furthermore, disallowing remote work could cause employees to feel distrusted or undervalued, possibly leading to less efficient and effective work.

However, remote work comes with many challenges. Although video chat has been instrumental in navigating the remote work environment, it still has limitations. Nothing can beat in-person conversations and the relationships they help build. Nearly every video chat has a purpose, and unfortunately, you can’t just “run” into somebody in a video chat as you can in the office. Building camaraderie and instilling your company’s culture is difficult in a remote environment. And, if your workforce is blended, with some working in the office while others work remotely, building culture may be even more difficult than if your entire workforce was remote. Employees in the office may be less apt to communicate with remote colleagues. If you have a task you wish to delegate, you may think of giving the assignment to someone in the office prior to thinking of your remote co-workers that may be just as able and willing to complete the assignment. It will be important to ensure all employees are provided with equal opportunities, no matter of where they work.

Remote work policy

Regardless of your company’s decision to allow employees to work remotely or not, we recommend developing a remote work policy addressing expected behaviors. When developing such a policy, consider:

  •  Will the policy’s provisions apply to the entire company or will there be different provisions by department? If the latter, consider what the implications may be on employee morale.
  • Will there be a minimum amount of days per week that must be spent in the office?
  • If employees are allowed to work remotely, do they need to work a set schedule or can the frequency, and which days they work remotely, change from week to week?
  • Who should the employee communicate their decision to? How will this information then be shared company-wide?
  • How do remote employees address document destruction? If they are handling sensitive and confidential documents, how should they dispose of these documents?
  • Similarly, what are the expectations for protecting sensitive and confidential information at home?
  • Are employees allowed to hook up company-provided equipment to personal devices, such as personal printers?
  • If an employee is customer/client facing, what are the expectations for dress code and backgrounds for video chat meetings?
  • What will staff development look like for individuals working remotely? Alternatively, what will their involvement look like in onboarding/developing new employees?
  • What are the expectations for meetings? Will all meetings be set up in a manner that accommodates in-person and remote attendees? Are there meetings where in-person attendance is mandatory?

The importance of these considerations will likely differ from company to company. Some of these considerations may be addressed in other, already existing policies.

Are your internal controls “blended workforce” ready?

If your company plans to allow employees to work remotely, you will need to assess if your internal controls make sense for both in-office and remote employees. Typically, internal controls are written in a manner irrespective of where the employee resides. However, there may be situations that require an internal control be re-worked to accommodate in-office and remote employees. For instance, do you have an internal control that references a specific report that can only be run in-office? If the control owner plans to transition to a hybrid work schedule, does the frequency of the internal control need to change to reflect the employee’s new schedule? Alternatively, does it make sense to transition this internal control to someone else that will be in the office more frequently?

Internal control accommodations

The transition to a remote environment was expeditious and many thought the remote environment would be over quickly. As a result, there may have been modifications to internal controls that were made out of necessity, although they were not ideal from an internal control standpoint. The rationale for these accommodations may have been the expectation that the remote environment would be short-lived. Although these accommodations may have made sense for a short amount of time, and posed little to no additional risk to your company, the longer these accommodations remained in effect, the greater the chance for unintended consequences. 

We recommend reviewing your internal controls and creating a log of any internal control accommodations that were made due to the pandemic. Some of these modifications may continue to make sense and, after operating under the new internal control for an extended period of time, may even be preferable to the previous internal control. However, for those modifications that do appear to have increased control risk, control owners should assess if the length of the pandemic could have resulted in inadequately designed internal controls. And, if so, what could the consequences of these poorly designed internal controls have been to the company?

Internal control vs. process

While reviewing your company’s internal controls, it will also be a good time to ensure your internal control descriptions actually describe an internal control rather than simply a process. Although having well-documented processes for your company’s various transaction cycles is important, a good internal control description should already incorporate the process within it. Think of your internal control descriptions as writing a story—the “process” provides background information on the characters and setting, while the “internal control” is the story’s plot.

For example: The Accounting Manager downloads the market values from the investment portfolio accounting system and enters the market values into the general ledger on a monthly basis. Once the journal entry is entered, the Accounting Manager provides the market value report and a copy of the journal entry to the Controller.

Although a savvy reader may be able to identify where the internal control points are within this process, it could easily be modified to explicitly include discussion of the actual internal controls. The text in bold below represents modifications to the original:

The Accounting Manager downloads the market values from the investment portfolio accounting system and enters the market values into the general ledger on a monthly basis. Once the journal entry is entered, the Accounting Manager provides the market value report and a copy of the journal entry to the Controller via email. This email serves as documentation of preparation of the journal entry by the Accounting Manager. The Controller then reviews the market value report against the journal entry for accuracy. Once approved, the Controller posts the journal entry and replies to the email to indicate their review and approval. The Accounting Manager saves the email chain as auditable evidence.

The text additions in bold font help provide a complete story. A new employee could easily read this description and understand what they need to do, and how to appropriately document it. Most importantly, the internal control is both in-office and remote environment friendly.

Transitioning back to the office has resulted in a mixture of excitement and anxiety. Routine office norms, such as shaking hands and having a spontaneous meeting over a cup of coffee need to be relearned. Likewise, policies and internal controls need to be revisited to address the changing landscape. The more proactive your company can be, the better positioned it will be to accommodate its employees’ demands, while also maximizing the effectiveness of its internal controls. Please contact David Stone or Dan Vogt if any questions arise.

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May the "blended workforce be with you": Policy and internal control considerations for a new era

Read this if you are a plan sponsor of employee benefit plans.

This article is the sixth in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with Employee Retirement Income Security Act (ERISA) requirements. You can read the previous articles here.

Plan sponsors have a fiduciary responsibility to provide oversight over the operations of employee benefit plans. This oversight involves a multitude of varying responsibilities. Failure to provide sufficient oversight can lead to non-compliance with rules and regulations. However, even if plan sponsors are providing sufficient oversight, lack of documentation of the oversight is arguably equally as severe as no oversight at all. Here are some common fiduciary responsibilities and how you should document them. 

Review of the report on service organization’s controls

Most employee benefit plans have outsourced a significant portion of the plan’s processes, and the internal controls surrounding those processes, to a service organization. Regardless of how certain plan-related processes are performed—internally or outsourced—the plan sponsor has a fiduciary responsibility to monitor the internal controls in place surrounding significant processes and to determine if these controls are suitably designed and effective. The most commonly outsourced processes of an employee benefit plan are the administration, including recordkeeping of the plan, through a third-party administrator; payroll processing; and actuarial calculations, if applicable to the plan.

When plan processes are outsourced to service organizations, generally the most efficient way to obtain an understanding of the outsourced controls is to obtain a report on controls issued by the service organization’s auditor. You should request the service organization’s latest System and Organization Controls Report (SOC 1 report). The SOC 1 report should be based on the Statement on Standards for Attestation Engagements No. 18, Reporting on the Controls at a Service Organization, frequently known as SSAE 18.

Plan sponsors should perform a documented review of the SOC 1 report for each of the plan’s service organizations. The documented review should most notably include discussion of any exceptions noted within the service auditor’s testing performed, identification of subservice organizations and consideration if subservice organization SOC 1 reports need to be obtained, and assessment of the complementary user entity controls outlined in the SOC 1 report. The complementary user entity controls are internal control activities that should be in place at the plan sponsor to provide reasonable assurance that the controls tested at the service organization provide the necessary level of internal control over the plan’s financial statements. Contact a BerryDunn professional to obtain our SOC report review template to assist in documenting your review.

Documentation of the plan within minutes

To provide general plan oversight, plan sponsors should have a group charged with the governance of the plan. This group should meet on a routine basis to review various aspects of the plan’s operations. Minutes of these meetings should contain evidence that certain matters that would be of interest to the Department of Labor (DOL) were discussed.

We recommend minutes of meetings document the following:

  • Investment performance—The plan sponsor has a fiduciary responsibility to ensure the investments offered by the plan are meeting certain performance expectations. Investment statements and the plan’s investment policy should be reviewed on a regular basis with documentation of this review retained in minutes of meetings. Any conclusions reached about the need to change investments or put an investment on a “watch-list” should also be documented in the minutes, including any additional steps that need to be taken.
  • SOC 1 report review—As noted above, the plan sponsor has a fiduciary duty to ensure all third-party service organizations utilized by the plan have suitably designed and effective internal controls. Plan sponsors should perform a documented review of the SOC 1 report for each of the plan’s service organizations. The results of these reviews should then be reported at plan oversight meetings with any subsequent actions or conclusions documented in the minutes to these meetings.
  • Reasonableness of fees—The DOL requires plan fiduciaries to determine if the fees charged under covered service provider agreements are reasonable in relation to the services provided. To determine the reasonableness of fees, the plan may (1) hire a consultant, (2) monitor industry trends regarding fees, (3) consult with peer companies, (4) use a benchmarking service, or (5) conduct a request for proposal. Failure to determine the reasonableness of the fees charged can result in a prohibited transaction. When doing such a review, the fiduciaries of the plan should document in the minutes the steps taken and conclusions reached.
  • Overall review of the plan—Plan sponsors have a fiduciary responsibility to review the activity of the plan as well as participant balances. We recommend plan sponsors implement and document monitoring procedures over the activities of the plan and participant balances. This review could be incorporated into documented self-testing procedures, by haphazardly selecting a sample of participants each quarter and reviewing their account activity and participant balances. The results of such self-testing should then be reported at plan oversight meetings with any subsequent actions or conclusions documented in the minutes to these meetings. Reach out to a BerryDunn professional to obtain our participant change review workbook to assist in performing this self-testing.

Retention of salary reduction agreements

During our audits of employee benefit plans, we often note that employee deferrals are not consistently supported by salary reduction agreements or other forms maintained in employees’ personnel files. Many third-party administrators allow participants to make changes to their elective deferral rates directly through the third-party administrators without the involvement of the plan sponsor.

We often recommend that you maintain all changes to employee elective deferral rates in employees’ personnel files using salary reduction agreements. We also recommend that employees’ elections to not participate in the plan be documented in their personnel file. If employees can elect to change their deferral rates directly with the third-party administrator, we typically recommend that management print support from the third-party administrator’s online portal as documentation to support the change in the employee’s deferral rate and retain this support in the employees’ personnel file. However, if the third-party administrator’s online portal provides adequate history of deferral election changes, the plan sponsor may be able to rely on this portal for documentation retention. In these instances, the plan auditor should request a deferral feedback report directly from the third-party administrator.  

Monitoring of inactive accounts

Inactive accounts should be monitored by the plan sponsor for unusual activity or excessive fees that may be posted to these accounts. To the extent that inactive accounts have not exceeded $5,000, consideration should be given to cashing out the accounts if allowed by the plan document. Plan sponsors should, on a periodic basis, review the accounts of inactive participants or those who have been separated from service to ascertain whether the changes and charges to those accounts appear reasonable.

Plan sponsors have many documentation responsibilities. This list is not meant to be all-inclusive. And, the facts and circumstances of each employee benefit plan will change the applicability of these items. However, this list should be used as a tool to help plan sponsors perform a deep dive of their current plan documentation processes. And, hopefully, a result of this deep dive will be a robust documentation process that deliberately documents all major decisions and review functions related to the plan.

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Plan documentation: Another key to successful oversight

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its first quarter 2021 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,978 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In first quarter 2021, this section included the financial information of 4,531 FDIC-insured community banks. Here are our key takeaways from the community bank section of the report:

  • There was a $3.7 billion increase in quarterly net income from a year prior despite continued net interest margin (NIM) compression. This increase was mainly due to higher noninterest income and lower provision expenses. Provision expense decreased $1.4 billion from first quarter 2020. However, it remained positive at $390.1 million. For non-community banks, provision expense was negative $14.9 billion for the first quarter 2021.
  • Quarterly NIM declined 28 basis points from first quarter 2020 to 3.26%. The average yield on earning assets fell 76 basis points to 3.64%, while the average funding cost fell 48 basis points to 0.37%.
  • Net operating revenue increased by $3.9 billion from first quarter 2020, a 17.1% increase. This increase is attributable to higher revenue from loan sales (increased $1.3 billion, or 126.4%) and an increase in net interest income (up $1.8 billion from first quarter 2020).
  • Non-interest expense increased 7.6% from first quarter 2020. This increase was mainly attributable to salary and benefit expenses, which saw an increase of $838.1 million (9.6%). That being said, average assets per employee increased 18.5% from first quarter 2020.
  • Noncurrent loan balances (loans 90 days or more past due or in nonaccrual status) remained relatively stable from a year ago having slightly increased by $19.3 million, or 0.2%. However, despite the slight increase in noncurrent loan balances, the noncurrent rate decreased 8 basis points from first quarter 2020 due to strong year-over-year loan growth.
  • The coverage ratio (allowance for loan and lease losses as a percentage of loans that are 90 days or more past due or in nonaccrual status) increased 30 percentage points year-over-year to 180%, a 14-year high.
  • Net charge-offs declined 7 basis points from first quarter 2020 to 0.04%, a record low. The net charge-off rate for consumer loans declined most among major loan categories, having decreased 41 basis points.
  • Trends in loans and leases showed a moderate increase from fourth quarter 2020, increasing by 1.4%. This increase was mainly seen in the commercial and industrial (C&I) loan category, which was driven by an increase in Paycheck Protection Program (PPP) loan balances. Total loans and leases increased by 10.8% from first quarter 2020. The majority of growth was seen in C&I loans, which accounted for approximately three-quarters of the year-over-year increase in loans and leases. However, keep in mind C&I loans include PPP loans that were originated in the first half of 2020, with additional funding provided by the Consolidated Appropriations Act in December 2020.
  • Nearly all community banks reported an increase in deposit volume during the year. Growth in deposits above the insurance limit drove the annual increase while alternative funding sources, such as brokered deposits, declined. However, even when doing a quarter-to-quarter comparison, deposits were up from fourth quarter 2020 by 5.6%.
  • The average community bank leverage ratio (CBLR) for the 1,845 banks that elected to use the CBLR framework was 11.15%.
  • The number of community banks declined by 29 to 4,531 from fourth quarter 2020. This change includes two new community banks, five banks transitioning from community to non-community banks, 24 community bank mergers or consolidations, and two community bank self-liquidations.

First quarter 2021 was a strong quarter for community banks, as evidenced by the increase in year-over-year quarterly net income of 77.5% ($3.7 billion). However, tightening NIMs will force community banks to either find creative ways to increase their NIM, grow their earning asset bases, or find ways to continue to increase non-interest income to maintain current net income levels. Some community banks have already started dedicating more time to non-traditional income streams, as evidenced by a 45% year-over-year increase in quarterly non-interest income. The importance of the efficiency ratio (non-interest expense as a percentage of total revenue) is also magnified as community banks attempt to manage their non-interest expenses in light of declining NIMs.

Despite the strong first quarter, there is still uncertainty in many areas. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain, and payment deferrals have made some credit quality indicators, such as past due status, less reliable. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important. This monitoring will become increasingly important as we transition into a post-pandemic economy. For seasonal borrowers, this summer could be a “make-or-break” point. If strong demand does not materialize, the economic consequences of the pandemic may not be reversible. 

Additionally, as offices start to open employers will start to reassess their office needs. Many employers have either created or revised remote working policies due to changing employee behavior. If remote working schedules persist, whether it be full-time or hybrid, the demand for office space may decline, causing instability for commercial real estate borrowers. Recent inflation concerns have also created uncertainty surrounding future Federal Reserve monetary policy. If an increase in the federal funds target rate is used to combat inflation, community banks could see their NIMs in another transitory stage. As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

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FDIC Issues its First Quarter 2021 Quarterly Banking Profile