Updated: May 23
The following research was previously published by Prof. Davide Accomazzo on his firm's website THALASSA CAPITAL
“Architecture Begins Where Engineering Ends.” Walter Gropius The evolution of investment management theory and practice is a constant process of unfolding complexity and human brilliance. As society’s complexity increases, so do people’s organizational and financial needs. Risk management, for instance, increases in prominence as life becomes more complex; in fact, dealing with risk nowadays requires a much more comprehensive view of what risk really is and where it may strike. From a financial perspective, risk was first interpreted merely as potential loss in a portfolio. Modern Portfolio Theory (albeit with many questionable assumptions) tried to codify and quantify performance risk in a portfolio. However, for the affluent investor, financial risk is a much more pervasive entity. The inherent complexity of great wealth requires a multi-level approach similar to the process of building a great palace. Engineering creates solid foundations and attempts to pre-empt different potential risks in order to eventually allow architecture to synthetize art, science, technology and humanity into the final artifact. In the same fashion, modern financial management must combine investment performance with the process of “wealth engineering.” In simple terms “wealth engineering” is the process of structuring transactions and frameworks to improve financial results and wealth transfers success. In the past, the process was defined by linear expected return analysis within the framework of financial planning. In other words, an advisor would use as inputs, MPT style expected returns, standard deviations and run simple statistical analysis within the specific context of the client in terms of expected cash inflows and outflows, insurance policies and other financial planning details. However, successful financial plans and large wealth transfers depend on many elements beyond reasonable forecasts of investment returns. A fruitful plan will start with the proper acknowledgement of soft issues such as family governance, next generation training and alignment of core values. Investment portfolios are then designed to meet such values as much as financial goals. The last step deals with packaging the two previous procedures into the proper legal and regulatory structure. We have written extensively on investment analysis and portfolio allocation and we also offer seminars dealing with the utterly important soft issues but for the purpose of this article, we want to focus our attention on the “engineering” part of the process of wealth protection and transfer. Private Placement Life Insurance (PPLI) One of the most interesting tools for estate planning, asset protection and performance enhancement is Private Placement Life Insurance (PPLI). This is a complex structure that provides the affluent investor with a powerful instrument dedicated to tax-optimization, risk management and investment diversification. PPLI has served the affluent community for a long time allowing enhanced after tax performance. A lowering of its working costs have now made such solution available for a wider audience. Essentially, PPLI is a diversified investment portfolio wrapped into a customized insurance product with all the advantages afforded by insurance related schemes. PPLI policies can be structured as domestic or offshore policies. Practically, an investor can create a diversified portfolio based on the general PPLI guidelines and place the underlying investment in what is essentially a variable universal life insurance framework within a private placement. Such solution provides the ability to defer taxes on less tax efficient strategies such as Hedge Funds, to acquire asset protection and to receive an income tax-free death benefit for the estate. An interested investor should analyze a PPLI from four different angles: risk management, tax efficiency, portfolio construction and costs. In terms of risk management, the potential benefits are diverse. As a Variable Universal Life structure, the assets are held separately from the general account of the insurance company and their creditors. From an investment risk perspective, a PPLI allows for the construction of a diversified, low volatility portfolio that outside the insurance framework could see its attractiveness reduced due to an inherent tax inefficiency. While an investor experiences some loss of control over the assets, he/she does not lose access to the funds; a well-structured policy allows the investor to remove cash value as well as borrow from the policy tax-free. As far as tax efficiency, to the extent that the policy is compliant with U.S. tax rules, it will receive preferential tax treatment. Once the PPLI is structured and premia are fully paid, the benefits accumulate as such under tax laws:
Cash value and investment income grow tax free
The policy owner maintains tax free access to the cash value (under specific terms)
The policy beneficiary is exempt from income tax on the death benefit amount (which includes any produced investment income)
Distributions are taxed at ordinary income tax rates.
In terms of portfolio construction and investment choices, a PPLI must adhere, among other elements, to the following guidelines:
No more than 55% of the account value represented by any one investment
No more than 70% of the account value represented by any two investments
No more than 80% of the account value represented by any three investments
No more than 90% of the account value represented by any four investments.
In regards to portfolio construction, specialists suggest to consider the following principles:
Use the scheme to support long term financial needs; from a strategic perspective, longer dated assets are usually utilized to fund PPLI structures
Select a portfolio of assets with high tax exposure
Consider a proper mix of two portfolios: one dedicated to meet working and retirement needs structured outside the insurance umbrella and one dedicated to long term needs structured under the PPLI framework.
As far as costs, as mentioned earlier, the fees associated with a PPLI structure have become more competitive and they usually are below fees for other forms of investable insurance. A PPLI policy should incur, beyond investment management fees which would be due in any structure, a required annual mortality expense, a monthly cost of insurance and a deferred acquisition cost (domestic). As mentioned, PPLI policies can be structured domestically or offshore; in the case of an offshore solution, among other differences, the cost tends to be much lower. Grantor Retained Annuity Trust (GRAT) GRATs have been very popular estate planning tools in the last few years given the fact that this configuration gets direct validation from the IRS and if properly structured it is very unlikely to be challenged. A GRAT is a structure that allows an investor – the grantor – to transfer assets to a Trust (GRAT) in exchange for an annuity stream set for a number of years. At the end of the annuity, whatever assets are left become the assets of the remaindermen usually the donor’s heirs. The amount of the taxable gift related to the transfer of assets to the GRAT is set when the initial funding of the Trust is implemented. The size of the annuity paid out to the donor will be discounted to present value by using an interest rate published by the IRS (the so called 7520 rate); the discounted annuity is then subtracted from the value of the assets passed on to the GRAT and the net result will be considered as the taxable gift. There are essentially two risks with GRATs: mortality risk and performance risk. In the first instance if the grantor dies before the annuity is completed, the value of the remaining assets will go to the taxable estate and the GRAT advantage will not be monetized. In the second case, if the investments in the GRAT perform below the 7520 rate, the GRAT is said to be “out of the money” and what has essentially occurred is a return of the assets to the donor via the annuity and the heirs will receive nothing. Looking to the future, there may also be a legislative risk as proposals have been circulating lately on ways to limit the tax advantage provided by the GRATs. Charitable Lead Trust (CLT) In our research, it has transpired that no successful family estate planning can overlook the philanthropic aspect. Managed philanthropy achieves multiple goals, from preparing heirs for the responsibilities associated with great wealth to optimization of fiscal liabilities. A CLT structure allows an investor to make a pre-defined annual gift to philanthropic projects of interest to her/him. Typically, CLTs are set up for terms of 10 or 20 years and the corresponding annual stream of distributions is often set on a fixed schedule determined by US Treasury rates, projected investment returns and projected self-liquidation. For instance, a family could fund a CLT with $2 million and set the term at 20 years. Assuming 2.2% IRS return rates based on current 10 Year US Treasuries, the CLT could pay $125,000 per year to be worth zero at the end of the term. However, if the CLT returns an average 7% annualized, there would be $2.62 million left to distribute at liquidation to the heirs tax free. Usually a $1 million minimum is suggested to establish a CLT. From a US investor’s perspective, cash and high basis marketable securities are the best assets to fund a CLT. Whether an investor decides to utilize a CLT or alternative structures such as Donor Advised Funds or Family Foundations, we have found that an investment plan that incorporates philanthropic objectives with specific personal, family, dynastic purposes and financial aims has a greater chance to achieve set goals more meaningful than just mirror indexes or benchmarks. Conclusion The extraordinary wealth creation of the last thirty years has produced a whole new different landscape in terms of financial management, performance analysis and wealth transferring. The business of investing cannot be dealt with in a vacuum anymore; performance analysis needs sophisticated tools and it must be contextualized beyond mere index benchmarking and ultimately all these steps must be coordinated with the proper training of the next generation. When a comprehensive financial blueprint is being laid out, not only investment risk tolerance should be determined but also a client’s loss of control tolerance and possibly his/her acceptance of transaction complexity. Proper planning requires an investor to truly understand the ramifications of such planning; one must truly understand what really is the ultimate desired result and the emotional issues associated with the strategy needed to achieve such final goal. Elements such as loss of control, current and future access to assets and the influence of wealth on the heirs must be analyzed clearly in order to chart the proper course. Values, proper communication rules, investment strategy and estate planning must come together into the process of “wealth engineering” and “financial architecture” to ensure successful results.