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Help clients boost returns without increasing risk

If your clients are considering private placement life insurance or private placement variable annuities, here's what you should consider as part of the planning process

Apr 3, 2017 @ 1:00 pm

By Aaron Hodari

Private placement life insurance and private placement variable annuities have grown in popularity among financial professionals seeking tax-efficient investment vehicles for their affluent clients. These products enable investors to defer or even eliminate taxes on hedge funds and other tax-inefficient vehicles by holding them within an insurance structure. In addition, private placement life insurance (PPLI) and private placement variable annuities (PPVAs) have extremely low costs and no surrender charges.

(More: DOL rule blamed for massive hit to variable annuities sales)

PPLI and PPVAs take advantage of structural alpha, which measures the ability of an efficient asset and ownership structure to maximize after-tax returns without adding significant risk to the underlying investments. In PPLI and PPVA, investors are trading the tax cost of direct ownership for the insurance costs. The results if investments perform well are compelling.

PLANNING CONSIDERATIONS

If your clients are considering PPLI or PPVAs, here are some questions you should ask as part of the planning process:

LIFE INSURANCE OR ANNUITY?

Both PPLI and PPVAs permit investments to grow income-tax-free until they're withdrawn or distributed. But PPLI offers a decided advantage: If the policy is structured properly, the client can access the funds tax-free either by withdrawing up to the investment in the contract or by borrowing from the policy. Clients who leave funds in a policy for life will escape income taxes permanently and their heirs will receive the funds as an income-tax-free death benefit.

PPVAs don't offer these benefits — the gains in annuity contracts are taxed as ordinary income, while the investment is treated as return of principal. The main benefit of PPVAs is tax deferral.

Nevertheless, PPVAs offer clients some advantages. For example, they're easier and cheaper to set up and, unlike PPLI, the amount a client can invest isn't limited by financial capacity, medical underwriting or modified endowment contract (MEC) considerations. If a client or their family intends to keep the funds within the family, tax will eventually be paid and PPVA is a tax deferral vehicle. However, if a client intends to leave assets to charity at death, PPVA can serve as a tax elimination vehicle. The assets will continue to be in the estate of the client during their lifetime, providing them with the flexibility of accessing the funds if needed. If the annuity is left to charity at death, the client would have never paid tax on the growth in the contract and the charity would receive the full amount of the proceeds. This is becoming a popular tool for ultra-high net worth investors that intend to leave large portions of their estate to charity.

Typically, PPLI policies are structured as non-MECs. That's because MEC status, which is triggered by cumulative premiums that exceed certain limits during a policy's first seven years, causes withdrawals and loans to be taxable. But if a client plans to leave assets in a policy for life without withdrawing or borrowing funds, MEC status is desirable because it allows the client to build account value more quickly.

(More: 6 essential ingredients to life insurance advice)

INVESTMENT OPTIONS

Generally, PPLI and PPVAs are most suitable for hedge funds and other tax-inefficient investments — those that generate ordinary income. Typically, investments are made through insurance dedicated funds (IDFs), which are designed to ensure tax-advantaged status by meeting all statutory life insurance requirements (although some insurance companies permit clients to use separate account management). A wide selection of IDFs are available from well-regarded investment management firms. And insurance companies are adding new funds to their platforms every day.

Account owners are permitted to select, change and rebalance between investment managers within the contract with no tax consequences, subject to underlying fund liquidity.

INVESTOR QUALIFICATIONS

PPLI and PPVA products are unregistered securities available only to investors who meet the SEC's definitions of accredited investor and qualified purchaser. Accredited investors are those with either 1) a net worth of at least $1 million (excluding their primary residence), or 2) income of at least $200,000 ($300,000 for married couples) in each of the preceding two years. Qualified purchasers include individuals (and certain trusts) with at least $5 million in net investments and entities with at least $25 million in net investments.

(More: Rules governing indexed universal life insurance may not go far enough)

When discussing PPLI and PPVA with clients, it's important to emphasize the effectiveness of these products as investment tools that provide structural alpha. Too often, clients view life insurance and annuities as passive vehicles. But PPLI and PPVA are true investment-like accounts that permit clients to create a diversified, tax-advantaged portfolio and to adjust and rebalance their accounts on a continuing basis.

Aaron Hodari is managing director of Schechter Wealth.

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