Economics of Accounts Receivable Financing

In the Aug/Sep Edition of Developments I mentioned that accounts receivable fi-nancing plans for retirement have the chance to create significantly more money for a business owner than if he did noth-ing. I stand behind that statement with emphasis on the operative word “chance”. Mathematically, the arbitrage of com-pound interest over simple interest should produce substantial gains over time. However, there are “ifs” and “buts” within that statement which must be considered.

Aside from other reasons for entering into a plan to use your accounts receivable to help finance your retirement, the key components to make the program work economically are the interest rate on the loan, the achievable gains within the in-vestment vehicle and timing. These com-ponents have to be in sync. For example, you can’t have a 10% loan interest and a 3% gain in the investment vehicle to make the plan work even if the vehicle provides compounded interest and tax-deferred gains. Similarly, you can’t count on the arbitrage to work over a short period of time (i.e. less than 10 years). Be leery of a proposal that projects unreasonably low loan rates and/or very high net gains from your investment vehicle.

On a long term loan, you can expect the lending rate to be an adjustable interest rate supported by a published index such as the prime rate, LIFOR, etc. If you look at what is happening to interest rates in today’s economy, which way do you think the future adjustments are going to move in the next five years? How about the next 20 years? Importantly, the possibility that the lending interest rate will move up-wards to a point the cost of supporting the loan will become untenable is real and you should be prepared for that potential situation in your plan. Similarly, you should understand any early pay-off pro-visions or surrender charges if that situa-tion occurs and have a plan to repay the loan.

You have choices in selecting the invest-ment vehicle to provide the needed arbi-trage. Obviously, in selecting the appro-priate vehicle, two important components to consider are compounded interest and tax-deferred gains. This pretty much lim-its you to an insurance product such as an annuity or life insurance policy. With adjustable interest rates on the loan, the gains earned on the investment side must be at able to keep-up with increases. Clearly, fixed products offered by the insurance companies will not provide you with any guarantees in that regard as they generally offer a very low minimum guar-anteed rate and a higher year-by-year rate that varies in accordance with the invest-ment successes of the company. While that rate may increase in some years, it is not tied to a specific index and there are no guarantees the company will invest successfully each year.

With accounts receivable retirement plans, the obvious choice for an invest-ment vehicle is an equity indexed pro-gram, either an equity indexed annuity or an equity indexed life insurance program. With 100% participation rates and no-caps on the indices growth, these pro-grams have the better chance of keeping up with the adjustable interest rates on the loans. Equity indexed life insurance prod-ucts offer the advantage of tax-free loans which the annuities cannot offer. Gener-ally, equity indexed universal life insur-ance products are used because of the ability to adjust both the premiums and the death benefits to suit your changing needs over the years.

Timing is also an important component in accounts receivable financing for retire-ment. Again, the economic success of the plan is based on the arbitrage between the simple interest-only loan and the com-pounded tax-deferred gains within the investment vehicle. The arbitrage must have some time for it to work and the more time available the better the arbi-trage. Clearly, any plan under 10 years would not realize much of an arbitrage.

Following are a couple of tables which demonstrate the results with varying in-terest rates. The first table shows a loan of $1,000,000 for a 20 year period with both a 7% interest-only loan and a 7% com-pounded growth rate in the investment product.

In the above table, using a $1 million loan on the accounts receivable, the borrowed funds have been converted into an in-vestment vehicle valued at $4 million and, after providing for the loan payments and repaying the loan, realizing a $1.2 million gain. The $400,000 tax on the loan re-payment results from the tax incurred by collecting the final receivables to repay the loan without corresponding expenses to offset the income.

But, what happens if the investment prod-uct only earns an average rate of 3% over the period?

In this scenario, we have spent the same $2.8 million dollars and we end-up with $2.8 million in our investment vehicle for a wash. However, these numbers do not account for the commissions and other costs associated with setting-up the loan and purchasing and maintaining the in-vestment vehicle which can be substantial.

The economics can work out. However, prior to jumping into a program you should consider the fact that you are committing substantial dollars as interest on the loan for a long period of time. Are there other opportunity costs for those funds? For example, if you consider the $1.4 million loan payments in the above scenarios with payments made at the rate of $70,000 per year over the 20 year pe-riod, that $70,000/year would be worth $2.8 million if you could earn 7% interest over the period. Even if you assume after tax dollars at the 38% tax bracket, the after-tax $43,400 would be worth $1.8 million for your retirement. Are there other in-company investment opportuni-ties which would yield a higher return?

Deductibility of the loan payments is also an issue, and a very delicate one. Since I am not a tax person, going into the details of this tax issue is not something I am comfortable with other than to say that it is incumbent upon anyone proposing to enter into a program where they believe the interest rates are deductible to obtain professional guidance before making a commitment. Tax issues vary from pro-gram to program and from participant to participant, so my advice to you is to seek your own separate tax advice.

Probably the most advantageous way to capitalize on the merits of financing ac-counts receivable for retirement is to con-tain it within your organization.

Ronald J. Adkisson is the author of “Financ-ing Accounts Receivable for Retirement and Asset Protection” available through his web-site at farbook.com