Private insurance contract + hedge funds = tax-efficiency.
It's no secret that the hedge fund industry is
mushrooming. What you may not know about is its penetration into the
little-known province of private placement life insurance and variable
annuities. "Hedge funds have come to me and said, 'Help us get on a
platform,'" says William Dreher, a New York City actuary and consultant
and the managing director of Compensation Strategies Inc., which helps
corporations, wealthy individuals and their advisors evaluate private
placement contracts. "I've also had insurers ask me who from the
hedge-fund world should be added to their platforms."
Why the marriage of exotics? Hedge funds are coveted because they aren't highly correlated with traditional stock and bond investments because of their short-term trading strategies. However, hedge funds often beget oodles of ordinary income. Wrapping hedge funds in private life or annuity products affords tax deferral, or in the case of insurance, tax-free gains via the death benefit. Private life or annuity products feature a traditional (but unregistered) variable-life policy or VA chassis, outfitted with an investment menu that only can be made available to accredited investors as defined by the Securities and Exchange Commission.
"The combination makes an investment in hedge funds tax efficient while solving financial planning goals such as retirement income or estate planning," says Thomas Bounty, managing director of the private client group at MassMutual Financial Group. "It's part of an overall plan."
In the typical case, the objective is tax-deferred growth beyond the limits of qualified plans. Clients must usually commit seven figures (albeit payable to the carrier over a number of years), so realistically their net worth should be at least $8 million to $10 million.
Exclusivity is one reason the two-headed vehicle hasn't been used in large numbers by planners. Complexity is another. "It's a sophisticated product for a sophisticated client recommended by a sophisticated advisor," says Joseph Spada, co-founder of the Family Wealth Institute in Parsippany, N.J.
Investors must be accredited and, according to Bounty, should have hedge fund experience. "Introducing someone, even a very high-net-worth individual, to both hedge funds and private placement contracts at the same time is probably pushing it, given the complexity of each," Bounty says.
On the advisor's side of the table, product distribution is snarled with regulation. Both NASD registration and an insurance license are required. Fee-only planners will likely need to partner with a specialist. Registered investment advisors can charge clients an up-front fee through their RIA for recommending the vehicle, as well as annual asset-management fees-provided there isn't any compensation from the insurer, says Lawrence J. Rybka, president of ValMark Securities, a broker-dealer in Akron, Ohio, whose reps primarily specialize in advanced insurance transactions. But the money isn't easy, Rybka warns. "You may have a hundred hours into the transaction by the time it's all done," he says.
How Private Placement Products Work
Written by behemoth carriers, private insurance products mirror their registered counterparts in many respects. For instance, state creditor-protection laws (if any) apply to both genres. Further, a private life policy can be owned by an irrevocable insurance trust to pass death benefits estate-tax-free to heirs. And like any variable-life policy, Spada points out, exceptionally poor investment performance could theoretically require additional premiums to keep up the policy.
That said, private contracts do possess unique features, starting with strikingly low costs. You, or the licensed specialist helping on the case, may be able to negotiate with the carrier for skinny administrative charges and mortality expenses. In addition, because the compensation is negotiated, it is usually significantly lower than that on a shelf product, nor is there typically a surrender charge if the client wants out of the contract early. "The all-in cost on two cases I recently worked on averaged between 1% and 1.25% annually over a ten- to 15-year time horizon, dropping down to 0.75% for a 25-year horizon," Dreher says. "That compares with perhaps 4% for a traditional product."
The low costs yield impressive economics. In ten years, says Dreher, his 71-year-old client will be able to take tax-free withdrawals of 90% of his policy's projected cash value, an amount that is materially more than he will have put in and more than he could have accumulated in a taxable portfolio. The client will also have a considerable death benefit after the tenth year, something he wouldn't enjoy under a traditional contract with its higher costs. Dreher notes that to take tax-free withdrawals of policy cash value, the private contract must satisfy the "seven pay test" defined in Section 7702 of the Internal Revenue Code. Under this test, the running total of premiums paid during the first seven policy years may not exceed the level annual premiums that would fully fund the policy's initial death benefit by the end of the seventh policy year.
Because of the large minimum investment, sky-high death benefits are required for these policies to qualify as life insurance. Given the insurer's risk, the underwriting process can be quite strict and time consuming. "In many cases, the client will need to go to a doctor for a stress EKG (electrocardiogram) exam, rather than have a resting EKG, which can be done at home in ten minutes," says Spada. An applicant with a history of health problems can expect intense scrutiny. Yet not every carrier looks at a client's health the same way, Rybka points out. The more favorable the underwriting classification, of course, the lower the insurance charge. "We have three former underwriting executives on staff who help our reps package the client's health conditions and shop for the most favorable cost," he says.
There is also a financial underwriting designed to thwart over-insuring. "There has to be a very detailed financial justification for the large amount of insurance (the client is requesting). He usually has to furnish a financial statement signed by his CPA," Rybka says. Clients who can't pass the underwriting may turn to private placement variable annuities instead, although in such cases the gain in the contract is taxable at death.
Incorporating Hedge Funds
The contract must adhere to certain Internal Revenue Service rules to qualify for tax-deferred treatment. Among those is a requirement that the subaccounts offered must be "insurance dedicated"-that is, available only to insurance company clients. Hedge fund managers have nimbly responded by creating new funds that mirror their publicly available ones. Dreher's last count shows some 70 insurance-dedicated hedge funds, mostly funds-of-funds, scattered across a dozen platforms (see sidebar, How To Reduce Hedge Fund Volatility). Advisors should be aware that performance of a fund's insurance company and commercial versions won't be identical. One reason: "Most insurance-dedicated funds start small and thus won't be as diversified as the public sister fund," Dreher says.
Another IRS mandate is that investors can't exert control over the insurance-dedicated fund's management, or over the carrier's selection of fund managers. A product that fails to pass these and other tests won't qualify as insurance or an annuity. In practice, it is not unusual for offering circulars to stipulate that there is no guarantee that the benefits of life insurance or annuity taxation will inure to the purchaser-a statement the client acknowledges with his signature.
Because a private placement of securities is involved, Rybka has brought in specialized securities counsel to review transactions handled by his firm. "These contracts are complex and involve substantial regulatory risk if not done in proper form, or if the risks are not adequately represented to the client," he says. "An unhappy client is likely to bring a claim against the advisor and the broker-dealer."
Be Careful Who You Talk To, And How
Marketing the unregistered product must follow very specific rules. For example, creating advertising for public consumption is not allowed. "You can't do a seminar on the product because only accredited investors can be shown material about it," says Spada. Further, the product may only be discussed with existing clients-investors whom you can document are accredited.
A final caution is that no communication about the product may be made to qualified clients until the broker-dealer has signed a selling agreement with the insurer and approved the marketing materials. Although hedge funds are less regulated than mutual funds in the sense that they may short securities and have greater latitude to use derivatives, says Rybka, "the distribution of this product is much more highly regulated than the distribution of mutual funds or registered variable life and annuities. Specialized knowledge of the rules is required."
Traditionally hedge funds have been viewed as investments with high return potential and off-the-charts volatility. But that perspective doesn't necessarily apply to a fund of hedge funds, says Thomas W. "Woody" Keesee, a principal at CDK Investment Management LLC in Manhattan, a fund-of-funds assembler. Most superfunds hold a portfolio of individual funds that pursue different strategies, such as equity long-short, short only and merger arbitrage, to name a few. The returns of these objectives aren't always correlated. "So a well-diversified fund-of-funds can provide moderate risk and stable returns," Keesee says.
Platforms offering these funds generally list between two and five on their investment menu (along with other nontraditional, as well as traditional, investment options). How many should the client invest in? Only one if they are all multistrategy funds-of-funds, because "they will overlap," says Robert Rosenbaum, head of advisory sales for the U.S. at Tremont Capital Management, a fund-of-funds manager. "But if the choices include multistrategy funds as well as funds investing in several managers that pursue the same strategy, then you may want both," Rosenbaum says.
Advisors should bear in mind that using superfunds doesn't eliminate the asset class's lack of liquidity. Typically, clients must give 30 to 90 days advance notice for redemptions.