At Life Insurance Strategies Group, we are increasingly consulting with family office representatives, trust and estate attorneys and major wealth management firms who want to learn more about PPLI and to see if they are missing out on an opportunity. Since we do not sell products, these groups have come to appreciate our candor and unbiased advice on this often-confusing investment strategy.
PPLI is the use of a life insurance chassis to overlay or wrap highly tax-inefficient investments in order to recharacterize those investments as part of a cash value life insurance policy. The result is that the investments receive the more desirable tax treatment of life insurance – income tax-free growth, the ability to obtain income tax-free loans and, if held until death, the ability to pass the investments along to heirs along with additional policy death proceeds income tax-free.
This sounds especially appealing to advisors to high net worth individuals and families who often have significant allocations in highly taxed investments such as hedge funds, private equity and other alternative assets. PPLI may be even more attractive if, on top of the tax savings, there is also a need for life insurance for traditional estate and wealth planning. Hearing all of this, our clients are usually ready to ask us to refer a life insurance producer to move forward.
Not so fast! This was one side of the story – what PPLI can do if applied properly. How about the client? Can the client meet a number of narrow qualifications to be a fit for PPLI and to be able to obtain all of the tax benefits?
The size of the transaction is the first criteria to consider. While those participating in PPLI must be a qualified purchaser and/or (depending upon the insurance company) an accredited investor, a client should be able to commit no less than a total of $10 million over four years or less. While the institutional-like fees charged for private placement are small, they are the largest at smaller sums in order to make the transaction even marginally worthwhile to the insurer and the producer.
It becomes a simple math problem: the client is in good shape if all the policy costs are less than the tax savings. At a low investment amount, combined with fixed policy set-up costs and regular premium and asset charges, the math may not work. Although there are some carriers who will accept premiums sums under $10 million, they typically do not allow much in the way of customization of the investment choices, choice of an investment manager or choice of a custodian.
More problematic can be a client’s time horizon for being committed to the PPLI policy. In the first seven to ten or more years, the U.S. Treasury Department requires a high amount of death benefit be included in order to classify the structure as life insurance and not as an investment. After this period, which depends upon a client’s initial age, sex and health, most of the death benefit can be removed, allowing more efficient cash value growth. This means that a client will need to hold a policy for many years beyond when there were high life insurance costs charged in order to off-set those years with extremely low cost years – perhaps twenty or more. If a client cannot commit to holding the PPLI policy for the time needed to reap the benefits, the policy may end up being more expensive than just holding the investments directly and paying the taxes.
A third consideration is the client’s acceptance of the types of investments which can be held under a PPLI policy. A PPLI policy can hold either insurance dedicated funds (“IDFs”) or independently managed separate accounts (“SMAs”). IDFs are typically insurance versions of popular hedge funds or similar alternative investments and are only open for direct investment by insurance carriers, including through private placement life insurance and annuity contracts.
SMAs under a PPLI policy can be identical to a managed account held outside of a policy and are growing in popularity with clients who wish to recreate an already successful strategy inside of a life insurance policy. SMAs permit direct investment into a broad variety of asset classes, from funds to LP interest in private equity to LLC interest and even investment into third-party promissory notes.
Finally, a client should be aware of the Treasury’s Investor Control Doctrine and its prohibition against investment control. Violations of either could lead to the structure being deemed not to be life insurance, resulting in cumulative taxation, including interest and penalties. In preventing an investor control misstep, a client should not make specific decisions about the investments held under a PPLI. In addition to selecting specific investments within an IDF or SMA, this means a client may not include assets they control and enjoy such as GP interest in private equity, interest in a family business, personal real estate, artwork and classic cars.
When it comes to what is required for diversification, the investment positions within an IDF must meet the Diversification Test as outlined in Treasury Regulations Section 1.817-5. Unlike with a SMA, which is treated as a single separate account, the Treasury Regulations provide a “look-through rule” that allow an IDF to be ‘seen through’ to its underlying investments for purposes of satisfying the Diversification Rules. Diversification under the Test is met provided that no more than 55% of the value of the total assets of the account is represented by any one investment with increasing thresholds for additional investments: no more than 70% of the value for two investments; no more than 80% of the value for three investments; and, no more than 90% of the value for four investments.
If a client’s investment needs can be addressed through an IDF and/or a SMA and the client is able to accept a ‘hands off’ approach to managing the investments under a PPLI policy, they have leapt through the major hurdles which are the cause for many clients not moving forward.
When considering a retail life insurance policy, a client’s insurability is typically a top concern. This is not always the case with a PPLI policy where the death benefit is incidental to the cash value performance aspect of the policy. If the primary client’s health leads to underwriting challenges, writing the policy on the life of another family member is usually acceptable. Care should be taken that the policy is always owned in a manner to keep any death proceeds out of an estate should an unexpected death occur and a large death benefit is paid.
Is a PPLI policy the right answer? If, after being down a path which keeps narrowing as the rules and restrictions of PPLI are explained, a client can still realize impactful tax savings, the answer may be “yes”. If our team at Life Insurance Strategies Group can be of assistance in hearing your specific situation and walking you through the path of PPLI suitability, visit us at www.lifeinsurancestrategiesgroup.com.
Read our companion Tier One Interview with Michelle Dauphinais by clicking here.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.