PPLI: Tax-Efficient Investing for UHNW Clients

Summary:

In a rising interest rate and high tax-rate environment, current investment and estate planning strategies are no longer sufficient to meet client needs.

Private placement life insurance (PPLI) allows RIAs, CPAs, portfolio managers, estate attorneys, and trust officials the ability to create investment and estate strategies that minimize tax drag and offer better risk-adjusted portfolio solutions for their Ultra-High Net Worth (UHNW) clients.

Using private placement life insurance allows UHNW clients and their advisors the ability to essentially create a “Super Roth” retirement and estate investment strategy that allows for a more optimal risk-adjusted and tax-efficient portfolio solution that protects clients from current and future tax increases.

For RIAs and portfolio managers, PPLI allows these advisors to charge their fee from within the vehicle instead of from an after-tax account. This helps minimize the drag of the advisor’s fee on returns. In this article we will take a look at why bond allocations in a rising interest rate and high tax rate environment are not sufficient to create optimal risk-adjusted portfolio solutions and how PPLI can be utilized to create both portfolio alpha and “tax alpha”.

In a low-yield environment the 60/40 portfolio no-longer works

Current modern portfolio theory rests on the idea that a portfolio can be constructed that maximizes the return of a portfolio for a given amount of risk. The basic idea is that creating a portfolio of two or more asset classes that are ideally negatively correlated can help to optimize the return of the entire portfolio for a given amount of risk.

This is where the idea of the 60% stock portfolio and 40% bond portfolio originated. Researchers found that this was the optimal portfolio to optimize the return of a portfolio for a given amount of risk. However, this efficient frontier model has two key flaws:

1. The higher bond yields are, the better diversification and volatility reduction bonds are able to provide to a portfolio. In a low-yield environment these benefits are minimal.
2. The efficient frontier model doesn’t account for taxation and the fact that investing in stocks have built-in tax-deferral and are taxed at lower long-term capital gains rates while most bond gains are taxed yearly at higher ordinary income tax rates.

In a normal bond yield environment the 60% equity and 40% bond portfolio can optimize the portfolio’s return relative to the underlying risk. However, in a low-yield environment this is not the optimal allocation due to the low yields and higher taxation of bonds. In fact, in a low bond yield environment investors can increase the equity allocation of a portfolio to 100% in order to increase the return of the portfolio without significantly hurting the return-to-risk ratio.

Why do low bond-yields and high taxes make bond allocations difficult?

It’s not difficult to understand how low bond yields and the higher taxation of bonds make allocating to bonds not worthwhile for investors in this current environment—particularly in states like California with high state income taxes. But a quick numerical example can help illustrate the impact.

After-tax returns of Stock and Bond Investments

For an RIA that’s looking to allocate clients to a bond portfolio, such an allocation can actually create negative net returns for the client after taxes, RIA fees, and inflation are taken into account.

Real returns of Stock and Bond Investments after taxes, fees, and inflation

Rising interest rates further reduce the value of bond investing

Inflation over the past few months has been rapidly increasing. In order to combat this the Fed has indicated that they plan to raise interest rates as many as three times in 2022.

For clients that currently are heavily invested in bonds, an increase in interest rates poses heavy losses for these investments that may take years or decades to recover from.

Effect on bond prices of raising interest rates by 1%

Democratic and fiscally conservative agendas point to increasing taxes on the wealthy

In addition to rising interest rates, which make low-yielding bonds even less appealing, it appears that both Democratic and Republican parties will have their own reasons for increasing income and/or estate taxes on the wealthy. High taxes on bond gains further reduce the viability of fixed income for wealthy clients in creating diversified portfolio solutions. Democratic and fiscally conservative agendas point to increasing taxes on the wealthy.

On the left, Democrats have increasingly pointed out income inequality and the gap in wealth between the richest Americans and the middle class in their talking points and have increasingly aimed to cut loopholes that previously allowed the wealthy to reduce or eliminate their taxes.

The original Biden tax-proposal included a number of elements aimed at increasing taxes on the wealthy:

• Removal of grantor trust benefits for estate planning (GRATs, IDGTs, etc)
• Limitation of step-up in basis provision
• Increase payroll taxes on individuals with >$400k/year in income
• Increase capital gains tax-rate on individuals making $1M+/year
• Phase out QBI deduction for filers earning $400k+
• Reduce estate exemption limit to from $24.2M to $12M immediately (instead of in 2026)
• Increase estate tax rate from 40% to 45%
• Limitation on 1031 exchanges to $1M
• Elimination of Backdoor Roth IRA

While none of these elements were ultimately passed, the Democratic agenda was clear: Increasing taxes on the wealthy is a key priority that they are unlikely to walk away from in the near future.

Although increasing taxes on the wealthy is a current refrain of the democratic party, rising debt to GDP levels in the wake of large COVID spending bills point to a need for higher taxes (as well as reduced spending) from a purely fiscally conservative position as well. Given that raising marginal tax-rates is anathema to the right due its perceived effects on private investment into the economy, it’s more likely that the right will agree to reduce estate tax exemptions in order to compromise with the left. Given that estate tax exemptions are set to sunset in 2026 anyways, it’s unlikely that future generations will be able to transfer as much generational wealth tax-free as they have in recent years due to increasing pressure to address both federal debt levels as well as wealth inequality in the U.S.

How do advisors add value to UHNW clients in a rising interest rate and rising tax environment?

While low-yields and rising interest and taxes on the wealthy pose a notable problem for the wealthy individuals, they also provide an opportunity for advisors to these clients to create niche solutions for these issues that other advisors aren’t creating.

If you’re an advisor to HNW or UHNW clients, there are two key ways to address these issues:

1) Improving portfolio diversification by decreasing allocation to bonds and increasing allocation to uncorrelated alternative investment strategies with higher risk-adjusted returns

As we discussed earlier, low-yielding bonds no longer provide the same diversification benefits to equity risk that they did in a higher interest rate environment. In fact, in a rising interest rate environment bonds can pose more risk than benefit.

In order to provide better diversification and higher risk-adjusted returns, portfolio strategies need to look at other strategies that have lower/negative correlation to market risk in the equity markets and/or higher risk-adjusted returns in comparison to bonds.

For example, alternative strategies like life settlements, reinsurance, volatility strategies, etc can help offset equity risk in the portfolio while also helping the portfolio provide higher risk-adjusted returns.

2) Improving overall “tax alpha” of the portfolio by making the portfolio more tax-efficient (income and estate)

In a high tax-rate environment the ability to create solutions that protect clients’ investment strategies from both current and future tax laws can provide immense value and allow advisors to craft their own niche amongst the ultra wealthy.

Private placement life insurance (PPLI) is a vehicle that helps advisors to UHNW clients address both of these issues by creating better risk-adjusted portfolio solutions in which the gains are free from both income and estate taxes.

What is Private Placement Life Insurance?

Private placement variable universal life (PPVUL) insurance, also known as just private placement life insurance (PPLI), is a customized version of variable universal life insurance (VUL) that allows policyowners and their financial advisors a significantly reduced expense structure and more flexibility in how the underlying investment strategy is chosen and who it is managed by. This allows clients to chose their own RIAs to manage their investment strategy and have all the principal and gains be tax-free and outside of the client’s estate.

Essentially the PPLI vehicle serves as a “Super Roth” retirement strategy by which to invest millions of dollars of assets that will be both tax-free and outside of the client’s estate. Investment managers can then invest this money at their discretion. Ideally the best strategy for these assets are ones that would be income tax-inefficient or estate tax-inefficient if invested in outside the PPLI policy.

Making Investing in Tax-Inefficient Assets Tax-Free through PPLI

Income tax-inefficient strategies are taxed at high ordinary income or short-term capital gains rates and often lack the ability of tax-deferral. Some income tax-inefficient strategies are high yield debt strategies, long/short strategies, high portfolio turnover strategies, volatility strategies, hedge fund strategies, and life settlements. Also equity strategies can be tax-inefficient for clients living in states that charge high state income taxes on capital gains (California, Hawaii, New Jersey, Oregon, etc.).

Estate tax-inefficient strategies are assets that are expected to experience rapid growth in the future and could subject the client to an estate problem (especially with the future reduced exemption limits). These strategies include venture capital strategies, individual stock strategies, and art investing.

Why is PPLI a more tax-efficient estate planning vehicle than grantor trust strategies (GRATs, IDGTs)?

Grantor trust strategies like grantor annuity trusts (GRATs) or Intentionally Defective Grantor Trusts (IDGTs) are popular estate planning tools as they allow clients the ability to move assets outside of their estate and have them grow free from the estate tax. However, the downside with this approach is that even though all the investment growth is outside of the estate, the realized taxable gains are fully taxable to the grantor. Furthermore, assets in grantor trusts don’t qualify for step-up in basis. So when the grantor does die, any unrealized gains on the assets in the grantor trusts creates a large tax-liability for the beneficiaries. In order to counter this, clients using IDGTs must utilize swap powers to swap out the low basis assets in the IDGT with high basis assets outside of the IDGT. The downside with these swap powers is that if the client waits too long to use the swap powers and the client dies beforehand, then all the grantor trust assets are fully taxable. Also, in order to use the swap powers the client has to have an equal amount of assets outside the IDGT as they do inside the IDGT. For those that have gifted the majority of their wealth to the IDGT in the first place, this might not be a realistic possibility.

A PPLI vehicle, on the other hand, allows all the investment gains to be outside of the estate and tax-free for both the client and the client’s beneficiaries without worrying about swap power issues. Furthermore, even if step-up in basis is repealed in the future—like the Democratic proposal attempted to repeal in 2022—this will not affect the assets in the PPLI vehicle. So using PPLI in combination or in place of grantor trust strategies like GRATs or IDGTs creates a more comprehensive investment and estate planning solution for RIAs, estate attorneys, and their clients.

Liquidity: How is PPLI similar to a Roth IRA?

Similar to a Roth IRA, UHNW clients can use the PPLI vehicle to accumulate tax-free growth for retirement or to pass on wealth tax-free to their beneficiaries—or a combination of both.

If the client wishes to fully exit the vehicle instead of taking a tax-free loan, they are free to do so at any time. Similar to a Roth IRA, they can take out their principal with no taxes or penalties or surrender charges. While there are no surrender charges on the gains either, there are insurance expenses and ordinary income taxes owed on the gains. These insurance expenses are high in the early years as a percentage of the assets in the vehicle but low in the later years. If the client exits early, these insurance expenses will eat up a good portion of the game that they could have readily accessed in the later years without loss.

For those looking to exit early, the PPLI vehicle allows clients the ability to take out up to 90% of the principal and gains tax-free. Therefore, it’s better to use the tax-free loan option to take out 90% of the total principal and gains tax-free than to just exit early and have the gains be subject to ordinary income taxation. In order to gain the most benefit from the tax-free PPLI vehicle clients should aim to keep the assets in the vehicle for at least 10 years before removing the assets via liquidation or a tax-free loan.

Why is PPLI better than a traditional VUL product?

PPLI (also known as PPVUL) is just a customized version of traditional VUL product offered at most large life insurance carriers. However, PPLI has significant advantages over traditional VUL products for two key reasons: significantly lower expenses and a larger spectrum of tax-inefficient strategies to invest in.

The PPLI market is able to offer significantly lower expenses due to the fact that it benefits from economies of scale and that it eschews large upfront commissions in place of a small trail commission for the life of the policy. Wealthier clients invest significantly more in assets into a PPLI policy than they do into a traditional VUL policy. This means that the product has more built-in economies of scale available to it and the insurance company can have a smaller expense ratio on a larger base of assets and be just as profitable as the traditional VUL policy which charges a larger expense ratio on a smaller base of assets.

Another reason why PPLI products have lower expense ratios is that PPLI products replace the large upfront commission (which is often 80%-100% of the first year premium) with a small trail commission. Changing this commission structure means that actuaries don’t have to build in large expense and surrender charges within the policy to recover the large upfront commission which results in a PPLI product with significantly less drag on returns than traditional VUL products. Also, wealthier individuals tend to have better access to healthcare, which means that insureds in PPLI products are typically living longer than the general insurance population and have lower expected mortality costs for the insurance carrier providing the coverage.

Another huge advantage of PPLI over traditional VUL products is the investment flexibility and availability of investment options. Most investment options available within a traditional VUL product are equity investments which are already tax-efficient and qualify for step-up in basis—so the need to put these assets into a tax-protected vehicle is limited unless the client lives in a state with high state income taxes. PPLI on the other hand allows clients to work with their own investment advisors to craft a strategy that is specific to them that would maximize the tax-benefit to the client. This includes a variety of alternative asset investments that would otherwise be tax-inefficient if invested outside the PPLI vehicle.

Comparison of illustrative expenses in a VUL vs PPLI policy

PPLI Costs vs Income Tax and Estate Tax Rates

Who are the best clients for a PPLI solution?

PPLI is a solution that is only available to clients who are qualified purchasers ($5M or more in investments) who are willing to commit at least a total of $1M to $2M to the vehicle over 4 years. Clients who are qualified purchasers should also have one or more the following attributes:

1) Have an estate tax issue now or in the future

One of the main benefits of PPLI is to protect clients who either currently have an estate tax issue or may have one in the future if estate tax limits change.

2) Want greater access to tax-efficient alternative assets

In the wake of low bond yields and rising interest rates, alternative assets can provide greater portfolio alpha. However, alternative strategies are often not tax-efficient. The PPLI vehicle allows clients who want greater access to these solutions to invest in them in a tax-efficient manner.

3) Live in a tax-inefficient state

Traditionally equity strategies have been taxed at lower long-term capital gains. However, some states charge high state income taxes on these long-term capital gains. For clients in living in such states, it can be valuable to use the PPLI investment to manage equity strategies that are tax-inefficient.

4) Between the ages of 40-65 in order to maximize investment growth and minimize insurance costs

Like any investment plan, clients need to dump in as much as possible for as long as possible and to minimize investment expenses in order to maximize investment growth. However, life insurance policies limit the ability for clients to dump-in large amounts of money based on the insured’s age. If the client is too young, then they are limited in their ability to contribute to the vehicle to begin with. However, if the insured is too old when they acquire the policy the high insurance expenses associated with the age of the insured can eat up a lot of the tax-benefits of the policy—especially if the investment strategy has poor returns at the same time.

What are the risks associated with investing through a PPLI vehicle?

While PPLI can provide greater tax-advantaged portfolio and estate solutions, it comes in exchange for having to manage additional risk—namely insurance risk. As such, there are a couple of key areas that clients need to be aware of before committing to the vehicle:

1) Liquidity and Investment Horizon:

Clients and their advisors need to treat the PPLI investment vehicle the same way they would for a Roth IRA and understand that just like a Roth IRA, this is a long-term investment vehicle. While a Roth IRA and a PPLI vehicle both allow clients to take out their principal at any time without a penalty, taking out gains early results in charges being assessed on the gains. With a Roth IRA clients will pay a 10% penalty and then have to pay ordinary income taxes on the gain. With a PPLI vehicle, clients will have insurance expenses deducted from their gains and then have to pay ordinary income taxes on the remainder of the gains. The amount of insurance expenses will depend on how early the client exits the investment. The earlier they liquidate, the larger the insurance expense deduction is. Typically the break-even point here is between 7-10 years. In other words, if the client exits a PPLI investment before 7-10 years, then they would have been better off having invested directly in the underlying assets via a taxable account then through the PPLI structure. Also, as we discussed before, instead of liquidating the investment completely and having to endure these deductions, clients can typically take up to 90% of the principal and gains out via a tax-free loan. This is a much better alternative than liquidating 100% of the investment.

2) Insurance risk:

Most retirement plans come only with contribution and investment risk. In other words, if the client doesn’t contribute enough to the retirement account then there won’t be enough investment growth over time to provide them with the retirement income they need. However, with insurance policies this risk is exponentially magnified. If clients stop contributing to their PPLI vehicle then insurance expenses will eat up the investment gains. Conversely, if clients properly fund the vehicle then the insurance expenses will eat up only a small portion of the gains. This is why the goal of the policy is not to maximize the death benefit, but to minimize the death benefit and maximize the contributions to the vehicle. For those interested in more information, I’ve previously written about the importance of minimizing the insurance charges in order to maximize the CSV IRR and the reasons behind this.

Failure to properly contribute to a life insurance policy is one of the main reasons why life insurance policies underperform policy owner expectations. This underperformance is often entirely blamed on the insurance policy when in reality a large amount of the blame belongs on the policy owner and his or her advisors for failing to understand and actively manage the risks. These same risks also need to be managed when the underlying investment strategy underperforms and exposes the policy to more insurance risk. The policyowner and the advisors need to be proactive about reducing the death benefit, utilizing loan provisions, and taking less investment risk as the client ages and the cost of insurance charges increase.

3) State issuance/premium load risk:

An often neglected area in the set-up of both regular and PPLI life insurance policies is choosing the right state from which to have the policy issued in. Different states assess different premium load expenses on the premiums being paid into the policy. These premium load expenses can be as low as 0.08% of the premium paid into the policy to as high as 3.5% of all premiums being paid into the policy.  South Dakota currently has some of the lowest premium state taxes with a 2.5% premium load up to $100,000 in a given year and only 0.08% above that. This means that clients are better off dumping large amounts of premium into a policy in one year as opposed to spreading it out evenly over a number of years.

Note that insureds do not need to live in South Dakota in order to have a policy issued in South Dakota. The trust or LLC that owns the policy needs to be located in South Dakota.

4) Onshore/offshore life insurance carriers

There are two types of life insurance carriers that offer PPLI: carriers that are based outside of the United States (offshore carriers) and carriers that are based in the United States (onshore carriers). Onshore and offshore companies have different pros and cons.

Onshore companies typically have lower cost of insurance charges, M&E charges, and better loan provisions, but have less flexibility when it comes to investment strategies. Offshore companies on the other hand, are more open to allowing more niche and alternative investment strategies, but have higher cost of insurance and M&E charges and less attractive loan provisions. Some offshore companies can also skirt the intent of the law—even if they abide by the letter of the law—by allowing discounted valuation practices on in-kind securities. While this is currently allowed in grantor trust strategies, utilizing these strategies in PPLI may be contested by the IRS. As such, whenever considering utilizing offshore life insurance companies for complex estate planning strategies like this, it’s important to work with an established estate attorney who can offer a statement of opinion or get a definitive private letter ruling from the IRS.

Conclusion: Improving portfolio diversification and after-tax returns for UHNW clients through PPLI

In the wake of low bond yields and rising interest and tax rates, using PPLI as an investment and estate planning vehicle allows RIAs, CPAs, and estate attorneys who provide services to UHNW clients to provide more holistic tax-efficient portfolio and estate planning solutions to their clients—which ultimately will help both retain and attract more UHNW clients.

Wealth managers using PPLI for their UHNW clients will be able to create better risk-adjusted and diversified portfolio solutions for their clients—all while charging their fee on a pre-tax basis instead of the more expensive after-tax basis.

Estate attorneys that choose to use PPLI in combination or in place of their existing Grantor Annuity Trust (GRAT) or Intentionally Defective Grantor Trust (IDGT) strategies will able to create more tax-efficient investment and estate strategies for their clients. Portfolio managers that manage tax-inefficient alternative asset strategies will be able to make their investment strategies more attractive to potential investors by encouraging them to invest in their strategy through the PPLI vehicle.

Improving after-tax, after-advisory fee returns by charging RIA fee on a pre-tax basis

Further Reading: Using Life Insurance for HNW Clients

While PPLI is only available for qualified clients, traditional life insurance structures can be used for HNW clients who are not qualified purchasers to address the same fixed income issues in a rising interest rate and rising tax environment. For more information on how life insurance solutions can improve after-tax, after-advisory fee solutions for the fixed income portion of a client’s portfolio, feel free to read the articles below.