Ever since the Internal Revenue Service’s introduction of the safe harbor rules for private placement life insurance (PPLI) in 2003, this vehicle has steadily grown in popularity.1 Interest in the product has been even more robust lately, as families face higher income tax rates (after the repeal of the Bush tax cuts at the end of 2012) and the new Medicare tax on investment income. Maybe because people are beginning to expect better investment returns, or maybe because the debate at the national level seems to signal yet higher taxes (especially on the wealthy), the demand for PPLI continues unabated.
Much has been written about the many important uses of the product. It can be an excellent vehicle for saving for retirement; funding future liabilities (like estate taxes or tax on the sale of closely held stock); funding a future transaction (like one branch of a family buying out the other branch’s interest in a business); leveraging a gift to future generations; acting as a substitute for the old “drop-off” trusts that non-U.S. individuals used before moving to the United States: facilitating gifts to U.S. beneficiaries from abroad; and freezing (or preventing) the build-up of undistributed net income in a foreign trust with U.S. beneficiaries.2
Not nearly as much has been written on the challenges of successfully proposing the product to a client. The most typical sticking point is cost. Many say that the cost of the insurance is too high. Others say that the cost diminishes the value of the income tax deferral on investment earnings. But, as we’ll describe below in more detail, cost really isn’t a factor. Instead, most objections boil down to a single problem: The client hasn’t evaluated whether he has an insurance need. Most advisors considering any form of PPLI (including frozen cash value (FCV)) should be attuned, first and foremost, to whether there’s an insurance need.
Even when a client needs insurance, the advantage of PPLI (namely, holding a portfolio within the policy and shielding it from income tax) can be diminished by the insurance-related costs, making the PPLI product a difficult one for clients to accept.
Consider a healthy 40-year-old male who wants to put a $5 million single payment into a U.S.-compliant PPLI policy. He could be required to buy $30 million (Modified Endowment Contract (MEC3)) to $40 million (non-MEC) in life insurance to support that investment. With costs of insurance in this type of product ranging from $0.60 to $0.65 per $1,000, that could cost $20,000 to $30,000 per year in mortality charges, increasing over time as the insured gets older. In addition, there are federal and state premium taxes, placement fees (that is, broker compensation), plus insurance company mortality and expense (M&E) charges. All in, the cumulative average annual “drag” (over the first 20 years) on the investment performance of the portfolio supporting the policy could average approximately 37 basis points (0.37 percent). (See “Cost Comparison,” pp. 16-17.)
Compare Tax Costs
While those costs might not be in themselves prohibitive, one shouldn’t evaluate a PPLI product on cost alone. Instead, it’s important to evaluate the cost against the level of tax that the portfolio is expected to attract. And, the level of tax we suggest isn’t simply the tax rate. One should consider the tax rate, the anticipated return of the asset class and the level of turnover to better understand the expected tax cost of a portfolio.
For example, a typical multi-asset class portfolio earning 8 percent over the long run could have an average effective tax rate of about 2 percent per year.4 After mortality and other charges of approximately 0.37 percent per year (20-year average), the benefits of income tax deferral remain material but are much less compelling relative to some of the product’s complexity.
A portfolio attracting a higher rate of tax (for example, ordinary income) but lower expected returns might not justify the product. For example, core taxable bonds might have an average effective tax rate of about 2 percent per year and could be just as easily implemented in a tax-advantaged way (for example, municipal bonds). In contrast, a riskier bond portfolio (like high yield or emerging market bonds) with a higher expected return could have an average effective tax rate of more than 3 percent per year, with no good alternative to minimizing the tax burden, possibly justifying the use of a PPLI product.
Similarly, a portfolio that’s usually not associated with a higher rate of tax (for example, equities when the bulk of the return is capital gains attracting a relatively low rate) could justify the use of a PPLI product when there’s particularly high turnover or high expected returns. For example, a U.S. equity hedge fund with 100 percent turnover could have an average effective tax rate of more than 3 percent per year; compared to the average effective tax rate of 1.5 percent per year on a traditional equity manager with similar expected returns but only 50 percent turnover. Emerging market equities, likewise, could justify use of a PPLI product given the higher expected returns even if the manager had relatively lower turnover.
All of which is to say that the advisor should partner with the client’s investment advisor to be sure that the expected portfolio and its tax costs are a good match for the costs of a PPLI product.
Another reason that some advisors have trouble implementing a PPLI solution for clients is the necessary insurance capacity to hold the proposed portfolio. For example, if our healthy 40-year-old wanted to invest $25 million in a PPLI policy, he could be required to buy as much as $150 to $200 million in life insurance. Aside from the impediments to executing that strategy given the significantly higher annual cost of the insurance, it could prove challenging to find one carrier with sufficient capacity and reinsurance to underwrite the coverage. While multiple carriers could underwrite that level of coverage, it could prove more complex to execute.
Frozen Cash Value
Given the cost and capacity issues challenging the execution of a PPLI solution, a new type of PPLI product has arrived on the scene: the FCV policy. Like domestic PPLI, this product is designed to defer income tax on the investment in the policy and pay out a death benefit plus the underlying portfolio free of income tax. But, unlike the domestic PPLI product, FCV policies are underwritten exclusively by offshore insurance companies. In addition, the policy is designed to require much less mortality; therefore, it has lower insurance costs (and fewer capacity demands). The quid pro quo for this arrangement is that the holder can’t access the earnings and growth in the underlying portfolio. Instead, that will be paid (income tax-free) to the beneficiaries on the death of the insured.
Our healthy 40-year-old who wanted to invest $5 million in an FCV policy would be required to buy as little as $250,000 of life insurance. That will require a one-time payment of $50,000 to fund the necessary mortality costs for 25 years. After 25 years, the insured would be required to provide funding for the additional costs to maintain that level of insurance, which could be quite expensive (the client could pay more than $50,000 up-front and extend the life insurance feature for more than 25 years). Altogether, the average annual cost of the product could be $55,000 to $60,000, or about 0.34 percent per year over 20 years (see “Cost Comparison,” this page).
And, our larger client who wanted to invest $25 million in such a policy might be required to buy only $1.25 million in life insurance with a one-time payment of $250,000 to secure the life insurance feature for 25 years (again, the client could pay more up-front to secure the level of life insurance beyond year 25). Other related insurance charges are very much like domestic PPLI. Again, the all-in cost of the product could average out to about 0.37 percent (or less) per year over 20 years.
“Cost Comparison,” this page, compares illustrative costs of a domestic PPLI and FCV life insurance. As you can see, the average annual all-in “drag” on the portfolio’s performance is slightly better with FCV (an average of 0.34 percent per year in the first 20 years of FCV, versus an average of approximately 0.37 percent or 0.39 percent, respectively, in the first 20 years for domestic PPLI (MEC or non-MEC)). For such a slim difference in cost, the advisor should be on-guard against the argument that FCV is “cheaper” than domestic PPLI. In fact, over a long period of time, they should cost about the same. With larger deposits, an experienced broker should be able to negotiate customized pricing for domestic PPLI, as well as FCV products.
An excellent article in Trusts & Estates has described FCV life insurance in detail and analyzed its legal, tax and regulatory underpinnings.5 Rather than recite that analysis, we recommend it to you for consideration. “Feature Comparison,” in this issue, p. 18, summarizes some of the salient differences between domestic PPLI and FCV life insurance. Those types of insurance are both regulated by Internal Revenue Code Section 7702, which Congress created in the early 1980s. That section defines a life insurance contract based on computational rules and tests currently used by all life insurance companies issuing U.S. products.
Evaluating FCV Insurance
Having dispensed with the argument that FCV is less expensive (because of its smaller required mortality component) and summarized the legal, tax and regulatory issues, we’ll now focus on the questions that a planner should consider when evaluating FCV life insurance for a client.
The first issue is whether the client can truly afford to relinquish access to the earnings and growth on the investment portfolio during his lifetime. Certainly, there are many clients who can. But, this point shouldn’t be taken lightly. It isn’t simply that the access to the earnings and growth is tax-disadvantaged—it’s inaccessible. Making sure your client understands this fact (and that you believe it’s advisable) is crucial.
As described in “Cost Comparison,” the cost savings provided by this limitation is about 0.02 percent per year on a $5 million investment portfolio over 20 years. To put that into perspective, on a $5 million initial value, that amounts to about $2,000 a year. Depending on how confident the client is about not needing access to the portfolio’s earnings and growth, this savings might not be sufficient to justify the limitation.
The analysis on this point should be little different from the analysis of whether to create a dynasty trust. Indeed, many advisors may consider FCV life insurance as a way to enhance a gift to a dynasty trust. In the end, a combination of the client’s total net worth, expected needs for liquidity and psychology will be determinative.
If the advisor is satisfied that domestic PPLI would be a more appropriate option, but the concern is that the insurance charges (as a percentage of the investment portfolio) are too great given its anticipated returns, the client might consider whether the portfolio design isn’t misaligned with the objectives. For example, while there are many excellent insurance-dedicated funds available through most U.S. carriers offering PPLI, it may be that the strategies selected (or the managers being considered) aren’t best suited to achieve a return consistent with the costs of the structure. It seems foolish to change the structure (that is, to use FCV, instead of domestic PPLI) simply because the portfolio design or execution is sub-optimal.
This could be especially true for a family considering using the vehicle for a large (more the $25 million) investment. In that case, the family might consider working with a manager to customize an investment mandate in a bespoke insurance-dedicated fund that will more likely be consistent with the family’s objectives and the design of the structure.
Third, the planner shouldn’t forget that the small difference in cost per year between domestic PPLI and FCV isn’t simply “wasted.” In the example illustrated, the additional cost for domestic PPLI will result in as much as 10 percent more death benefit (including the portfolio) over the long run. “Payout Comparison,” p. 19, compares the total payout for each product. In year 25, the total death benefit of the domestic PPLI is about $1 million more in a non-MEC (about $3 million more in a MEC) than the FCV life insurance. We believe that in evaluating these products, cost really isn’t a factor.
And fourth, in a large case like the one involving our client who wanted to invest $25 million in PPLI, we believe an advisor might consider using both products. Particularly, given the cost parity, the advisor might consider a domestic PPLI product up to the carriers’ capacity supplemented by FCV on the excess.
Finally, a few words directed to fiduciaries. One can’t ignore the fact that a trustee runs a risk when authorizing an investment (especially if it comprises most, if not all, of the trust’s corpus) that doesn’t permit the trustee to access the increase in value of the portfolio for the current beneficiaries during the insured’s lifetime. These issues aren’t insurmountable and aren’t uncommon in many assets that are placed in trust (for example, interests in a closely held business or family limited partnership with no control over distributions and significant limits on liquidity). A fiduciary should engage counsel to ensure that the decision to make such an investment is weighed carefully along with those points raised above.
Little IRS Guidance
As clients continue to seek ways to shield portfolio income and growth from taxation, every planner will be called on to consider any number of options—one of which might be FCV life insurance. The IRS hasn’t given any guidance on whether the provisions on which those who design the product rely; and the precious little guidance there is leaves sufficient doubt about how the IRS might treat such a vehicle. Suffice it to say that there are very smart advisors who believe that the vehicle is permissible and works; and many equally smart advisors who aren’t so sure.
The planner will act prudently only by carefully understanding the clients’ objectives, aligning the vehicle with those objectives, comparing it to other similar options and considering the tax risks.
—Disclaimer: This article is meant to serve as an overview and is for informational purposes only. It doesn’t take into consideration specific circumstances, such as insurance needs, and isn’t intended to be an offer or solicitation, or the basis for any contract to purchase or sell any security, or other instrument, or for Deutsche Bank or Cohn Financial Group, LLC to enter into or arrange any type of transaction as a consequence of any information contained herein.
1. Revenue Rulings 2003-91, 2003-92; Internal Revenue Code Section 817(h).
2. See, e.g., Mike Cohn, “Domestic Private Placement Life Insurance,” Trusts & Estates (August 2010) at p. 27; Amy P. Jetel, “When Foreign Trusts Are Non-Grantor,” Trusts & Estates (April 2008) at p. 44; James R. Cohen and Jeffrey S. Bortnick, “PPLI Invested in Hedge Funds,” Trusts & Estates (May 2006) at p. 52; Charles L. Ratner, “PPLI Primer,” Trusts & Estates (September 2005) at p. 32.
3. A Modified Endowment Contract (MEC) meets the requirements of Internal Revenue Code Section 7702, but fails computational rules referred to as “seven pay testing;” distributions or loans from MECs are subject to income tax on investment gains. There’s a 10 percent penalty tax on distributions or loans from MECs before age 59 1/2. Distributions or loans from non-MECs meet seven pay testing requirements and are generally income tax-free.
4. Assuming that 30 percent of the portfolio return is taxable yield (at a 50 percent rate) and that 70 percent of the portfolio return is capital appreciation with 50 percent turnover (taxable at a 25 percent rate).
5. See, e.g., George R. Nowotny, “Frozen Cash Value Life Insurance,” Trusts & Estates (July 2012) at p. 33.