Overview

For some inexplicable reason, life insurance and annuity products seem to confuse even the most gifted and intelligent attorneys and CPAs. I personally have never understood the reason for this. It does not make any difference if the attorney has an LL.M in tax from NYU or a law degree from Harvard. The end result is confusion for the attorney. Insurance products coupled with attorneys spells “C-o-n-f-u-s-i-o-n”!

You may already be asking the critical question, “Who cares?”. Less I remind you, the Bush tax cuts are due to expire at the end of 2012. The top tax rate jumps to 39.6 percent. The new Medicare tax adds another 3.8 percent on unearned income. The phase out of personal exemptions and itemized miscellaneous deductions has the effect of adding another two percent. All of this before state taxation which can add another 5-10 percent. Taxpayers will be at a combined marginal tax rate of 52-57 percent..

At the same time, the estate and gift tax exemption equivalent drops from $5.125 million to $1 million per taxpayer. As Congress can’t agree on anything, it seems unlikely that any last minute change will take place.

Are you listening yet?

On one level, the tax treatment of life insurance and annuities is pretty straight-forward. However, on another level, the array of different insurance products combined with the sales tactics of retail insurance agents has resulted in most attorneys avoiding the discussion and recommendation of insurance and annuities products. Nevertheless, clients have purchased significant amounts of these insurance products which have a substantial impact on client planning and recommendations. In the meanwhile, attorneys and CPAs have remained on the sidelines.

My mission over a series of articles on life insurance and annuity-related topics is to create a level of understanding of insurance products that goes beyond knowing the difference between whole life and universal life insurance.

Two products that have eluded the notice and attention of attorneys are private placement life insurance and variable deferred annuities. The purpose of this introductory level summary is to provide the background and planning uses of these products for high net worth and institutional purchasers of life insurance and annuities.

Background on Variable Insurance Products

In case you did not know, the assets of variable life insurance and annuities in the U.S. life insurance industry exceed two and a half trillion dollars. The Pareto Rule applies here. Eighty percent of these assets are held by twenty percent of the life insurers. The majority of the assets are held in retail variable life and annuity products sold by insurance agents.

The majority of the assets are part of variable annuity arrangements. Life insurers have managed to squeeze out $150 billion in variable annuity sales in 2011 and preceding years never missing  a beat during the economic and market downturn by adding relatively high guaranteed returns to the contracts.

The marketplace for private placement life insurance and annuities easily exceeds $100 billion. High net worth assets account for approximately $15 billion while corporate and bank owned life insurance programs account for $100 plus million.

A.    What is private placement life insurance (aka PPLI)? 

A variable life insurance policy is a permanent life insurance contract that has a cash value component and a death benefit component. The growth of the cash value is tied to the investment performance of investment sub-accounts that the policyholder is able to select,. In retail variable insurance products, these investment choices are mutual fund clones or sub-accounts. The policy holder bears all of the investment risk. The assets supporting the policy cash value are separate or segregated from the life insurer’s general account asset and its creditors. The policyholder is able to select these funds within the life insurance policy with the carrier’s fund election form.

PPPLI is a form of variable universal life insurance. The policy is strictly available for accredited investors and qualified purchasers as defined under federal securities law. The policy is institutionally priced and is virtually a “no load” product. The insurer provides the policyholder with the ability policyholder to customize the investment options within the policy. The range of investment options can include a customized fund managed by the client’s existing investment advisor as well as a range of asset classes including hedge funds, real estate and private equity.

B.    What is a private placement variable deferred annuity?

An annuity contract is a contract between the policyholder and insurance company to pay an annuity to the policyholder. Insurance companies offer two types of annuities – immediate and deferred. Immediate annuities provide a stream of payments at fixed intervals (monthly/quarterly/semi-annually or annually). The annuity is paid for a term of years or based on a life contingency such as “life only” or “joint and survivor” The payments end at the end of the fixed term or death of the annuitant (measuring life).

A deferred annuity is a deferral of that promise to make a series of payments to the policyholder. The deferral may be set for a fixed period of time. Many contracts list a maximum age of 85 or 90 for the deferral period. The account value in a “fixed” annuity is based upon the crediting rate based upon the insurer’s investment performance on general account assets. Most insurance general account investments are in investment grade bonds.

In a variable annuity the investment performance is based upon the on investment performance of separate account funds. These funds are segregated from the insurer’s general account assets Traditionally, these funds are mutual fund clones or sub-accounts managed by investment management firms in the mutual fund industry. The investment performance  for these accounts is a direct pass-through to the policyholder.

The private placement version of this product is for accredited investors and qualified purchasers based upon the definition under federal securities law. Like PPLI, the products are institutionally priced with no surrender charges. The investment options include hedge fund, private equity and real estate options as well as traditional mutual fund-like options.

C.     How do private placement insurance products differ from retail insurance products in regard to sales loads?

In order to appreciate the cost perspective of PPLI, you need to understand the cost structure of retail insurance products. Variable life insurance products have a commission structure that pays the agent 55 -95 percent of the target (commissionable) premium in the first policy year.

Commissions in subsequent years on premiums vary by carrier from 2-5 percent of the premium. Additionally, the agent receives 25-35 basis points (.25-.35 percent) of the policy’s account value each year. The policies usually have declining surrender charges of 10-12 years. These charges allow the insurer to amortize and recoup these sales

Variable annuities have a commission structure that pays the agent 4-5 percent in the first year and on any subsequent premium payments. Additionally, the agent receives 25-35 basis points of the account value each year. The policies have declining surrender charges over 5-8 years.

Private placement life insurance and annuities have no surrender charges and compensate the distributor (agent) with premium based commissions equal to 1-3 percent and asset based commissions based on the account value of 25-35 basis points. The impact of these charges creates a “drag” on the investment performance of approximately one percent per year over the life of the policy.

D.    What are the tax advantages of life insurance?

Your life insurance agent is right! Permanent life insurance is the most tax-advantaged investment vehicle on the Planet. The investment growth of the cash value is not subject to current taxation. The policyholder is able to take a tax-free policy loan during his lifetime generally up to 90 percent of the policy cash value.

The net cost of the loan which does not have to be repaid is approximately 25-50 basis points (.25%-.50%) per year. The death benefit is income tax-free and can also be arranged so that it is estate tax-free. Not bad, right! However, the premiums are not tax deductible.

In plain English, the policyholder’s account value grows tax-free, can be withdrawn tax-free, and is received tax-free by beneficiaries.

E.     What are the tax advantages of deferred annuities?

Deferred annuities provide for tax deferral. At the death of the policyholder, the account value must be distributed to the beneficiaries within five years of the policyholder’s death unless the beneficiary is the policyholder’s spouse. In that case, the spouse is treated as the new owner and policy benefits may continue to be deferred until the spouse’s death.

Income taken “other than as an annuity” during the policyholder’s lifetime  is treated as taxable income (at ordinary rates) to the extent of investment income within the policy. Income that is taken in the form of an annuity is partly taxable and partly treated as a return of principal based on a formula known as the exclusion ratio. The big point here is annuities are not as tax advantaged as life insurance.

F.       Who can purchase a private placement insurance contract?

The purchase of private placement insurance products is limited to accredited investors and qualified purchasers as defined under federal securities law. Private placement insurance products are a non-registered security for federal and state securities law purposes. The product is available to accredited investors and qualified purchasers as defined in federal securities law. The Securities Act of 1933 provides an exemption under Section 4(2) from securities registration for accredited investors as defined in Rule 501(a) of Regulation D under the Securities Act. An accredited investor is defined as an investor with a net worth of at least $1 million and joint income of at least $300,000 in each of the last two years, with the likelihood of continuation in the current year.

PPLI offerings are exempt from the Investment Company Act of 1940 under Section 3(c)(1) and 3(c)(7) offerings. Under Section 3(c)(1) the number of beneficial owners is limited to 99 investors.Investors must be accredited investors or qualified purchasers. A qualified purchaser has investable assets of at least $5 million. Under Section 3(c)(7) the number of beneficial owners is limited to 499 investors. The investors must be qualified purchasers. New SEC proposals would exclude the value of an investor’s principal residence from investable assets. 

G.     The Bottom Line PPLI

I have outlined a hypothetical purchase of a PPLI contract. A high net worth investor, age 50, invests a single premium of $10 million into a contact issued by a domestic life insurer. The policy is a modified endowment contract. The initial death benefit is $35 million. The cash value is invested into a customized hedge fund managed account managed by the client’s multi-family office.

The policy is invested at an assumed rate of 15 percent per year (I know- wishful thinking!). The comparison demonstrates the difference between a taxable account (far left column in red) and a tax-advantaged column (second and third columns in green). The taxable account is taxed at a combined rate of 47 percent.

The long-term results in favor of PPLI are staggering.

H.     The Bottom Line – PPVA

The advantage of tax deferral within annuities is frequently taken for granted particularly with investments that are taxed as ordinary income. The hypothetical illustration compares a $10 million investment into a PPVA contract against the same investment in a taxable account. The hedge fund managed account is taxed as ordinary income at a combined rate of 53.4 percent. The assumed investment return is ten percent in all years (net of fees). As you can see, the results are dramatic.

Summary  

Your clients have excellent options that are not being brought to the table for consideration for tax-advantaged wealth accumulation purposes. Tax rates on both the income and estate tax front are headed upward. The tax deferral options are increasingly limited. The tax advantages of life insurance and annuities are statutory and do not rely on a twisted interpretation of case law.

The “haircut” on investment returns due to the cost of the insurance product is minimal in comparison to the tax cost of most alternative investments. Private placement insurance products by definition have smaller sales loads and infinitely more investment flexibility than retail products. In short, it is the best product option for the institutional investor or high net worth client with investment income that is largely taxed as ordinary income. Unfortunately, these products frequently never see the light of day as a recommendation.

Take it upon yourself to seize the planning initiative to maximize planning results for your clients.