Private placement variable annuities (version 2)

Private Placement Variable Annuities A Sophisticated Tax Deferral Solution for High Net Worth Investors

Private Placement Variable Annuities (PPVA) I. Purpose This report is designed to provide high net worth investors that invest in hedge funds with an overview of the benefits and potential uses of private placement variable deferred annuities (“PPVA�). Most of the existing PPVA marketplace primarily consists of deferred annuity offerings; however, recently a few carries have begun to offer annuities with variable annuitization provisions instead of a fixed payment, aka immediate annuities.

The marketplace for private placement deferred annuities developed due to the fact that most hedge fund fund-of-fund offerings are tax inefficient primarily generating short-term capital income that is taxed as ordinary income. Unlike a single manager strategy, the manager of the fund-of-funds has less ability to control taxation so while a fund-of-funds may provide a market neutral return, the taxation of the fund generally results in taxation at ordinary rates. Additionally, many high net worth families no longer have a traditional need for life insurance.

The tax horizon looks turbulent as the Bush Tax cuts are due to expire on December 31, 2011. The top federal marginal tax bracket is due to increase to 39.6 percent. An additional Medicare tax of 3.8 percent will also apply for married taxpayers with adjusted gross income (AGI) of $250,000. The rate for qualified dividends returns to the normal rate for ordinary income. The long-term capital gains rate increases to 20 percent. The top marginal federal estate tax bracket increase to 55 percent with the exemption equivalent reduced to $1 million from the current level of $5.125 million.

The paper is intended to serve only as an overview for informational or educational purposes and is not intended as a solicitation or sale of any product.

II. Introduction In spite of volatile equity markets, the retail variable deferred annuity marketplaces, according to The Annuity Fact Book, have $1.5 trillion of assets under management. Obviously, this is no small amount of capital particularly when you consider the exodus from the stock market since 2008. Life insurers during this time frame have managed to add new annual premium of $140-150 billion per year since 2008. The

annuity industry was largely able to accomplish this level of premium growth in the face of adverse market conditions by offering contracts features – guarantees to attract new capital.

Banks have also become large distributors of fixed and variable annuities over the last fifteen following the repeal of the Glass-Steagall Act, which allowed banks to begin selling insurance products. PPVA policies were created with this issue in mind, namely- How does the high net worth investor combine the strong tax advantages of annuities with a annuities product that offers customized investment options for the sophisticated investor in a product that is institutionally priced?

III. Annuity Basics A. What is Annuity?

An annuity is a financial instrument that requires a premium paid to an insurance company in return for a promise to pay a certain amount for either a specific period of time or over the lifetime of an individual An annuity contract might provide for multiple payments for a period of time following the issuance of the contract – an immediate annuity. Alternatively, the annuity contract might delay future payments until some future time period – a deferred annuity contract. Immediate annuities provide for payments within a career.

An annuity contract has an owner or policyholder that has control over the policy rights, an annuitant, which is the measuring life for annuity payments, and a beneficiary.

Fixed annuity annuities provide a crediting rate for the annuity based upon the investment performance of the insurer’s general account assets. Most life insurer general account investments are restricted by statute. Most investment guidelines found in insurance statutes limit insurance investment to fixed income assets – investment grade corporate bonds and mortgages.

An additional factor in investments is the risk based capital ratio used by financial rating agencies to measure the financial solvency and claims paying ability of a life insurer. These tests look towards liquidity and the quality of bonds and mortgages held by the life insurer. Most life insurers have very little exposure to the equity markets. As a result, the crediting rate for a fixed annuity is conservatively tied to the yield on mid-term investment grade bonds. In the current low interest rate environment, crediting rates have been very low.

Variable annuities provide a pass-through of the investment performance of investment sub-accounts that are similar to mutual funds. The insurance company makes these investments on behalf of the policyholder through sub-accounts or insurance dedicated funds held in separate or segregated accounts. These assets are segregated from the claims of the insurer’s creditors unlike assets in the insurer’s general account. The policyholder receives a direct pass-through of the insurance dedicated fund’s investment performance.

The insurance company is treated as the owner of the investment assets and included on the insurance company’s balance sheet as separate or segregated account assets. The insurance company receives a reserves deduction for any investment income received and credited to variable annuity contracts. The investment income is credited to the policy. The policyholder is not taxed under IRC Sec 72.

IV . Tax Advantaged Wealth Accumulation Using PPVA A. Product Basics

PPVA policies have no surrender charges and, like private placement life insurance (PPLI), the investment options may include sophisticated investment options such as hedge funds. The typical retail variable annuity pays the agent a commission equal to 4 percent to 6 percent of premiums paid into the policy, and has declining surrender charges over five to eight years.

The contract additionally pays the agent, through the agent’s broker-dealer, an asset-based charge of 25 to 35 basis points. Retail variable annuity contracts typically provide the policyholder with a wide range of mutual fund sub-accounts. PPVA contracts have customized and negotiated sales loads that generally are equal to 1-2 percent of each premium deposited into the contract. These sales loads are much lower than retail variable annuity contracts.

The taxation of annuity contracts is governed by IRC Sec. 72. PPVA contracts are also subject to the same investment diversification and investor control considerations as PPLI under Section 817(h) and Treasury Regulations Section 1.817-5. PPVA provides for tax deferral.

The retail variable insurance market offers immediate variable annuities, which provide for annuity payments to the annuitant within a year of the premium payment. Rather than provide a “fixed” payment, variable immediate annuities provide for payments that increase or decrease based upon the investment performance of the underlying investment(s) within the contract. The policyholder is able to make an election to determine fund selection. These contracts are just becoming available with the high net worth PPVA marketplace. Generally, wealthy individuals have other sources of income and use insurance products for tax-advantaged accumulation rather than income planning.

The retail variable marketplace has evolved with a number of interesting product developments and features. Other features found in retail variable insurance products that are not found in PPVA products include the Guaranteed Minimum Death Benefit Rider and the Guaranteed Minimum Income Benefit Rider. These riders provide a guaranteed income at age 65 regardless of the underlying investment performance of separate account investments. Similarly, the policy also provides for a guaranteed accumulation payable at the death of the policyholder. These contracts come at a price. It is not uncommon for a life insurer in the current market to offer a 5 percent guaranteed return while charging 4 percent (including the policy’s mortality and charge expense).

B. Cost/Benefit Analysis

It is not clear when and why variable deferred annuities garnered such a bad reputation among the financial press. When did tax deferral become such a bad thing? Most likely it is due to the product pricing and sales loads. PPVA contracts maximize the benefits of tax deferral with institutional pricing and sales loads.

The investment flexibility and range of investment possibilities make PPVA contracts an ideal vehicle for registered investment advisors to utilize as part of the investment planning process. High net worth investors should consider a tax-free exchange (under Section 1035) from a retail variable annuity to a PPVA contract. The contract is ideally suited for managing asset classes that generate ordinary income such as interest, dividends, and short-term capital gains.

The sophisticated planning opportunities are not lost on ultra-high net worth individuals who may be heavily invested in tax-inefficient hedge fund strategies. Additionally, families with multi-generational wealth may already have significant investment assets managed outside the taxable estate in trusts. If these assets are held in grantor trusts, the income will be taxed to the settlor.

Though the primary attraction of PPVA contracts for the high net worth investor might be the combination of the tax advantages along with the institutional pricing and investment flexibility, PPVA offers the same utility of any other variable annuity contract to meet important tax and investment planning objectives. In a PPVA policy, the owner enjoys income tax deferred growth of capital during the life of the insured. In addition, the product provides the named beneficiary(ies) of the policy with an in tax-deferred payout if the policy is annuitized.

C. Tax Advantages of Annuities

Annuities have enjoyed significant tax advantages for a life time period. In general, annuities offer two distinct tax benefits: 1. Tax-deferred “inside build-up” of policy account values.

2. Annuity payments of affixed term or contingency period such as life or joint and last survivor. An “exclusion ratio” allows each annuity payment to be treated as a return of principal and investment gain so that investment gain is recognized ratably over the annuity payout period.

The original legislative intent behind the tax-advantages of annuity contracts is rooted in social policy designed to encourage household savings. Over the course of time, these tax advantages have remained steadfastly in place.

The insurance industry has fiercely guarded these long-standing benefits that are written in the Internal Revenue Code (“IRC” or “Code”) over the years through a well-organized and funded lobbying effort through its lobby the American Council of Life Insurers (“ACLI”).

Life insurance agents also have a well-funded and organized lobby that has effectively preserved the tax advantages of life insurance.

D. U.S. vs Offshore PPLI 1) Domestic PPLI PPLI is available in both the domestic and offshore marketplaces. Over the last ten years, high net worth PPLI has become more of a domestic market. The two leading life insurers are Philadelphia Financial Life Assurance Company (PFLAC) and American General. Over the last two years, several large life insurers have left the marketplace- Sun Life of Canada,, Nationwide, New York Life and MassMutual. The nature of PPVA and its institutional pricing requires a smaller life insurer that is able to dedicate resources to a niche market segment.

The decision of which offering, domestic or offshore, to purchase is a function of personal tax planning needs. Generally, the domestic offering for a U.S. taxpayer provides coverage through an institutional quality carrier with a long track record, independent third party ratings and extensive regulatory oversight by the various states and industry groups.

The policy must satisfy the tax definition of annuities under IRC Sec. 72 in order to preserve the tax advantages. Annuities have some basic well-known rules. Distributions before age 59 ½ are subject to a ten percent penalty unless it falls into exceptions under IRC Sec 72(t) for hardship or disability. The bestknown exception is the “substantially equal periodic payment” over the life expectancy of the annuitant.

Annuities must be distributed at the death of the policyholder over a five-year period under IRC Sec 72(s) unless the beneficiary is the spouse who then becomes the policyholder. Death payments to a nonspousal beneficiary can also be paid over the life expectancy of the beneficiary.

Annuities that are owned by a Trust must be distributed at the death of the annuitant (measuring life).

The payments may be paid under a lump sum or over the life expectancy of the beneficiary. However, annuities that owned by a non-natural person excluding a Trust lose the benefit of tax deferral under IRC Sec 72(u).

Most annuities are not subject to a premium tax until an annuity is annuitized. . State premium taxes vary between 1-2 percent depending upon the state. A federal tax known as the DAC (Deferred Acquisition Cost) is an additional cost within the product. Unlike life insurance, most life insurers do not charge for the DAC tax within an annuity contract.

Domestic PPVA offerings have minimized the importance of offshore options as well as the increased compliance requirements for offshore investments.

Offshore annuities are subject to the reporting requirements of the Foreign Bank Account Reporting Act (FBAR) in the event the cash value exceeds $10,000, which requires a taxpayer to file TDF 90.22.1 no later than June 30th. The Foreign Account Tax Compliance Act also becomes effective on January 1, 2013. Several offshore life insurers have created Puerto Rica subsidiaries in response to these compliance requirements. Puerto Rico as a U.S. Commonwealth is not subject to FBAR and FACTA. 2) Offshore PPVA The asset protection opportunities available in certain tax-haven jurisdictions may point the investor towards an offshore purchase. Generally, most offshore jurisdictions have adopted separate account legislation, which exempts the separate account assets from the claims of the insurer. The policy is also exempt from the claims of the policyholder. Tax haven jurisdictions have adopted sophisticated trust legislation to protect the assets of a trust. These jurisdictions such as Nevis and the Cook Islands combine a short stature of limitations with a very high burden of proof on creditors along with a legal policy not to recognize foreign judgments.

From an insurance standpoint, the difference in the insurance regulatory environment provides the opportunity to offer PPVA with investment options, which are less liquid. Investment options within a variable annuity may be restricted in the domestic marketplace to the extent that they provide little liquidity. Offshore PPVAs may provide access to non-SEC approved offshore investments, which are unavailable in the United States.

All states have adopted non-forfeiture laws, which require paying the policyholder in cash within a sixmonth period from the time of notification for policy loan, or surrenders. Similarly, the most states have adopted statutes with respect to the timeliness of the death benefit payment. Generally, an annuity death benefit payment made after a 30-day period carries an interest penalty, which can be as high as 12 percent.

While many states would allow a delayed payment through a policy endorsement such as an in kind death benefit of the limited partner interest, Rev. Rul. 2003-91 and Rev. Rul. 2003-92 have placed in question the ability to use this endorsement. While an offshore insurance regulator would allow for much greater flexibility in this area, the in kind benefit is still subject to the same federal tax considerations regarding the Investor Control Doctrine.

As a result, domestic and offshore life insurers have opted for a deferred payment endorsement.

Depending upon the jurisdiction, a life insurer may have the ability to delay payment for six months up to an indefinite amount of time. Offshore PPVA may allow investment options such as private placement offerings for venture capital, private equity, and leveraged buyout, which tend to have longer “lock up” periods. Domestic carriers will frequently only allow a “lock up” and payment deferrals of up to one year.

These investment offerings are generally highly illiquid. Many states have approved carrier endorsements for deferred payment on policy benefits.

Generally, a U.S. taxpayer or a policy with U.S. beneficiaries should purchase, which is compliant with IRC Section 7702 through an insurer, which has made an IRC Section 953(d) election. The IRC Section 953(d) election is corporate election, which allows the insurer to be treated as a U.S. taxpayer. This election avoids income tax withholding on certain categories of investment income such as dividends, portfolio interest, rents and royalties. This election removes the risk of the carrier being “dragged� onshore as a U.S trade or business since it is insuring U.S. lives.

In the event an offshore life insurer suffered an adverse result on a tax audit, the risk to the policyholder is the risk that the policy would need to be re-priced for U.S. corporate taxes. This result could have a devastating impact on the policyholder. As a result, a U.S taxpayer should purchase a policy from an insurer, which has made this election.

A non-resident may also purchase PPLI from an offshore carrier. Most tax treaties with the U.S. provide favorable tax treatment of annuity income providing that annuity income is not subject to U.S. income and withholding taxes. Therefore, income that might be taxable under IRC Sec 871 is converted into taxexempt income under income tax treaty provisions.

These policies do not require a carrier, which has made the IRC section 953(d) election. The non-resident would generally need a policy issued by a carrier that has made an IRC Sec 953(d) election if the investment income is subject to withholding taxes. Additionally, investment income that would be treated as effectively connected income to a U.S. trade or business (ECI) is better suited within a policy issued by an IRC Sec 9539d) electing carrier.

Bermuda and Cayman Islands are the primary offshore jurisdiction for offshore insurers. Both have a long stable history both politically and economically. In choosing an offshore situs, political and economic stability are critical factors.

V. PPLI and Its Impact on the Estate Planning and Wealth Preservation Planning A. Dynasty Annuity

The Dynasty Annuity is a tax planning strategy that allows a high net worth individual to accumulate investment income on a tax deferred basis outside of the taxable estate for multiple generations.

The Dynasty Annuity involves the purchase of a PPVA contract by the trustee of the Family Trust. The trustee selects young annuitants (grandchildren or great grandchildren) as the measuring lives of the annuity in order to maximize tax deferral within the PPVA contract. This structure maximizes tax deferral

for the over the lifetime of the PPVA’s young annuitant(s). In the case of a three-year old grandchild, tax deferral could be accomplished for more than eighty years before a distribution is required.

As mentioned in an earlier part of this article, it is the death of the annuitant, which triggers the requirement to distribute tax-deferred income within five years of the death of the annuitant or over the lifetime of the beneficiary.

The steps of the transaction can be summarized as follows: (1) Purchase of a PPVA Contract - The trustee of the Family Dynasty Trust is the Applicant, Owner, and Beneficiary of a PPVA contract(s).

(2) Selection of Young Annuitants - The critical element in the maximization of tax deferral is the selection of a young annuitant(s) with the greatest potential of outliving their normal life expectancy(ies) for each separate PPVA contract. The trustee may purchase multiple policies with different individual annuitants to “hedge” against the possibility of exposing the trust to a tax burden as a result of distribution requirement caused by the pre-mature death of the annuitant.

All of the investment income and gains from the PPVA will accrue within the contract on a tax-deferred basis. At any time prior to the death of the annuitant, the trustee may request a distribution from the life insurer in order to make a distribution to a trust beneficiary. At the death of the annuitant, the trustee will be required to make a distribution of the annuity based upon the life expectancy of trust beneficiaries over the life expectancy of trust beneficiaries (presumably the surviving Doe Children).

The approximate cost of the PPVA contract is 40 bps per year. The PPVA contract has the investment flexibility to add investment options to the contract. The Customized Account provides an open architecture allowing the investment advisor to manage based upon its asset allocation model and changes to the model. The PPVA contract is ideally suited to manage trust assets that generate ordinary income.

A ten million single premium invested into a PPVA contract earning eight percent per year over an eightyyear period grows to $2.5 billion in the 80th year. This small example illustrates the power of tax deferral compounding over a long time period.

B. Frozen Cash Value Life Insurance – The Pseudo Annuity

Frozen cash value life insurance is a specialty life insurance contract that acts as a surrogate for a deferred annuity contract. Frozen cash value annuities (“FCV”) is best known as a flexible premium variable adjustable (universal) life insurance policy that is issued by offshore life insurance companies domiciled in tax-haven jurisdictions such as Bermuda or the Cayman Islands. Recently, a two-specialty life insurers

have emerged in Puerto Rico that offer both traditional PPLI as well as FCV policies. In many respects is similar to a deferred annuity with better tax treatment upon death as well as distributions during lifetime.

The policy is intentionally designed to violate IRC Sec 7702, the Internal Revenue Code tax law definition of life insurance. The other legal considerations are imposed under the insurance laws of the jurisdiction where the coverage is issued. Generally speaking, all of the carriers issue the coverage as variable life insurance.

In the beginning FCV policies were only issued by life insurers that had not made the election under IRC Sec 953(d) to be treated as a U.S. taxpayer. This election is important since the life insurer's separate account is treated as a non-resident alien for income tax purposes. Without the election, certain categories of investment income would be subject to withholding taxation under IRC Sec 871(a) at a 30 percent rate. Recently, several life insurers have started issuing FCV policies in their IRC Sec 953(d) electing companies.

Under most FCV contracts, the death benefit is equal to the sum of guaranteed specified amount of death benefit plus the cash value on the claim date plus the policy's mortality reserve value on the claim date. This amount is essentially the cumulative premiums plus or minus investment experience along with a death benefit corridor which most carriers express as a fixed percentage between 102.5% - 110%.

A Puerto Rican life insurer referenced above issues policies with a fixed amount of coverage - $1 million above the initial premium and mortality reserve.

The cash value under most FCV policies is defined as the fair market value of all assets constituting the policy fund, less any policy loans and less any accrued unpaid fees or expenses due under the terms of the policy. The “Cash Surrender Value� of the of the Policy is the lesser of (a) the cash value or (b) the sum of all premiums paid under the Policy, computed without regard to, any surrender charges, and policy loans, under the terms of the Policy.

The cash value increases or decreases depending upon the investment experience of the policy fund.

FCV policies do not provide for or guarantee any minimum cash value. The insurer holds the appreciation of the assets (in excess of the amount of cumulative premiums) held in the separate account as a mortality reserve within the insurer's separate account solely for the purposes of funding the payment of the death benefit payable under the FCV policy.

Under most FCV contracts, the policyholder may take a tax-free partial surrender of the policy cash value up to the amount of cumulative premiums within the policy. The policyholder may also take a policy loan up to 90 percent of the policy's cumulative premiums. The policy loan terms will vary from company-tocompany. The significance of a partial surrender versus a policy loan is that the partial surrender will not leave the policy with a liability. The surrender and loan proceeds are tax-free under any circumstance and provide the policyholder with access to policy assets on a tax-free basis.

The tax authority for FCV policies is very straightforward. Several large national law firms have opined favorably on this type of policy. The legal analysis is straightforward in IRC Sec 7702(g). The policyholder

is taxed on any inside buildup of the cash value and mortality charges except that the policy cash value definition does not provide for any inside buildup.. The mortality corridor is also very small. IRC Sec 7702(g) states that a tax-defective policy still receives income tax-free treatment for the death benefit under IRC Sec 101(a).

One way to look at the FCV policy is that it effectively similar to a variable deferred annuity only with better taxation for the taxpayer. Similarly, it is like a Modified Endowment Contract (MEC) without being subject to the MEC rules.

FCV policies are extremely efficient for accumulating wealth with a minimal cost “drag� due to the policy’s mortality cost for the net amount at risk in the policy. Whether a carrier has a fixed percentage corridor of 105-110 percent or a fixed amount corridor of $1 million, the FCV policy is very efficient for wealth accumulation purposes. The death benefit ultimately delivers the investment accumulation in excess of the initial premium on a tax-free basis. The policyholder is able to take loans from the FCV policy on a tax-free basis in amount equal to 90 percent of his cumulative premiums in case the taxpayer needs to access his investment.

The policy is well suited for taxpayers whose single premium would exceed the available reinsurance capacity for an insured. This amount is believed to be approximately $65 million on a worldwide basis.

The tax -free death benefit is a much stronger result that the taxation of a deferred annuity at death.

VI. Conclusion PPVA is an exciting solution to many of the concerns of the wealthy. Contrary to what is popularly believed by most financial advisors variable annuity contracts can provide important investment and tax planning benefits particularly when the policy is institutionally priced and has investment flexibility.

PPVA provides a low cost flexible platform for individuals to tax advantage tax inefficient investments. It provides a tax benefit to heirs on an income tax deferred basis and if the contract is set up properly, can provide a tax deferred income stream following the death of the policyholder or annuitant. .. PPVA is still largely under-utilized by high net worth investment investors and provides an excellent opportunity to enhance the after-tax return of hedge fund investments while addressing a number of other tax and estate planning issues at the same time.