Addressing Tax-Efficiency through IDFs

Many Ultra-High Net Worth (“UHNW”), Family Office, and Institutional investors dedicate substantial amounts of time performing due diligence and research on their alternative investments. Representative asset classes might include hedge funds, private equity, private credit, real estate, venture capital, and others.

That said, while many allocators are finely attuned as to what they invest into, many fail to take into account for how and where they make said investments on their balance sheet. Unfortunately, depending on the asset class, income taxes can meaningfully dilute an investor’s net-of-tax or “take home” returns. This can be especially pronounced for investors who reside in high income tax states like CA, NY, CT, MA, and IL (to name a few).

How can tax-sensitive investors allocate in a more “tax savvy” fashion? One alternative is to invest into an Insurance Dedicated Fund (“IDF”) managed by their desired investment manager. IDFs are specialized funds accessible through institutionally-priced variable life insurance and annuity contracts, called Private Placement Life Insurance (“PPLI”) and Private Placement Variable Annuity (“PPVA”). IDFs can offer several unique benefits to both UHNW and Family Office clients, as well as asset managers.

Value proposition to the UHNW and Family Office investor

Rather than investing in a given manager’s traditional taxable fund, the client purchases a PPLI or PPVA contract through an insurance carrier. In exchange for one or more cash premium payments, the insurance carrier issues a PPLI or PPVA contract. The contract features a segregated investment account through which the client’s premium dollars can be allocated.

PPLI, like traditional life insurance contracts, requires a medical underwriting upfront. Upon contract issuance and funding, the policyholder can then direct the insurance company to invest the contract’s segregated account into one or more IDFs approved and offered by the carrier, or into a Separate Managed Account (“SMA”) managed by a 3^rd party RIA or asset manager. Investment dollars inside the contract then grow tax-deferred until the later of death or surrender of the contract by the client. Under Code Section 7702 of the Internal Revenue Code, PPLI contract proceeds also distribute income tax (and potentially estate tax) free at death, if structured properly.

PPLI and PPVA contract fees and expenses are fully transparent and disclosed upfront. In effect, instead of paying income tax on the growth of their investment dollars, the investor pays the fees and costs associated with the insurance contract. Because these contracts are transparently priced (and often negotiated with the carrier upfront), there is often a substantial arbitrage clients can realize just by altering the “asset location” of certain investments to inside of the contract.

A few attributes of PPLI and PPVA contracts:

1. Institutional (and transparent) cost structures
2. Investment flexibility (premium dollars can be invested in a combination of either IDFs offered by the carrier, or into a more custom SMA approved by the carrier and managed by the client’s desired RIA or asset manager)
3. Elimination of K-1s associated with the underlying investments held within the contract
4. No contract surrender penalties (although a 10% penalty will apply if the contract is surrendered before age 59 ½)
5. Ability to take tax-free loans from the contract during the insured’s lifetime (if structured as a Non-MEC PPLI contract)

PPLI and PPVA contracts are offered via a smaller subset of institutional insurance carriers, including Prudential, Lombard International, Pacific Life, Zurich, Crown Global, and Investors Preferred. These products are also generally only available to clients that qualify as both an Accredited Investor and Qualified Purchaser. Practically speaking, an investor should have a minimum investable net worth of $20mm or more to consider PPLI or PPVA, where the contract may represent a subset of their overall investable wealth.

That said, for the right client, these contracts can serve as a long-term tax-efficient asset location, and allow investors to maximize the long term growth of their investment dollars on a tax-deferred (or potentially income and estate tax-eliminated) basis. PPLI and PPVA can also function as a powerful wealth compounding tool for investors who intend to grow and transfer assets to family or charities tax-efficiently upon death.

Value proposition to the Investment Manager

While this marketplace has existed for roughly 25 years, improvements in both product design and investment flexibility have made this a much more investment and asset manager-friendly tool in recent years. For example, the IDFs marketplace today includes roughly 200 IDFs. A growing number of institutional asset managers, multi-family offices and major wire houses have launched solutions in this marketplace to provide clients with a more tax-efficient option for accessing their strategies.

There are certain rules specific to IDFs (as well as similarly-administered SMAs) that the asset manager or RIA must adhere to:

1. The IDF must be a wholly separate fund structure offered by the manager (meaning, it cannot simply be a share class of an existing fund they oversee).
2. The IDF also must meet specific diversification requirements defined under Section 817(h) of the Internal Revenue Code. In short, the IDF must hold at least 5 underlying assets, where no one investment represents more than 55% of the portfolio, no two represent more than 70%, no three 80%, no four 90%, etc.).
3. Finally, the policyholder is not permitted to direct the specific investment decisions made within the IDF (commonly referred to as the ‘Investor Control Doctrine’). All discretionary “buy” and “sell” decisions made within the IDF must be made by the IDF manager, in accordance with the IDF’s more broad investment mandate.

Surprisingly, the barriers to entry in this marketplace are not high. Generally speaking, a new IDF can be launched with as little as $10mm in seed capital from a single investor, or combination of investors. The manager of the IDF must be SEC (or industry equivalent) registered and will need to complete an onboarding and approval process in advance with the insurance carrier.

Many clients fund and maintain a PPLI/PPVA contract with the intention of owning it for the remainder of their lifetimes, as it functions as a tax-efficient asset location on their balance sheet. As a result, many asset managers structure IDFs as evergreen vehicles for clients to access through PPLI and PPVA. Hence, the IDF can also function as a long-term pool of capital for the asset manager to oversee, and provide an alternative means for UHNW and Family Office clients to access their strategy.  

Further, for established investment managers who oversee tax-inefficient strategies (including some hedge funds, private credit, and private equity managers), creating an IDF may help clients to optimize their long term net-of-tax returns. For clients who prefer a particular manager’s investment strategy, the IDF can provide a more tax-advantaged option for the client to make their investment. By doing so, an IDF can also provide the manager with a differentiating “edge” over the competition when fundraising within increasingly sophisticated UHNW and Family Office circles.

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David Reynolds is Chief Marketing Officer at Spearhead Administrative Services

Information provided herein is for informational and educational purposes only and is not a recommendation to take any particular action, or any action at all, nor is it an offer or solicitation to buy or sell any securities or services. It is not investment advice. Spearhead Administrative Services, LLC does not provide legal or tax advice.

Securities offered by The Leaders Group, Inc., Securities Dealer, Member FINRA/SIPC.