The RIA Retirement Plan - Subtle Strategies Designed to Retain AUM
Overview
Growing up in the Panama Canal Zone was a special experience. The recent passing of Manuel “Cara De Pina” Noriega reminded of my time growing up in the Panama Canal Zone. The Year was 1968 and Omar Torrijos had just overthrown the government of Arnulfo Arias. His G-2 was Manuel Norriega.
My parents actually met him at a dinner following a little league baseball game between Canal Zone kids and Panamanians. My mother of blessed memory allowed my brother (age 12 at the time) and I (age 8) to travel alone by public bus to the bus station on the border of the Canal Zone and Panama to be first hand witnesses to the Revolution. It is etched in my memory as the “Day We went to watch the Revolution” Additionally, the bus terminal was in very bad section of Panama City.
I lived in the town of Balboa on the Pacific side of the Canal Zone until I was eight years old. Next to the Balboa Elementary School at the entrance of Ancon Hill, the headquarters of the U.S. Southern Command, was a jungle with an old dungeon left by the British pirate, Henry Morgan. Panama was the pathway of the famed Camino Real that allowed the Spanish to transport gold from Peru to Spain. Presumably, a lot of gold was lost along this route. I never found any.
This article is intended to show Registered Investment Advisors to find “gold” along the Camino Real of financial services using private placement life insurance and private placement variable deferred annuities as an investment structure for assets under management. This strategy will allow investment advisors to retain and manage more assets on a tax-advantaged basis.
The More that Things Changes
The financial services industry has changed a lot over the last ten years. In general, there has been a move away from registered representative status with FINRA to Registered Investment Advisor (RIA) status at the federal and state level. Over the last decade, the sale of equity indexed annuities and equity indexed life insurance has largely replaced the sale of variable life insurance and annuities. Agents and financial representatives have moved away from large career companies and broker-dealers to independent status.
From a compliance perspective, the sale of equity indexed products, does not require FINRA registration. From a marketing and sales perspective, the product design provides the purchaser with upside participation and downside protection, e.g. “Heads I win, and Tails you lose”. Additionally, the products have a retail commission structure.
In the old days, a successful agent focused on the sale of life insurance and had a group health insurance business. The complexity of the group health business, commission cuts and Obamacare, droved agents out of that business. Finally, agents began to ask their clients for the opportunity to manage their investment portfolio.
I recently spoke at an event sponsored by Advisors Excel, the Topeka-based insurance marketing organization. The company is incredibly well run and very successful with almost as many employees as a small to medium sized life insurer. I had the opportunity to meet and visit with a number of agents who were making very nice incomes, selling equity indexed annuities and gathering assets under management. Some of the representatives marketed using a weekly radio show. With the average fee-based compensation around one percent, it does not take long before the asset-based compensation becomes a meaningful number that grows and continues. It is a simple but beautiful strategy.
My question is how much larger would the pot of gold be if taxes were taken out of the equation? The balance of this article introduces private placement life insurance and annuities as an investment structure for the assets under management. The insurance products provide for tax deferral and elimination while administratively creating an additional hoop for the client who gets upset and wants to redeem his investments from the agent. As result account turnover is reduced.
The strategy turns the assets of the short-sighted investor into a long-term strategy. When you take taxes out of the question, you gain several hundred basis points in positive investment performance.
Background on Private Placement Insurance Products
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What is Private Placement Life Insurance (aka PPLI)?
A variable life insurance policy is a permanent life insurance contract that has a cash value component and a death benefit component. The growth of the cash value is tied to the investment performance of investment sub-accounts that the policyholder is able to select,. In retail variable insurance products, these investment choices are mutual fund clones or sub-accounts. The policy holder bears all of the investment risk. The assets supporting the policy cash value are separate or segregated from the life insurer’s general account asset and its creditors. The policyholder is able to select these funds within the life insurance policy with the carrier’s fund election form.
PPLI is a form of variable universal life insurance. The policy is strictly available for accredited investors and qualified purchasers as defined under federal securities law. The policy is institutionally priced and is virtually a “no load” product. The insurer provides the policyholder with the ability policyholder to customize the investment options within the policy. The range of investment options can include a customized fund managed by the client’s existing investment advisor as well as a range of asset classes including hedge funds, real estate and private equity.
PPLI like other types of permanent life insurance enjoys superb tax attributes. The policy investment income accumulates within the policy on a tax-free basis. The policyholder has the ability to access these investment gains on a tax-free basis through policy loans and withdrawals. The policy death benefit receives income tax-free treatment. No other investment structure including Sep-IRAs; IRAs and qualified retirement plans enjoy this favorable taxation. The tax code makes no distinction between the wealthy policyholder or poor policyholder.
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What is a private placement variable annuity?
An annuity contract is a contract between the policyholder and insurance company to pay an annuity to the policyholder. Insurance companies offer two types of annuities – immediate and deferred. Immediate annuities provide a stream of payments at fixed intervals (monthly/quarterly/semi-annually or annually). The annuity is paid for a term of years or based on a life contingency such as “life only” or “joint and survivor” The payments end at the end of the fixed term or death of the annuitant (measuring life).
A deferred annuity is a deferral of that promise to make a series of payments to the policyholder. The deferral may be set for a fixed period of time. Many contracts list a maximum age of 85 or 90 for the deferral period. The account value in a “fixed” annuity is based upon the crediting rate based upon the insurer’s investment performance on general account assets. Most insurance general account investments are in investment grade bonds.
In a variable annuity the investment performance is based upon the on investment performance of separate account funds. These funds are segregated from the insurer’s general account assets Traditionally, these funds are mutual fund clones or sub-accounts managed by investment management firms in the mutual fund industry. The investment performance for these accounts is a direct pass-through to the policyholder.
The private placement version of this product is for accredited investors and qualified purchasers based upon the definition under federal securities law. Like PPLI, the products are institutionally priced with no surrender charges. The investment options include hedge fund, private equity and real estate options as well as traditional mutual fund-like options.
Deferred annuities provide for tax deferral. At the death of the policyholder, the account value must be distributed to the beneficiaries within five years of the policyholder’s death unless the beneficiary is the policyholder’s spouse. In that case, the spouse is treated as the new owner and policy benefits may continue to be deferred until the spouse’s death.
Income taken “other than as an annuity” during the policyholder’s lifetime is treated as taxable income (at ordinary rates) to the extent of investment income within the policy. Income that is taken in the form of an annuity is partly taxable and partly treated as a return of principal based on a formula known as the exclusion ratio. The big point here is annuities are not as tax advantaged as life insurance.
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The Strategy
RIAS have the ability to manage assets within private placement insurance contracts. The policy investment options are customized and the RIA can be appointed to manage the investments within the policy. Generally, the life insurer will agree to use the RIAs choice of custodian for the policy’s investment assets. The assets will be managed within a Managed Account option within the policy or a customized Insurance Dedicated Fund (IDF) sub-advised by the RIA. The RIAS will receive management fees on a quarterly basis from the life insurer.
The strategy would allow the RIA to transfer existing client life insurance or annuity assets into private placement insurance contracts through tax-free IRC 1035 exchanges. Non-insurance assets can be liquidated and transferred into private placement insurance contracts for long-term investment management and tax advantage. Depending upon a number of variables, it may also be possible to transfer an existing portfolio into the contract without liquidation. The tax-advantaged accumulation within the policy will generally cause consequently cause the asset management fees to increase exponentially. The client wins and the advisor wins.
Summary
The independent RIA channel is growing dramatically. RIA investment management within private placement insurance products provides an investment structure with tax advantage; higher asset management fees and lower account turnover. The RIA community to this point has not embraced these products in the manner that they should due to a general prejudice against life insurance and annuity commissions and restrictions. These products are no-load products with complete open investment architecture. The strategy will reduce your ability to retire by ten years because the management fees will double in those same ten years.
In order to find the gold, you need to take the first step on the Camino Real.
