#288 | Private Placement Goes Mainstream

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Over the last couple of weeks, Private Placement Life Insurance (PPLI) has gotten more attention from mainstream media than it ever has before. Bloomberg ran a click-bait article on September 2nd entitled “How Rich Americans Plan to Escape Biden Tax Hikes” and the article was picked up and parroted by numerous financially-oriented small media outlets. A few days later, Bloomberg reporter Alexis Leondis followed it up with “The Latest Tax-Avoidance Trick Probably Isn’t for You,” which was also splashed around in other publications, including the Washington Post.  The message from these articles is clear – PPLI is a “trick” that the “rich” use to “escape” taxes.

It’s a good thing that the folks writing these articles don’t really understand what they’re writing about. The reality is that, under the same logic, life insurance is a “trick” that “absolutely anyone” can use to “escape” taxes. Massive, white-shoe Private Placement policies share the exact same tax treatment, limitations and guidelines as any other permanent life insurance policy. Actually, the relationship works the other way – PPLI enjoys its tax benefits because of the humble retail permanent life insurance policy. PPLI may be a Porsche 911 GT2 RS, but don’t forget that the engine is in the back because Ferdinand Porsche designed the lowly, pedestrian Volkswagen Beetle “people’s car” first.

What sets PPLI apart from traditional life insurance is that it offers investment strategies that are only available to accredited investors, hence the exclusive aura of the product. If you want to buy hedge funds, private equity funds, MLPs or any myriad of other sophisticated investments, you have to do it in PPLI. In the retail market, life insurers compete on illustrated performance and commissions for accumulation products. In the PPLI market, life insurers compete to offer the widest array of compliant investment strategies on the lowest cost platform. Illustration gimmicks and commission specials need not apply.

For PPLI, it’s a cold, hard calculation – are the tax savings from using PPLI worth the drag from state premium taxes, cost of insurance charges and insurance administration fees? If the answer is yes, then the discussion moves to the next point – can the client invest in desirable strategies inside the PPLI wrapper? In an ideal world, the client would be able to put shares of their privately held business (or their car collection or crypto or their beach house or whatever) into the PPLI policy and shield it from taxes forever. That would be the perfect tax-efficient vehicle.

Unfortunately, that’s not how it works. Any variable life insurance policy, including PPLI, has to use insurance-dedicated funds for its subaccount options that adhere to certain diversification and investor control limitations. But there is a lot of gray area and, ultimately, gray area creates the potential for a tax liability that the client and the insurer may be willing to take. Hence, the market for insurers accepting edgier investments from clients in order to earn the business. And hence the growing market for advisors creating bespoke strategies for clients that qualify as IDFs, despite the fact that the client is actively telling the advisor what kind of investments he’d like to have in the portfolio – a suggestion, of course, not a directive.

PPLI will always be the product of choice for very wealthy, very sophisticated investors who are trying to mitigate or eliminate tax incidence on investment strategies with meteoric growth or lots of tax friction. The only way to put those types of strategies into a life insurance policy is with PPLI. But what about a regular wealthy person who is just trying to shield some gains from taxation without going crazy on the investment side and keeping the product as simple and as straightforward as possible? Or, to put it back in car terms, what about the guy who just wants a 911 and doesn’t need the track-weapon GT2 RS variant?

Retail Variable UL is a more-than-adequate solution. It’s the 911 Carrera of the lineup. As I’ve written before, retail Variable UL policies can compete with PPLI in terms of overall cost efficiency as long as the time horizon is sufficiently long. Retail VUL policies are front-loaded with fixed charges in large part to cover heaped commission. After those charges burn off – usually the 10th year – retail VUL is wickedly efficient. The typical retail VUL usually only assesses COI charges and a modest per-policy fee of a few dollars a month. Most life insurers have moved to eliminating asset-based expenses (usually referred to as an M&E charge) on either a current or guaranteed basis and even to adding guaranteed or non-guaranteed interest bonuses, essentially a negative M&E.

PPLI, by contrast, always has a lifetime asset-based expense that may ultimately drag more on cash value growth than the front-loaded expenses of a typical retail VUL. But the optics of PPLI are much better. If you put $100,000 into a retail VUL, you might have $90,000 of Account Value and $35,000 of Cash Surrender Value in the first year. With PPLI, the AV will be (ballpark) $97,000 with no surrender charges, and that doesn’t include any appreciation on the asset. PPLI doesn’t have the stink or structure of heaped commissions and that is one of its chief selling points. It looks institutional. It feels institutional. And the fact that it allows for sexy investment strategies only makes it more appealing and more up-market, despite the long-term asset-based drag from the chassis.

The holy grail, then, would be to design a retail VUL product that has some of the same institutional feel as a PPLI, but without the massive premium requirements ($5M+ for PPLI), complex investment choices and restricted distribution. There are two ways to create that type of product. The first is a no-commission VUL designed to be sold directly to consumers or in conjunction with an RIA, which is what TIAA CREF did before it got out of the business, what Ameritas is currently doing with Ameritas Direct and what Nationwide has filed to do as a part of its Nationwide Advisory Solutions platform. These products are basically priced like PPLI – although with zero commissions and without the investment choices that push the product into accredited investor territory.

That’s a solution, but it’s not the only solution. In the annuity market, fee-based products that are designed with the same philosophy as the products above constitute a tiny (but growing) sliver of the market. Far more successful have been so-called Investment Only Variable Annuities (IOVAs) that still pay heaped commissions but are designed primarily for tax deferral. Over time, IOVA products may actually outperform fee-based products for the same reason that retail VUL may outperform PPLI. Or, at least, the final result will be comparable. But there is no IOVA-like product on the retail VUL side. We have massive heaped comp products with bad first-year optics and we have fee-based, zero-commission products. Isn’t there a middle ground, one that takes the IOVA playbook to the Variable UL space without moving all the way into PPLI?

Enter Equitable Advantage, a Variable UL product without VUL in the name. The product itself is a cousin to Equitable Optimizer VUL, but with some twists that make its ambitions clear. The compensation is 9% of each premium paid for the first 7 years rather than a traditional Target-based compensation structure with excess and renewals. Advantage is meant to be funded at exactly the maximum non-MEC premium. A dollar less and you’re leaving compensation on the table. Spreading the 7 Pay funding over 10 years also means a compensation cut. Paying the same premium over less than 7 years but with a higher death benefit to retain non-MEC status doesn’t increase compensation the way it does for typical retail life insurance policies.

Advantage exists within a streamlined process designed to focus the sale exclusively on accumulation. The illustration software will only spit out overfunded scenarios with non-MEC premiums between 5 and 10 years in duration, although 7 is obviously the optimal number. The producer just has to specify the desired premium, payment period, rate assumption and distribution solve. Everything else is a default. Equitable has an underwriting process available with a 48 hour turnaround time with no labs, as long as you’re willing to take the Advantage Max variant of the product with about 15% more expensive COI rates than the fully underwritten Advantage product. That’s a fair trade for a simplified underwriting process because COIs have such a small impact on accumulation performance. Equitable is clearly trying to make the process for buying Advantage as easy, as simple and as straightforward as possible. If you can sell an IOVA, then you can sell Advantage, too. And that’s not necessarily the case for most retail VUL out there.

Like a Variable Annuity, Advantage has a 5-year surrender charge schedule that is based on premium, not face amount. It starts at 6% and falls by 1% each year to 2% until it drops off. In a Variable Annuity, surrender charges are necessary because the heaped commission is recaptured by the product’s M&E over the remainder of the Surrender Charge period. The same sort of thing is going on with Advantage, which has a stout fixed per thousand charges for the first 10 years of the policy that presumably goes primarily to recapture the premium-based commissions. But then again, the compensation on Advantage is pretty stout as well – 9% is quite a bit higher than traditional VA comp of around 6%.

There are a few other quirks to the Advantage structure as well. There’s a 0.4% M&E for the first 8 years that drops to 0.05% thereafter and is offset by a Customer Loyalty Credit (CLC) of 0.45% for years 11-20 and 0.25% thereafter. Equitable has traditionally had some of the most expensive funds in the business, but a couple of years ago they started to incorporate a guaranteed Investment Expense Reduction to bring down the cost and now they offer a suite of passive index strategies, all at 0.4%, which is still pretty expensive relative to the index funds available outside of the product. And, of course, there’s a 5% premium load in the first year that drops to 4% thereafter.

In terms of fees, Advantage isn’t any cheaper than a typical retail VUL product – but it is different. It pays compensation based on total premium, not Target premium. It has a surrender charge based on a percentage of premium, not Face Amount. The net effect is a policy that looks much more like an IOVA than a typical VUL. For comparison, funding Equitable Optimizer VUL at the maximum non-MEC premium yields a first-year surrender value equal to about 60% of premium paid. For Advantage, it’s 80%. But the strange part is that after the first year, Optimizer takes the lead in surrender value because its surrender charge is shrinking while Advantage’s surrender charge is actually growing because each new premium creates a new surrender charge. That may seem weird to life insurance folks, but it’s pretty normal in the annuity space.

Like any other retail VUL, Advantage ain’t cheap, but does it still work as an efficient tax wrapper? It does. Take a look at a simplistic view of after tax returns (calculated with the classic formula: pre-tax return * [1-tax rate]) versus Advantage cash value IRRs using the same 5.58% net investment earned rate:

Taking a more sophisticated (and accurate) view, Advantage Max illustrates $40,514 of income from years 21-40 on a 45 year old Male with a $25,000 annual premium for 7 years. If the client would have instead put the $25,000 into a taxable account and never reallocated the money or incurred any taxes along the way, he would completely exhaust the taxable account with a $35,998 income stream taxed at 15% on gains. At 25%, the income would be $33,437 and just $29,482 at a 40% tax rate on gains.

And this isn’t even a fair fight. The taxable account goes to zero after the distributions, but Advantage keeps $50k in the Account Value in order to keep the death benefit in-force from that point afterwards. And beyond that, Advantage pays compensation to the advisor, but we’re assuming that the brokerage account does not. If it did, and if the compensation was the usual 1% of AUM, then Advantage would be heads and shoulders better than the taxable account. The only assumption that is conservative in favor of the taxable account is that the fund expenses are the same 0.4% in both examples. In the real world, that probably wouldn’t be the case, but it wouldn’t be out of the realm of possibility either.

This leaves us with an inescapable solution – no matter which way you cut it, regardless of whether you’re using PPLI, retail VUL, Advantage VUL or a fee-based VUL, life insurance offers an incredibly compelling value proposition if you’re looking for a tax efficient way to accumulate assets. We can debate about policy charge structures, investment options, compensation arrangements, whatever. It doesn’t matter. Life insurance as a tax wrapper works marvelously.

This leads us to two questions. First, why don’t more financial advisors recommend that their clients use life insurance as a way to exert tax control and potentially eliminate taxes altogether? My theory is that the reason is that most financial advisors were raised on the “buy term and invest the difference” mantra. Life insurance doesn’t fit in their usual point-and-shoot asset allocation process. Confidently positioning life insurance requires a deep understanding of both the product and the process that most financial advisors don’t possess. Products with focused design parameters and streamlined underwriting are one way to overcome the hurdles for advisors in using permanent life insurance – products like Advantage Max.

The second question is trickier – why is life insurance such a tax-efficient vehicle? I’ve spent more time reading about and contemplating life insurance tax treatment this year than I would have liked thanks to the changes to Section 7702 and I’ve come to a rather uncomfortable realization. The intuition behind Section 7702 is that because the death benefit is income tax free, any cash value growth necessary to support and ultimately endow the death benefit does not incur current taxation. Cash value in excess of that amount, as calculated by Section 7702, would disqualify the policy as life insurance for tax purposes and cash value growth would be taxable. The bright line within the internal logic of Section 7702 is that necessary cash value grows tax free, unnecessary cash value gets taxed.

However, Section 7702 calculates the necessary premium using CSO mortality and a minimum 2% interest rate. In the real world, policies have mortality priced far below CSO and credit interest higher than 2%. Therefore, they produce unnecessarily high cash value even though they are funded at the premium levels calculated to generate the necessary cash values under Section 7702. In other words, Section 7702 uses guarantees to determine the maximum premiums and relationships between cash value and death benefit that define a policy as life insurance, but the real world uses non-guaranteed elements, whether in the form of dividends in Whole Life or non-guaranteed charges and credits in Universal Life.

To put it bluntly, Section 7702 is designed specifically to eliminate the ability to use life insurance for any sort of tax advantage beyond the tax-free death benefit. The flaw in the code, though, is that it bases the calculation on guaranteed elements rather than non-guaranteed elements. If 7702 took non-guaranteed elements into account, then it would be impossible – yes, impossible – to use life insurance to accumulate tax-free assets in excess of the death benefit. The idea of using life insurance as a tax wrapper would disappear and with it, most of the accumulation-oriented sales we see prevalent in today’s market.

But Section 7702 is what it is. Changing the code to take into account non-guaranteed elements would be a herculean task that you can be assured will be met with a furious assault from industry organizations. They know what’s at stake. For the time being, though, let’s not kid ourselves – life insurance is the last and greatest bastion against the ever-encroaching long arm of the taxman. To paraphrase Lieutenant Aldo Raine in Inglorious Basterds, we’re in the business of tax efficient accumulation and cousin, business is a’boomin’.