Private placement variable universal life insurance (PPVUL) and annuity products are hot topics today because they provide effective ways to invest without taxation (or with deferred taxation) on investment earnings. In light of recent tax reform, estate-planning advisors may be focusing more than before on income tax planning, and these vehicles offer solutions worth exploring. In addition, investment advisors are attracted because they can manage policy values through Internal Revenue Service-approved methods. Some advisors and clients believe the smart approach is to go directly to an insurance company that offers these products and negotiate fees without the use of a broker. After all, their thinking goes, what does the broker do except charge a commission?
Let’s explore four questions:
1. How can advisors decide which product (PPVUL or private placement variable annuity (PPVA)) is best for their client?
2. What is/should be the role of the private placement broker?
3. What incremental additional fees does PPVUL cost when compared to PPVA products?
4. What value should the broker bring to the transaction?
What are PPVUL and PPVA?
PPVUL and PPVA products are low-cost vehicles that provide access to funds and managers that aren’t Securities and Exchange Commission registered. PPVUL products meet all IRS requirements for life insurance described in Internal Revenue Code Section 7702, and PPVA products comply with IRC Section 72. They combine institutional pricing with an ability to customize investment strategies by following IRS rules for doing so. Often, the life insurance component in PPVUL is minimized as permitted in Section 7702. The all-in costs are typically 20 percent to 25 percent of what the income tax would be on a comparable portfolio of investments that generates a high percentage of ordinary income.
The ability to compound earnings without taxation is often referred to as “structural alpha”; over time, the impact of this compounding leads to significantly more wealth than a comparable taxable portfolio.
Brokers need a Series 7 securities registration (administered by the Financial Industry Regulatory Authority) in addition to a life insurance license and must be affiliated with a broker-dealer firm that permits the sale of these products.
Who Are They For?
These products are designed for high-net-worth clients. Due to SEC rules about investing in unregistered securities, investors have to meet income and net worth requirements as an “accredited investor” and “qualified purchaser” to consider these products, described via a private placement memorandum.1 Hence the name “private placement” insurance and annuities. PPVUL and PPVA products are best suited for the portion of a client’s portfolio that’s invested in tax-inefficient assets such as hedge funds, credit funds, high yield bonds and high turnover trading strategies. Primary applications are income tax planning for investment earnings, wealth transfer, charitable planning, informally funding executive benefit plans and buy-out arrangements.
The Broker’s Role
PPVA products generally don’t have commissions, sales charges or surrender charges. There are also no requirements to withdraw funds until the annuitant’s age 95. The broker’s role in PPVA is as a go-between for the client and the insurance company that issues the PPVA contract. Many financial institutions market PPVA products through internal financial advisors. Because there’s no medical underwriting, implementation is a fairly simple application process. For the financial institution, it’s a way to build, and charge for, additional assets under management (AUM).
• PPVA’s primary planning features are growth of assets via income tax deferral and for clients who are charitably inclined, as a bequest of the PPVA to a family foundation or other charity at death of the annuitant.2 The PPVA can successfully leverage a charitable gift at death while preserving access to policy values in the PPVA during lifetime. The PPVA can also act as a “blocker” for unrelated business taxable income, applicable when a family foundation or other charitable entity holds leveraged investments such as hedge funds.
• PPVAs, however, can’t be owned in limited liability companies (LLCs) (the exception is a single member LLC), partnerships, corporate entities and some trusts.
PPVUL products are more complex and require an experienced broker. The trade-off is PPVUL products provide income tax elimination, because cash values can be accessed tax-free during life, and the death benefit (absent of value during the insured’s life) is income tax free (instead of PPVA’s income tax deferral). A skilled broker is needed to pull together the various components. Entity ownership with PPVUL may be easier (than PPVAs) because PPVUL can be owned in most entities as long as accredited investor (AI) and qualified purchaser (QP) requirements are met. The broker’s role begins with:
• Extensive financial modeling to help clients and their advisors determine policy structure. For example, should the PPVUL be structured as a modified endowment contract (MEC) or non-MEC?
• While the MEC design allows a lower initial death benefit (and therefore lower mortality costs for the life insurance feature), the drawback is any lifetime withdrawals, loans or pledges are subject to income tax (along with a 10 percent penalty tax on withdrawals before age 59½). There are also limitations in using MEC policies as collateral for financing. MECs, however, can be attractive when owned in a generation-skipping transfer (GST) trust or other trusts in which access to policy values isn’t anticipated.
• Non-MECs permit tax-free withdrawals of basis and tax-free loans thereafter and are more suitable when trustees (or insureds) want flexibility in accessing policy values in the future. Non-MECs, however, require (under Section 7702) more (than MEC policies) life insurance in the first seven years, although the life insurance feature can be reduced in Year 8 to lower MEC limits, while preserving the ability to take tax-free withdrawals or loans.
• Choice of insured is another option when considering PPVUL. Because the life insurance feature in PPVUL may not be a primary consideration, understanding the lower costs of insuring next generation adult children may be attractive. In some cases, a family constellation may be insured (that is, multiple family members) to maximize life insurance capacity and investment opportunities.
• Negotiating medical underwriting with PPVUL issuers to obtain best available rate classes that affect internal charges (and ultimately the return on investment). The broker should be skilled in understanding reinsurance and how to allocate reinsurance among carriers.
• Survivorship policies are an option with PPVUL and are effective in reducing costs because the mortality charges for two lives are lower than the costs to insure one life.
• Financial underwriting for the entity (which will purchase the PPVUL policy) and the deemed insured to demonstrate they meet SEC requirements for private placement products.
• Collaborating with existing advisors for the legal architecture (for example, an LLC or trust) and state of issue for PPVUL (for example, a low premium tax state like Alaska, Delaware or South Dakota), along with advanced estate planning and financing options3 necessary for funding the PPVUL transaction.
Overall, the cost for the broker will be a placement fee (typically a percentage of the total premium commitment with a minimum amount agreed on by the client and broker), subject to broker-dealer requirements. In addition, a portion of the insurance company’s mortality and expense (M&E) risk charges are designed to be used by the broker to provide policy servicing as outlined below. On more complex cases, the broker can easily spend several hundred hours of time before final decisions are made to implement and fund the PPVUL policy(s).
Is PPVUL more expensive? Yes, annually by the cost of the life insurance component. This should be about 25-75 basis points (bps) higher than the PPVA transaction, for the life insurance feature and for federal and state premium taxes not assessed on PPVAs. On the other hand, PPVUL’s annual “all-in” costs may be significantly lower than the income tax on a comparable taxable investment for those in high income tax states like California, Illinois and New York. For clients in states with no state income tax, like Florida, Nevada and Texas, the benefits will likely be less.
Six Responsibilities of PPVUL Broker
The experienced broker will also know how to use PPVUL in a sophisticated planning perspective. Here are six responsibilities of the broker:
1. Align objectives with the PPVUL policy design. Each of the following objectives can dictate a different PPVUL design by the broker.
a. Maximize wealth transfer. This could mean a MEC survivorship policy owned in a GST or defective grantor trust. The MEC might be a surprise solution for most planners who preach flexibility of non-MEC policies, but the benefits (and lower costs) should be considered. In addition, using PPVUL in a grantor trust as an income tax blocker for the grantor may be an added benefit;
b. Build a fund to meet philanthropic objectives.A PPVA could have a testamentary bequest to a family foundation (and a way to engage next generation adult children in a discussion of family values);
c. Provide tax-free access to funds for supplemental income. This could mean a non-MEC policy, with minimum death benefits and maximum premiums—like a no-limit Roth individual retirement account with greater flexibility;
d. Support next generation family needs. The broker might help with insuring younger family members (with lower mortality costs) with non-MEC policies in trusts (that also might have incentive provisions);
e. Buy out minority partners. Company-owned policies funded via business cash flow and distributed during lifetime as part of a buy-out/option arrangement, an interesting possibility instead of traditional death-only buy-outs funded with traditional life insurance.
Aligning objectives with product design means advisors and brokers working collaboratively for the “legal architecture” to reduce product costs and/or enhance overall results. For example, will new entities be needed under the umbrella of existing trusts to take advantage of lower state premium taxes? How will nexus be created for the policy owner to reduce risks? What will be the source of funds for the policy(s)? If intra-family loans are involved, an exit strategy to repay the loans from policy values will be needed. Will existing family trusts capitalize or make loans to a new partnership or LLC, and if so, how?
Overall, the broker should be able to create “what if” interactive spreadsheets and multiple financial models that illustrate and compare various planning scenarios, costs and exit strategies, if necessary for intra-family loans, so all can make an informed decision. Keeping the broker in the dark doesn’t create a solution-based approach that’s needed.
2. Provide transparency and best pricing. It’s a complex product because it combines the complexity of life insurance with the challenges of customizing an investment portfolio. The job of the broker is to analyze pricing across multiple carrier platforms and help the client make an informed decision about how to best structure a product and which carriers to use.
Some variables that aren’t obvious are PPVUL’s borrowing costs, which differ widely among carriers (for example, from wash loans after six-to-10 years, to 50 bps annually); current and guaranteed M&E risk charges; and whether they’re duration based or asset based. Can federal and state premium taxes and broker placement fees be amortized over a period of years, and if so, should they be? M&E fees are typically shared in some percentage between the carrier and the broker’s firm. The broker’s share of M&E revenue provides compensation to the broker for ongoing servicing as described below. M&E fees will be eligible for “breakpoints,” that is, a reduction in bps charged, based on policy values (for example, when cash values exceed $10 million) or by duration (for example, automatically after 10 and 20 years).
Best pricing may not be cheapest. A conversation about policy servicing can establish mutually beneficial expectations for both the broker and the client that can allow M&E fees (for the broker) to compensate for the time required to provide reporting and other services.
“What’s the Cost?,” p. 44, illustrates a pricing summary of three carriers’ PPVUL policies for a male, age 60, and female, age 59 (the male had a “rating” due to health issues, that is, additional costs for the life insurance component in the survivorship scenario). A 7 percent net rate of return was projected for PPVUL investments based on the client’s choice of managers with existing insurance dedicated funds (IDFs). The incremental additional cost for PPVUL versus PPVA is approximately 35-45 bps annually (Years 1-10) and 10-20 bps higher (than PPVA) over a 20-year period for the life insurance feature and to eliminate (instead of defer) income taxes.
3. Assist clients and their advisors with investment structures (or combinations) that best meet planning objectives. Should the client work with a known investment manager who’ll build an IDF or a separately managed account (SMA),4 as described in Revenue Rulings 2003-91, 2003-92 and IRC Section 817(h)? Each has different characteristics, carrier requirements, manager minimums and costs. Or, should the client use existing IDFs already available on an insurance company’s platform? If an IDF or SMA will be constructed, the broker should facilitate insurance company conversations to expedite the process, work with the investment firm and client to create an investment mandate that aligns with client goals, collaborate with third-party administration companies, negotiate best pricing and keep a complex process on track.
Before 2008, PPVUL buyers would typically allocate cash values to one manager. Unfortunately many managers (especially of hedge funds) didn’t hit performance goals. The sub-par investment results led to higher-than-expected mortality charges, due to lower cash values, and client frustration. The broker should track actual versus projected investment performance and be the first to alert the client to discrepancies. The broker should also help the client stay abreast of new investment funds and managers launching on insurance company platforms. In PPVUL, the illustrated (projected) rate of return when a policy is issued becomes a benchmark for tracking performance and managing expectations. When performance consistently lags the benchmark, the broker should initiate conversations about action (if any) to be taken.
Example: One client purchased PPVUL eight years ago in a customized IDF projected to produce (investment manager’s directive) a 6 percent to 7 percent return on policy values. Eight years later, the returns have been closer to 2.5 percent, creating tough choices for the client to avoid the PPVUL policies lapsing before normal life expectancy; policy values are 25 percent below initial projections.
4. Negotiate with carriers that have capacity to issue PPVUL. A limited number of U.S. life insurance companies issue PPVUL products. Each of them has different product features, different current and guaranteed maximum rates and charges and, most importantly, different internal capacities to issue a PPVUL policy. Internal capacity is important because that’s the amount of life insurance a company can issue using its own balance sheet. That is, the life insurance “risk” can be retained up to a certain amount—called “internal retention.” Because the life insurance process involves medical underwriting, a broker who can work directly with a company’s medical department to negotiate the best underwriting category (and obtain the company’s maximum internal retention) for the insured is an important skill—the underwriting category impacts the cost of insurance charges that are assessed in the policy.
Once a company’s internal retention is exceeded, the company will use reinsurance from multiple specialty companies. Often, reinsurance underwriting will be more conservative than the primary company’s underwriting, which impacts how the mortality risk is priced. A broker who can obtain internal retention from multiple companies may avoid reinsurance to obtain the best pricing for the client. That can lead to multiple policies and lower overall pricing. PPVUL clients may be concerned with “sizing,” that is, how much can be invested and how quickly. Therefore, the ability to create a multiple carrier solution with minimum reinsurance can expedite the process.
5. Implement the underwriting. The broker is responsible for all aspects of underwriting with PPVUL: medical underwriting, as well as financial underwriting. Financial underwriting can be challenging because the policy owner (that is, the LLC or trust that will own PPVUL) must be an AI and QP. The AI and QP rules can be complex when newly formed trusts, LLCs or other entities will be the PPVUL owner and additional disclosures are needed for the broker-dealer firm responsible for compliance with securities regulations. In addition, if intra-family loans (or other financing) will be used to fund the entity that will own PPVUL, the loan agreements and collateral assignments (if any) must also be in place along with a strategy for cash values (or other assets) to repay the intra-family loans.
“Product Costs/Features,” p. 46, compares product costs/features for five companies, for a 57-year-old male, preferred (best available) risk, assuming a 6 percent return on investments. The policy applied for was a non-MEC, with an initial death benefit of $35 million. The death benefit was designed to reduce to minimum Section 7702 levels after Year 7. The scheduled premium was $2.5 million annually for four years.
As illustrated in the chart, the policies are fairly close in projected performance, but differ in loan spreads, guaranteed M&E charges (not shown in chart), investment options and willingness to add new managers in the future and back-office technology needed to provide timely reporting.
6. Post-sale servicing. A number of years ago, a client asked “what happens after the sale?” PPVUL isn’t a product that can be set aside—it’s an investment inside a life insurance policy that must be monitored regularly with investments periodically re-allocated in the policy.
What can go wrong? The biggest mistakes are: (1) not monitoring carrier charges on an ongoing basis, and (2) not having a diversified allocation of cash values to different asset classes.
The broker should provide a written insurance services agreement that lays out what happens after the sale. What should be done monthly? Quarterly? Annually? Because these are long-duration, long-tail products, someone has to track them on a regular basis to see if they’re performing the way they were originally expected to do. If they don’t, what do you do if it’s off track? When should the broker call the client if one or more managers aren’t performing? The broker’s firm should function as a back office for the family office. The family office may not want (or have time) to become PPVUL experts. They don’t want the transaction to go off track either. They want someone who can provide answers, as well as raise questions and get answers before problems occur.
The broker should provide consolidated monthly reporting, especially with multiple PPVUL contracts and carriers. Family offices and advisors who are using PPVUL want all product charges and performance data rolled up monthly into one report. Ask for a sample monthly report and references.
What about broker non-performance? If the broker leaves the business, or otherwise doesn’t provide promised services, there should be a mutually agreeable exit strategy for the client to move servicing to a successor broker. Typically, the client would notify the broker of his dissatisfaction, the broker would have some period to cure the issue (say, 30-45 days) and if the problem hasn’t been fixed to the client’s satisfaction, the broker should commit to assist the client to move the servicing (and any recurring revenue) to a licensed broker associated with a broker-dealer firm that agrees to take on the servicing responsibility. PPVUL dissatisfaction generally occurs two to three years after implementation when clients realize the policies aren’t performing as expected. When brokers haven’t committed to post-sale servicing, frustration is created because clients don’t have anyone to call for help.
Questions to Ask
What to know/ask of the PPVUL broker to determine if his experience and commitment aligns with client goals:
• Does the broker’s practice focus primarily on PPVUL and PPVA transactions—NOT traditional life insurance sales?
• Is there a track record with multiple insurance companies in launching IDFs, funded with relevant AUM?
• Is there demonstrated access to multiple products and carriers for best pricing (and best underwriting for PPVUL)?
• Is there dedicated staff and resources for complex modeling and scenario planning?
• Is there a commitment to transparency and full disclosure?
• Is the broker experienced with sophisticated planning applications, including working with trust and estate attorneys, premium tax planning and financing arrangements?
• What’s the commitment to post-sale servicing and reporting?
Endnotes
1. An in-depth explanation of these terms is beyond the scope of this article.
2. Because the gain in the annuity is income in respect of a decedent and isn’t stepped-up at death.
3. Loans to purchase or carry variable policies are potentially margin loans, because the funds underlying the policy are margin securities.
4. Supra note 1.
—The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that Cohn Financial Group is not engaged in rendering tax, legal or actuarial services. If tax, legal or actuarial advice is required, you should consult your accountant, attorney or actuary. Cohn Financial Group does not replace those advisors. The information in this article is for educational purposes only and isn’t intended as a solicitation.