A Hybrid
Haven
© Rob Report Worth
Michael Book,
a managing partner at the New York financial advisory firm Lenox
Advisory, recently sought to devise an investment plan that would
shelter assets from taxes for one of his clients, a newly retired
Wall Street executive in his mid-40s. The client has a tax-deferred
retirement account that will continue to grow for several years
before he starts drawing on it, and a portfolio of municipal bonds
that generate a few hundred thousand dollars in mostly tax-free
income living each year to cover his living expenses. He also has
about $4 million set aside to invest in alternative assets such
as hedge funds.
“As a
Wall Street person, he loves hedge funds,” Book explains.
He also knows that the funds’ active trading strategies generate
an unfortunate amount of short-term capital gains, which are taxable
as ordinary income, rather than at the lower, long-term capital
gains rate. To avoid this cost, Book advised his client purchase
a private-placement life insurance contract and use it as a vehicle
for investing in various hedge funds.
Private-placement
insurance policies are tailored to fit the needs of affluent investors,
and as their name of indicates, are unavailable to the public at
large. They are, essentially, variable insurance policies. Clients
have some degree of choice over the assets they hold – at
least when setting up these policies – and how well those
investments perform determines the size of the death benefit. For
example, the policy that Book arranged for his client starts out
with a $19 million death benefit. “But,” Book notes,
“We’re hoping the investments will grow to $30 million
to $40 million.”
Private-placement
life insurance is therefore a hybrid: half insurance policy, half
asset-management tool. It is a valuable financial planning strategy
for those of us who have enough liquidity to meet day-to-day expenses,
and who want to invest a portion of our capital for long-term appreciation.
For example, Anne Melissa Dowling, a senior vice president at MassMutual
Financial Group in Springfield, Mass., recommends private placements
for people who have recently had liquidity events, either inheritances
or windfalls from selling a business or investment.
Many major financial
companies, including New York Life, Massachusetts Manual Life Insurance
and Citigroup, offer these products. They have become more widespread
as hedge funds have grown in popularity, primarily because of tax
advantages. Any assets used to fund an insurance policy grow tax-free
inside the policy, and the death benefit paid out to beneficiaries
is also tax-free. Private placements are more flexible and less
expensive than other types of insurance policies, making them attractive
an investment vehicles.
“Still,
people shouldn’t lose sight of the fact that it is an insurance
policy, and there are complications,” cautions Douglas Moore,
national director of estate and charitable planning Citigroup Private
Bank in New York. For example, rather than investing directly in
a hedge fund, we pay a premium to an insurance company, which then
invests the capital for us. Private-placement policies typically
have higher premiums than other kinds of life insurance. This can
work to our advantage, because it allows us to put capital to work
quickly. The premiums typically start at around $2.5 million, are
spread over four or five years and can total as much as $10 million
to $20 million (there are limits on the extent to which we can insure
ourselves). The premium represents the initial cash value of the
policy, and the insurance company invests in its value partially
funds the death benefit.
CIRCUITOUS ROUTE
There are other
costs we will not bear if we invest in a hedge fund directly. The
federal and state governments levy taxes on insurance policies.
The insurance company itself will charge a commission and administrative
fees, and a management fee if the policy is big enough to require
its own asset manager. Advisors recommend factoring in all taxes
and fees for private-placement insurance when weighing it against
direct investments. “We assume a rate of return and run the
numbers with all these fees, and without the insurance policy. Then
we see what the consequences will be,” says Mark Watson, vice
president of financial capital services in the Orlando office of
Asset Management Advisors. “Usually the insurance product
looks better.”
The fees that
are charged for private-placement insurance are generally smaller
that those for other kinds of life insurance, partly because these
polices are far bigger, which gives a client bargaining power, and
partly because the companies offering them want to make them appealing
as investment vehicles. “On a good private-placement policy,
the fees should be about 1 percent of the premium, capped at $50,000,”
excluding taxes, which will vary by state, Watson says. By comparison,
on the more common kinds of variable policies, he says, fees and
commissions might total 9 percent of the premium.
Fees can vary
dramatically from firm to firm. “I’ve looked at about
10 insurance carriers who do this, and I was surprised at the difference
in fees,” Watson noted. They can vary from 1 percent to a
little over 2 percent of the premium. If we like a carrier, we should
bear in mind that in many case these may be negotiable.
One limit to
our investment choices is the IRS’s requirement that, for
these to be legitimate insurance policies, the funds in which they
invest must be set up specifically for insurance policy use. This
means the assent mangers or hedge fund managers must set up accounts
specifically for this type of insurance company investment, which
some will be loathe to do. The IRS also requires our portfolio to
have some degree of asset diversification. In practice this may
force us to invest our capital in more that one fund (typically
five or so), or to choose a fund of funds with diverse underlying
investments.
Watson says
it is important to research the private-placement carriers. “Some
insurers have a wide selection of well-performing funds,”
he notes. “Others don’t have as good a selection in
terms of number or quality. I was surprised by the discrepancy when
I started looking into them for our clients.”
Also, the policies
can change investments in midstream, if we are disappointed with
their performance. “If a fund isn’t performing, we can
pull the money away from that firm and find another fund that meets
the criteria we promised to the policyholders,” notes MassMutual’s
Dowling.
If we purchase
a large enough policy (at MassMutual, a minimum $5 million premium
paid over 4 years) our possibilities for customization increase
significantly. We can avoid the pooled investment funds altogether,
and, in effect, have our policy act as its own fund of funds, with
its own manager. This also gives s greater purview in our investment
opportunities. Because we are already in an insurance-only fund
(albeit our own), the manager can invest in funds available to the
public. “The couture of it is attractive,” Dowling says.
“Like a custom dress, it’s made just for you.”
Unfortunately,
this does not mean we necessarily have more control over our investments.
IRS regulations require that insurers, not policyholders, make asset
management decisions. So we need to discuss our goals and risk tolerance
with our insurance carrier, and make clear our preferred types of
investments. Once we have purchased a policy, we cannot influence
the choice of its assets. “Some clients see the lack of control
as enough of a deterrent to decide against doing a private placement,”
Citigroup’s Moore notes.
It is possible
to extract some capital from the policy while keeping the life insurance
active and the investment growing tax-free. The IRS allows us to
withdraw the amount we originally paid for the policy without penalty
or tax. Beyond that, we can borrow against the policy. If we choose
not to repay the loan, at death it will count against the benefit.
But, we have to leave some money in the policy to ensure it grow
