For the past several years some hedge funds have not met the expectations of investors. As a result, RIAs and wealth managers have recommended other investment options such as direct lending, private equity credit and mezzanine funds which in general have produced good investment results.
The use of those investments has created a second problem: taxes on the portfolio at ordinary income tax rates. As with hedge funds, the returns from credit and mezzanine funds are typically subject to ordinary income tax rates.
When structured properly, a private placement life insurance (PPLI) might be appropriate to provide high-net-worth purchasers with tax-advantaged portfolio income, tax-free growth within the policy, tax-advantaged cash access, creditor protection under some state laws and, because it’s life insurance, a tax-free death benefit.
PPLI is an institutionally priced policy, which should meet the definition of life insurance under the Internal Revenue Code if structured properly, but if structured improperly can lose that qualification. Institutionally priced does not strictly mean costs have been minimized from retail products, but they are in general much lower than retail priced products, and those costs are explicit.
There are no surrender charges for early cancellation, and charges for policy loans can be as low as five basis points. Additionally, the costs associated with funding the policy’s death benefit are minimized through policy design.
PPLI is an unregistered securities product, not subject to the same regulatory requirements as registered variable products. As such, PPLI should only be presented to accredited investors or qualified purchasers as described by the Securities Act of 1933. The typical PPLI buyer is a high-net-worth individual or family with greater than $25 million.
Unlike registered variable life insurance and annuity policies, insurance dedicated funds that mimic both hedge funds and credit funds are investment options available to PPLI owners. A private placement memorandum must accompany each PPLI purchase. Like other securities, a PPLI policy is subject to investment risk, and should be viewed as a long-term product.
In certain situations, investment options can be added to an insurance company’s PPLI offering, for which an RIA or wealth manager could manage or provide input. These policies are designed for high annual minimum premium commitments of $1 million or more for at least four years.
Many advisory clients purchased retail life insurance to protect their families in the event of a premature death or to provide liquidity to pay federal estate tax or state inheritance tax. Many of those policies were expensive, and in general fees were in a “black box” that was virtually impossible to open.
In contrast, to retain all the benefits of life insurance the strategy for a PPLI policy is to first determine the anticipated premiums, which in turn will determine the minimum death benefit. In the long run, this strategy results in more death benefit, because by minimizing expenses the internal cash build-up of the policy can grow faster, which can lead to more death benefit at an insured’s life expectancy.
Investors are drawn to the cost efficiency and transparency of PPLI for which each expense is explicit, and available for the purchaser to analyze. The annual costs for the insurance wrapper that provide the benefits discussed above is about 100 basis points after the first 10 years of a policy.
PPLI is treated under the same rules that apply to all permanent life insurance contracts. The cash value enjoys tax-deferred growth under Internal Revenue Code Section 7702(g)(1)(A). Moreover, there is tax-free growth of the policy value or internal equity build-up as long as the policy is never lapsed, surrendered or cancelled.
There is no income tax on withdrawals up to basis of a policy or loans from the policy, provided it’s a non-modified insurance contract. Thus, while an insured is alive most of the cash build-up in the contract can be accessed with no income tax consequences.
Last, death benefits are not subject to income tax. However, loans and partial withdrawals will decrease PPLI policy death benefits, and may be subject to limitations of the policy itself or in certain circumstances result in income tax if improperly structured.
Steven Zeiger and William Waxman are members of Waxman Lawson Financial.