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Private Placement Life Insurance: A Tax-Efficient Way to Invest in Hedge Funds

Allan Goldstein

As the stock market’s bull run extends into its seventh year, investment advisors are increasingly looking to hedge funds and other low-correlation alternative asset classes to generate alpha and diversification for their clients. According to data from BarclayHedge, total assets managed by hedge funds increased 46% from 2010 to 2014. Hedge Fund Research reported that investors allocated $18.2 billion of net new capital to hedge funds in the first quarter of 2015, increasing the hedge fund industry’s total assets to $2.9 trillion.

While the performance and diversification benefits of hedge funds can be very attractive for high-net-worth investors, the tax consequences are not. Many investors are hit with a severe case of sticker shock each April when they file their taxes and see that gains within hedge funds are taxed at ordinary income tax rates. Thanks to higher marginal tax rates and the 3.8% Medicare surtax on investment income that went into effect in 2013, the cost of investing in hedge funds, commodity funds, high-yield bond funds, and other tax-inefficient asset classes is now even greater for wealthy investors.

Within this environment of higher taxes and impressive performance by hedge fund managers, it is not surprising that private placement life insurance is generating increased interest from high-net-worth clients and their advisors. Private placement variable universal life insurance and private placement variable annuities can be a tax-efficient way for advisors to harness the alpha-generating potential of hedge funds and other asset classes plagued by tax inefficiency.

Enhancing “Structural Alpha” through Private Placement

Typically, gains, interest, and dividends generated by hedge funds are treated as ordinary income for investors. As a result, nearly 50% of the fund’s gains can be swallowed up by taxes. The situation becomes even more painful when considering that this income often results in a large tax bill without generating any cash flows for the investor.

Private placement life insurance and annuities, however, provide powerful opportunities to defer these taxes and enhance the structural alpha (after-tax returns) of the investment. When assets are owned in a private placement variable universal life (PPVUL) policy, taxes on investment gains are deferred throughout the insured’s lifetime. With a private placement variable annuity (PPVA), taxes on investment gains are deferred until withdrawals are taken from the annuity.  

In addition to the accelerated investment growth resulting from the deferral of income taxes, PPVUL provides important estate planning benefits as well. If the policy is held until the insured’s death, the beneficiaries receive the death benefit free of income tax. This means the investment returns can avoid income tax altogether.

PPVUL and PPVA can be particularly useful when used as part of a philanthropic strategy. PPVUL and PPVA can be used in charitable trust structures that have traditionally used retail insurance. Using PPVUL or PPVA in a charitable lead annuity trust (CLAT) eliminates the client’s income tax liability for any “phantom income” generated by the trust.

Overcoming Resistance to Private Placement

Despite these valuable tax benefits, some advisors have been hesitant to recommend private placement life insurance for their clients. We have found many of these potential objections go by the wayside once advisors learn more about the nuances and mechanics of private placement life insurance and annuities.

  • Transparent pricing structure: With any insurance or annuity product, it is important to understand the costs and fees of the policy. Private placement policies have a fully transparent pricing structure. There are four types of expenses involved with private placement life insurance: cost of insurance, mortality and expense (M&E) fees, policy loads (i.e., commissions), and insurance taxes. Commissions on private placement life insurance are often significantly lower than commissions on retail insurance products. When evaluating the economics of private placement life insurance, we feel it is appropriate to weigh the policy’s fees and expenses against the benefit of tax-deferred growth within the policy.

  • Fully recognized by the IRS: The favorable tax treatment of private placement life insurance has been firmly established in the Internal Revenue Code for several decades. The tax-deferred growth is recognized and unchallenged by the IRS.
  • Increased access to leading managers: When using private placement life insurance or annuities, investors can only invest in managers who are part of an insurance company’s private placement platform. Because of the increasing popularity of private placement life insurance, many of the industry’s leading hedge fund managers have chosen to join these platforms in recent years.
  • Elimination of K-1 tax reporting: In addition to tax inefficiency, one of the biggest drawbacks of investing in hedge funds and other alternative asset classes is the administrative burden of annual tax reporting. Investing in these assets through private placement life insurance eliminates much of this compliance burden. The policy serves as a wrapper around the investment, so the investor does not have to file many of the tax forms, including IRS Form K-1.
  • 1035 exchange opportunities: Clients who own existing annuity or life policy assets can transfer those assets into a new private placement policy using a 1035 exchange. This allows the client to take advantage of today’s improved pricing environment and enhanced investment choices without incurring any tax consequences.
  • Investor control test: To qualify for tax-deferred growth, the policy must pass the “investor control test.” This means the investor cannot exert control of the assets owned by the policy by communicating directly with the fund manager or by making specific investment decisions. The test also mandates that the funds cannot be accessible by the general public and the investments must meet diversification guidelines.

At Goldstein Financial Group, we have helped many advisors over the past 10 years understand how private placement life insurance and annuities can be a valuable part of their clients’ investment portfolio and estate planning strategies. To learn more about how private placement policies can enhance your high-net-worth clients’ after-tax returns when investing in hedge funds and other tax-inefficient asset classes, please do not hesitate to contact us or visit our website.