Private Placement Variable Annuities
By Jerry W. Hester, II CLU® - Founder/Principal of Hester Insurance Group LLC
The ability to recharacterize highly tax-inefficient investments as life insurance or an annuity is increasingly popular with savvy investors. If these investments are intended to be held long-term, ten years or more, or, potentially, for life, making the investment within life insurance or an annuity structure can produce incredible tax savings and bolster wealth transfer. This article focuses on the Private Placement Variable Annuity (PPVA) and its unique aspects.
Not your Traditional Annuity
A private placement variable annuity (“PPVA”) has some similarities to a traditional variable annuity contract that someone can purchase from a brand name life insurance company. Some parallels include tax deferral of investment gains, flexible premiums and the ability to take distributions. In addition, after the annuitant’s age 59 ½, distributions of investment gains from traditional variable annuities and PPVA’s are both taxed at ordinary income tax rates. (NOTE: distributions made prior to age 59 ½ incur an additional 10% excise tax along with ordinary income tax). But looking closer, this is where the similarities end and the distinctions for what is truly a ‘private placement’ annuity emerge. A PPVA policy is an unregistered securities product, not subject to the same regulatory requirements as registered variable products and only available to clients who are accredited investors and/or qualified purchasers.
Where someone purchasing a retail variable contract is generally concerned with a retirement strategy or principal protection, purchasers of PPVA are most interested in being able to choose customized investments within the policy. PPVA accounts do not have income or protection guarantee features, therefore the fees are substantially lower. Additionally, there are typically NO surrender charges with the PPVA account.
What’s the Value of Tax Deferred Growth?
PPVA contracts are institutionally priced, transparent and extremely flexible in design. The transparency of policy costs permit a potential client to evaluate if the Private Placement Variable Annuity’s annual fees are outweighed by tax savings the policy offers. It is also important to assess the impact of ordinary income taxation on distributions. This means someone considering the purchase of a Private Placement Variable Annuity should have a long-term investment horizon of at least 10 or more years.
Investments Grow Tax-Deferred
No Limits on Amount of Contributions
Eliminate K-1s, No Surrender Charges and Low Annual Fees
Investments Pass Tax-Free to Tax-Exempt Entity or Family Foundation
Enhanced Creditor Protection
A major concern for high net worth individuals and families are how to protect their assets from current and potential creditors. There are a number of different strategies that are being used including offshore trusts, LLCs and Asset Protection Trusts. However, an often overlooked and undervalued benefit of annuities and cash value life insurance is the potential for asset protection. Depending on your state jurisdiction, annuities and life insurance could have significant creditor and asset protection, giving some investors a superior cost-efficient solution compared to the fees and time-consuming administration of a LLC or offshore trust.
Charitable Giving Strategy
A common use of Private Placement Variable Annuities are for investors that have earmarked assets to be left to a public charity or private foundation at their death. If a charitable organization is the named beneficiary at the time of death, all the deferred investment gains are distributed tax-free to the charity. Some other popular charitable strategies may require irrevocable gifting. However, a PPVA account remains under the control and ownership of the policyholder and surviving spouse during their lifetime. This gives enormous flexibility to a policyholder and their family, allowing 1) access to the PPVA account assets during the policy owner’s lifetime and 2) the policy owner can change the beneficiary from one charitable organization to another. Most often investors utilize the PPVA in conjunction with other charitable strategies such as Charitable Trusts and Donor Advised Funds.
Permissible Investments Under PPVA
What type of investments can be held within a PPVA policy? This is where some of the restriction and rules the U.S. Treasury has developed come into play in order for a client to maintain the benefits of PPVA. A client may choose from one or more Insurance Dedicated Funds (“IDFs”) to serve as the cash value component of the policy, a Separately Managed Account (“SMA”) or a combination of the two. There are also investor control prohibitions and investment diversification thresholds as described in IRC §817(h) which call for a minimum of five different investments, with no one investment making up more than 55% of the total value, no two investments making up 70%, no three investments making up 80% and no four investments making up 90% of total value.
An IDF is simply an ‘insurance policy appropriate’ version of a fund a client may purchase directly. Many IDFs are hedge, direct lending or credit funds or other tax-inefficient funds which would greatly benefit from the tax-deferral a policy provides. The ‘appropriateness’ derives from the IDF treatment as a separate legal entity which cuts off investor control from the client and meets the required diversification of investment positions with the fund. Therefore, a client can personally choose just one IDF to be included and comply with the investor control and diversification tests.
A SMA can be identical to a SMA held outside of policy where a basket of investments is held. In a policy, direct investments into funds can be made within the SMA without the need of an IDF structure. However, there must be an independent manager making decisions about what is included in the SMA and the number and value of the investments in the SMA should be properly diversified. The types of investments which can be include in a SMA are broad and can include funds, LP interest in LLCs, LP interest in private equity and, even third-party promissory notes.
Clients are finding SMAs more and more useful when purchasing PPVA contracts. The ability for their investment advisor to recreate an existing investment methodology with a policy is enticing, especially where a client would be invested for the time horizon making PPVA beneficial.
Anthony age 57 and Janice age 56, a married couple from Atlanta, are accredited investors who want to donate a portion of their assets to charity. Anthony and Janice are hesitant to make an irrevocable gift in case they need access to the funds. They invests $5 million into a SMA managed by an independent investment advisor. The SMA contains a mix of investments with an exposure to short- and long-term gains and taxation at ordinary rates.
Their investment manager projects a 7% return with an average tax rate of 25%. Using these assumptions, after 20 years, Anthony and Janice’s portfolio would be worth approximately $13.8 million. They instead choose to invest into the SMA under a PPVA account. While the investments grow tax-deferred, the PPVA account costs 40 basis points or 0.40% annually. After twenty years, the PPVA value will be approximately $17.9 million --$4.1 million more than if they had not chosen PPVA. Further, Anthony and Janice have been able to keep control of the assets while they are both living.
Who Should Consider
Persons Who Favor Highly Tax-Inefficient Investments
Persons Likely to Bequeath Assets to a Charity
Persons with High-Fee Traditional Variable Annuities
Persons Wanting Access to Non-U.S. and Domestic Investments
The Right Choice?
For affluent investors who face penalizing taxation with their investment choices or who need an efficient method to transfer wealth, PPVA can be an incredibly powerful tool. As with any other complex financial strategy, clients should seek advice from life insurance, legal and accounting professionals. For questions or to learn more about private placement annuities and life insurance, please contact Hester Insurance Group.
This material is intended for informational purposes only and is not an offer or solicitation to purchase any securities or investments. Private Placement Variable Annuities should only be presented to Accredited Investors or Qualified Purchasers as described by the Securities Act of 1933 and Investment Act of 1940.
Private Placement Variable Annuities involve the investment risk of securities that include loss of value or total loss. Risks may include liquidity restrictions, lock-up periods, early redemption fees, transfer restrictions as well as other penalties that may apply to the underlying investments or securities. Additional risks could be associated with but not limited to government regulations that impact certain industries, changes in interest rates, pricing movement and transaction costs. Investments will fluctuate based on factors that include among others: performance, investment strategy, withdrawals and contributions. Actual investment results and performance will vary and are not guaranteed.
This document is not intended to constitute tax or legal advice and does not replace the professional advice of an attorney or tax advisor. Investors should consult with their own independent legal and tax advisors. Any tax and legal references herein are designed to provide accuracy with regard to subject matter. Hester Insurance Group LLC is not engaged in rendering tax or legal services.
The financial graphs/data in this document is purely hypothetical and solely for discussion purposes. Any illustration is not intended to predict or project future performance nor representative any actual investment results or performance.
A Private Placement Variable Annuity is entered into between the investor/policy owner and the insurance company. Policy owners should read the Private Placement Group Annuity Contract thoroughly.
Investors should consider the following before investing in a Private Placement Variable Annuity: 1) investment objectives, 2) risks, 3) charges and expenses of any variable product before investing. A Private Placement Memorandum offering will include this and other important information about the investment company.
Securities offered through Spearhead Capital, LLC, a Registered Broker/Dealer, member FINRA/SIPC.
Hester Insurance Group LLC is independently owned and operated.
© 2020 JERRY W. HESTER, II. HESTER INSURANCE GROUP LLC. ALL RIGHTS RESERVED. FOR ADDITIONAL INFORMATION PLEASE CLICK HERE.