Healthy investment returns coupled with rising income taxes have, for clients seeking “tax alpha,” created an ideal environment for the proliferation of private placement life insurance.
PPLI offers a tax-free environment for investments to accumulate at a time when rich clients are most acutely in need of efficient tax management.
Since 2009, the S&P 500 has averaged an annualized return of over 17% and the HRFI Equity Hedge (Total) Index has had average annualized gains of 8.39%. At the same time, federal income taxes have gone up, especially for clients with a net worth greater than $25 million.
The highest federal bracket for ordinary income is now 39.6%, up from 35.0% in 2012. The federal tax rate for long-term capital gains and qualified dividends is 20.0%, up from 15.0% in 2012. On top of these increases, the new Obamacare tax of 3.8% also applies to investors’ earnings. Essentially, without even accounting for changes to some of the phase-outs for deductions, federal taxes have risen 24% on ordinary income and 59% on long-term capital gains and qualified dividends. These increases are causing virtually all investors to seek methods of augmenting after-tax returns. Unlike most taxpayers with typical incomes who can turn to IRAs and Roth IRAs, ultra-high-net-worth clients are turning to PPLI.
PPLI is a life insurance product, and as such it enjoys the same income tax treatment as traditional life insurance:
• Tax-free growth of investment earnings (dividends, interest and capital gains) on policy assets.
• The ability to withdraw and borrow assets from the policy cash value free of income tax.
• An income-tax-free death benefit.
PPLI Economics
Put simply, the efficacy of using PPLI to invest in otherwise taxable investments hinges upon a friction analysis: the tax cost of the investment compared against the cost of the insurance fees and expenses. PPLI is only going to be a compelling structure for investments that are relatively tax-inefficient. Most clients and advisors will judge the merits of PPLI on the pre- and post-tax cash value (account value of the investment) in the policy. However, the death benefit component of PPLI should not be overlooked, as this benefit, which is always greater than the cash value or account value, is received income-tax-free just like a traditional life insurance policy death benefit.
Figures 1 and 2 summarize the advantage of using a PPLI product for a $10 million investment in an otherwise taxable hedge fund. Over the long term, the PPLI policy provides over 200 basis points in “tax alpha” or 72% more ending account value: $57,054,592 versus $33,224,392 in 25 years.
PPLI Vs. Traditional Life
Don’t let any preconceived notions about life insurance scare you or your clients away. PPLI is very different from traditional life insurance in several ways. The decision to procure a PPLI policy is usually an investment decision rather than a risk-transfer decision. The actual PPLI product has several tangible distinctions from traditional life insurance products:
1. PPLI fees are usually lower and more transparent than those of traditional life insurance. For example, the average insurance fees over 30 years should be less than 110 basis points.
2. There are no surrender charges in PPLI policies; any constraint on liquidity is driven solely by the liquidity provisions of the alternative investment.
3. Consultants or brokers that specialize in PPLI implementation and oversight typically receive lower commissions and fees than with traditional life insurance.
4. Investment options within a PPLI policy are highly customized investment options or sophisticated alternative investments, whereas traditional life insurance offers retail mutual funds and index funds.
5. Purchasers of PPLI policies must meet the “qualified purchaser” and “accredited investor” guidelines outlined by the Securities and Exchange Commission.
Private Placement
Variable Annuities
In addition to using PPLI policies, rich investors can also defer current-period tax on investment gains using a private placement variable annuity (PPVA). PPVA does not offer elimination of taxation like a PPLI policy, only deferral. Clients can remain invested on a tax-deferred basis until they choose distributions, which can be either onetime payments or systematic over a period of time.
Just as PPLI is different from traditional life insurance, PPVA differs from traditional annuity products in several ways:
1. There are no exorbitant fees and loads.
2. There are alternative investment options.
3. There are no up-front commission fees.
4. There are no surrender charges.
5. There are no complicated riders and features such as principal or income guarantees (which can add 100 basis points in fees alone).
It is also worth noting that one of several differences between PPVA and PPLI is that PPVA does not entail any medical underwriting or insurability requirements, which makes it the more attractive option for some investors.
Investment Options
Since using a PPLI or PPVA policy is driven by the desire to invest in a tax-favored environment, it is important to understand the investment options within these structures. PPLI offers investors sophisticated investment options such as long/short hedge funds, funds of funds, credit funds, direct lending funds and master limited partnerships, among others. Generally, the investment options available will be tax-inefficient investment options or have significant “tax drag.” Three components create the tax drag of an investment:
1) The expected annual return.
2) The percentage of gains realized as taxable income each year.
3) The ratio of ordinary income to long-term capital gains treatment applicable to yearly realized income.
Traditional private equity is not commonly found within PPLI because of its low annual turnover or realization of income, and private equity earnings are generally long-term capital gains. Although not all alternative investments are ripe for PPLI or PPVA products, many strategies are appropriate; more than 100 managers of various tax-inefficient alternative investments are suitable for investment through a PPLI or PPVA policy, and more are becoming available.
Some rich clients looking for customized investment solutions can also create their own fund with a nominated manager. One consideration for any PPLI investment, whether it’s a third-party manager or a custom fund, is that policy owners or those insured cannot direct or influence the investment manager to make the selections of underlying securities. If influence or control is exerted on the investment manager, the tax treatment of the PPLI may be lost or compromised.
Non-Income-Tax Benefits
While PPLI and PPVA can offer tremendous income tax benefits, they are also powerful tools for many other goals, including enhancing a well-conceived estate plan or generational wealth transfer plan. There are numerous non-tax benefits to using PPLI and PPVA products for these strategies:
• Integration with estate planning—PPLI policies can be integrated into traditional estate planning through common planning techniques such as a sale to an intentionally defective trust, etc. The life insurance component provides a tax-free death benefit for additional estate liquidity and capital leverage.
• Integration and enhancement of philanthropic goals—PPVAs are commonly used with philanthropic bequests or charitable lead annuity trusts (CLATs). Using a PPVA provides lifetime tax deferral for funds earmarked for a charitable bequest, while providing the annuity owner with the ability to change the bequest. At the insured person’s death, a charitable deduction is available to offset the inclusion of the annuity within the taxable estate. Similarly, a PPVA product owned within a grantor CLAT can provide all of the advantages of a grantor CLAT while providing tax deferral on the CLAT’s assets.
• Implicit deduction for otherwise non-deductible investment expenses—Given the phase-out of individual itemized deductions, the potential application of the alternative minimum tax or a trust’s inability to deduct non-trust exclusive fees, many alternative investors are unable to deduct investment management fees within their itemized miscellaneous deductions. Private placement products are taxed only on the actual realized gains, if surrendered. This creates an implicit deduction for fund fees that otherwise would not have been deductible, giving rise to “phantom income.”
• Creditor protection, subject to jurisdictional statutes—Depending on jurisdictional statute, life insurance policy cash values enjoy general creditor protection and are not liable to the claims of the policy owner’s general creditors. This can provide an additional layer of creditor protection on top of structuring the policy within a creditor remote entity such as a trust or LLC.
• International tax strategy management benefits—Private placement products provide an ability to shield worldwide income for pre-immigration planning to the United States. Additionally, private placement products are an effective tool in limiting the application of the “throwback” tax for undistributed net income in foreign non-grantor trusts with U.S. beneficiaries.
• Elimination of K-1 reporting for annual tax filings—Since investment is through the private placement product, the individual policyholder is not responsible for providing investment K-1s with the his or her income tax return. This simplifies the annual tax filing and will likely eliminate the need for extension requests or revised returns.
PPLI and PPVA policies can serve as compelling and effective tools for many rich families in achieving their planning goals, but they are sophisticated tools. As these are non-registered products, there is more latitude in permissible investments than there is in their retail product cousins, but they may have additional investment risks. Advisors knowledgeable about PPLI or PPVA policies may want to consider exploring the potential tax efficiency of the investment earnings provided by these products to add value for their clients in otherwise tax-inefficient investments. PPLI or PPVA may be even more attractive to clients who can benefit from the numerous non-tax benefits when customized to a client’s unique wealth planning objectives.
Michael Mingolelli Jr., ESQ., and Kenneth Masters are partners at Pinnacle Financial Group, a life insurance consulting firm serving affluent families, corporations and their advisors on complex life insurance matters. Pinnacle Financial Group is a member of M Financial Group.