Introduction
Many individual investors seek the advantages of diversification into hedge funds.[1] The advantages sought (depending on the funds selected) include: hedging market risk; diversification as to asset class; alignment of interest with the portfolio manager; specialized asset class knowledge; leverage; and, ultimately, superior risk-adjusted returns.[2]
However, many investors fail to inquire into the tax characteristics of favored hedge funds. The tax efficiency[3] of a hedge fund is closely related to its level of trading activity and portfolio turnover. There may well be merit in a very actively traded portfolio. Some of the funds of SAC Capital (Steven Cohen) and Tudor Investments (Paul Tudor Jones II) come to mind, for example. But these same funds can generate copious amounts of taxable income.
In the current environment, having taxable income from hedge fund may be considered a “high class problem,” given the many hedge funds that are suffering sharp losses. However, some hedge funds are indeed creating gains in the current environment. Others will no doubt soon return to that position.
Gains in a hedge fund portfolio can be divided into three types. First, there are gains that have not been realized (by the sale of a purchased security, for example). Under our tax system, unrealized gains (as a general principle, with exceptions) are not taxed. Second, there are short-term capital gains. Short-term capital gains, not offset by capital losses, will typically be taxed at the same high marginal rates as “ordinary income,” such as salary. Third, there are long-term capital gains, which apply only to assets held at least one year and a day. Long term capital gains are taxed at a preferred rate. A highly tax efficient fund maximizes deferred gains first, and long-term capital gains, second, while minimizing short-term capital gains; it may also generate or carry forward capital losses (short-term or long-term) that provide offsets allocable to the limited partners.
Suppose you wish to invest in hedge funds but would like to mitigate significant potential tax burden? Are there any solutions? In fact, there are workable approaches to this problem—through insurance vehicles. The first is “private placement life insurance.” The second is “private placement deferred variable annuities.” [4] Both vehicles offer the additional benefit that they do not lead, as investment partnerships do, to receipt of Form K-1 (stating allocable share of partnership income), which would in turn require an individual to file a Form 1065 (Partnership) tax return.
Private Placement Life Insurance
Private placement life insurance is a form of variable universal life insurance. This means that it is permanent life insurance (the policy illustration generally runs to age 100, or beyond), that it is “universal” in having flexibility as to contributions and withdrawals, and that it is “variable” in having the investor elect investment options whose minimum rate of return is not guaranteed. See Overview of Personal Insurance. In private placement life insurance, the investment options can (and generally do) include hedge funds. More specifically, the menu of investment options made available to such accredited investors may include hedge fund surrogates, usually in the form of insurance sub-accounts run in parallel to a hedge fund, and replicating or at least simulating its trades.[5] See Alfred Winslow Jones and the Idea of a Hedge Fund--Greenwich Alternative Advisors.
Private placement life insurance offers the three main tax advantages offered by all permanent life insurance. First, the death benefit on a life insurance policy, received by the named beneficiaries, is not subject to income tax. Second, accretions of gain in the investment account of a life insurance policy are not taxed. Third, there is the opportunity under most life insurance contracts to borrow against ones prior principal contributions at a low interest rate without creating taxable income.
It is also true that the death benefit on a life insurance policy for an insured person, owned by a properly structured irrevocable life insurance trust, will be outside the estate of the insured person, and therefore not subject to the probate process or the federal estate tax; this is true of any asset so owned. A life insurance policy, including private placement life insurance, may thus become part of a broader plan for transmitting wealth to a younger generation. Part of your consultation with specialized trusts and estate counsel in this regard would be structuring things to mitigate the impact of gift tax.
With private placement life insurance, the insurance agent accepts a much different commission setup from conventional life insurance. Instead of receiving most commission upfront (called “target commission”), the agent generally a much smaller percentage distributed as a level commission paid steadily over the years the policies is in force and remains agent of record. Consequently, private placement life insurance will usually show surrender values immediately upon being put in force (assuming adequate funding to create cash value in the policy). Of course, the overall burden of commissions and administrative expenses, and the cost of insurance itself, must still be assessed. Any commissions and administrative costs chargeable to the life insurance policy must be fully disclosed in the official illustration created by the carrier.
Permanent life insurance (whether private or conventional) offers various options, called “riders.” These must be registered with the states where the policy is being offered. The riders are usually included at the end of the policy description. Most carry an annual cost, so a tradeoff must be considered versus the potential advantage offered. Universal life policies generally offer a “guarantee” option, which locks in a fixed cost of insurance (COI) against possible future increases in mortality experience; this option often costs an additional 1/2 % per year or so in premium costs. As overall mortality experience (and hence, COI) is going down, not up, this option is of questionable value versus its cost. An option that is worth considering, with current longevity trends, allows extension of the policy beyond age 100 (sometimes without paying any additional premiums from that point onward). Another rider offers cash benefits for disability; this option is usually not priced competitively with the best pure disability policies.
As the owner of a life insurance policy depends on the paying ability of the insurance carrier in the future, life insurance policies should only be purchased from carriers with sound finances and a strong investment grade rating on long-term debt. See Analyzing the Credit Quality of Life Insurance Companies. With PPLI, the credit quality issue pertains to death benefit not covered by cash value in the (segregated) insurance sub-accounts. In the current credit crunch underway, this issue has been highlighted. Carrier credit quality is a point you should discuss carefully with your insurance agent or investment advisor.
Not everyone can take advantage of private placement life insurance. First, not everyone is an accredited investor. Second, it is not a suitable risk for all individuals. Third, not everyone is insurable, either because of poor health or advanced age (usually, over 90 years old). Fourth, not everyone has excess insurance capacity.[6] Fortunately, there is an alternative, private placement deferred variable annuities, for which there are no capacity limits.
Private Placement Variable Annuities
A private placement variable annuity is, as is indicated by its name, a variable annuity available exclusively to accredited investors through private placement. An annuity offers a potential stream of distributions in the future in exchange for an upfront payment by the investor. As with private placement life insurance, the menu of investment options made available to such accredited investors may include hedge fund surrogates, usually in the form of insurance sub-accounts run in parallel to a hedge fund, as with private placement life insurance.
Annuities include various options that need to be understood. With “variable” annuities, the investor chooses from a list of investment options, whose performance will vary; with “fixed” annuities, the carrier guarantees a rate of return. The kind of annuity that offers deferral of income is called a “deferred annuity”; those that that begin payout right away are called “immediate annuities.”
A similarity between private placement life insurance and private placement variable annuities is that commissions are generally not weighted upfront, but rather spread out evenly over the years. For example, conventional variable annuities may include upfront sales charges of up to 8% or so, and these commissions create a surrender charge issue in the early years of such an annuity. Any commissions and administrative costs chargeable to the annuity must be fully disclosed in the official illustration created by the carrier.
Deferred annuities (properly structured) lead to deferral of taxation. Eventually, though, the piper must be paid, and any future distributions are subject to tax at the full marginal rate for ordinary income. Note, however, that future distributions (when the instrument is ultimately “annuitized” or cashed out) are treated as ordinary income under federal and state law.
The deferral of tax is nevertheless an important advantage, and the longer the deferral, the greater the potential advantage. First, deferral allows the accumulation of wealth in the insurance account without taxation, thereby augmenting its potential growth and end value. Second, some investors may anticipate being in a lower tax bracket in the future (for example, upon retirement) than now, thus providing a double advantage. (Of course, no investor can know what federal marginal rates may prevail on income at that time, as those rates are subject to the will of Congress and the vicissitudes of the federal budget process; a similar stipulation applies to state and local income taxes, where these are imposed.)
The purchase of a private placement deferred variable annuity does not entail health examination, medical tests, or disclosure of ones medical records. Thus, for some investors, there is a significant privacy advantage versus the purchase of life insurance. Another reason some accredited investors buy private placement variable annuities is that sizable purchase of life insurance is not an option. This may be because of lack of insurability (owing to health problems or advanced age) or because one has maxed out on insurance capacity in relation to ones net worth.
Conclusion
An accredited investor may find some hedge funds attractive on a pre-tax basis but of equivocal benefit post-tax. This is particularly true of many hedge funds that engage in active trading. Such hedge funds can generate sizable percentages of short-term capital gains, and these are taxable to the limited partners at each partner’s marginal rate for ordinary income.
Two insurance vehicles offer a way to obtain the benefits of some actively traded hedge funds, while mitigating income tax burden: private placement life insurance and private placement deferred variable annuities. In the case of both vehicles, investment options often include insurance sub-accounts run in parallel to those of private hedge funds.
Private placement life insurance offers a more comprehensive tax mitigation scheme. Indeed, the death benefit of a life insurance policy, paid to the original beneficiaries, is generally not subject to any income tax. Further, the accretion of cash value in a life insurance policy, during the lifetime of the insured, is also not subject to income tax. Finally, one may generally borrow against the cash value of a life insurance policy at a preferred rate, and borrowings up to the amount of prior contributions are not includable in “income” for income tax reporting purposes.
Private placement deferred va riable annuities offer a deferral of income tax. Ultimately, though, the piper must be paid, and proceeds of future distributions will be taxable as ordinary income. However, the deferral of income tax burden can be very valuable; the longer the deferral, the greater the potential benefit. Private placement annuities can also be an attractive alternative for those high bracket U.S. taxpayers who do not wish to purchase, or cannot purchase, private placement life insurance.
The purchase of either private placement life insurance or private placement variable deferred annuities requires due diligence as to suitability, cost, availability, and ultimate economic advantage on a post-tax basis. There is also important investigation needed regarding the claims paying ability of the chosen carrier(s). The author would be glad to review such issues with investors and their advisors.
[1] Hedge funds distributed by private placement can only be invested in by individuals who are “accredited investors.” The same is true of private placement life insurance and private placement annuities. See Accredited Investors--SEC Definition. An accredited individual investor must have a net worth of at least $1 million or recurring annual income of at least $200,000 ($300,000 if married and filing jointly).
[2] As a preamble, we wish to state that investment in financial markets—including investment of the sort discussed in this article--involves risk and returns cannot be guaranteed.
[3] This article does not present expert tax advice and is not written by a tax expert. For tax advice properly customized to your particular situation, please consult your accountant or tax attorney.
[4] Private placement life insurance and private placement variable annuities are considered “securities” under federal and state securities laws; they can be offered only by properly licensed agents of licensed broker-dealers. The licensing status or registered representatives and broker-dealers can be checked at the following Website: http://www.finra.org/.
[5] Where a sub-account does not accurately parallel the performance of a corresponding hedge fund, there may be “tracking” error, which can be either favorable or unfavorable depending upon circumstances.
[6] No one, no matter how rich, is eligible to purchase infinite life insurance coverage. As a rule of thumb in the insurance business, “insurable capacity” equals approximately 80% of ones net worth, minus life insurance already in force, plus an amount equal to five times ones recurring non-investment income (such as income from salary or social security benefits). One is economically eligible to take out additional life insurance equal to insurable capacity. Of course, some individuals are not insurable for health reasons, even though they may have “capacity” in this economic sense. As a practical matter, individuals have difficulty assembling more than about $100 million to $150 million in life insurance coverage, even when a “syndicate” of carriers is arranged to spread the liability. The life insurance carriers do not want to risk breaking the bank through coverage of a single life.
Copyright © 2008; all rights reserved. The author, Andrew Szabo CFA, is Managing Director of Greenwich Financial Management Inc., a registered investment advisor. Questions, contact Szabo@GreenwichFinancial.com or call 917-796-8500.
