How to Craft 'Super Roths' for Wealthy Clients
What You Need to Know
- Insurance is a powerful way for advisors to help out high-new-worth clients in transferring wealth to others.
- Life insurance allows assets held in the structure to grow in a tax-deferred environment.
- Advisors should take advantage of the historically high current estate and generation-skipping trust exemptions to buy a life insurance policy under the exemption limit.
The historical split in advisor identity between insurance agents and investment advisors, arising from differences in regulation and compensation, created a wedge that often obscures the benefits of cash value life insurance as a product structure. These benefits can be significant for high-net-worth clients who have exhausted tax-sheltered savings opportunities and expect to transfer a large share of wealth to others.
Because of the reluctance of investment advisors to develop their knowledge of insurance, more insurance agents have mastered the tools of investment planning. In doing so, they have become comprehensive wealth managers who specialize in providing integrated insurance and investment solutions for high-net-worth clients.
Fewer fee-compensated investment advisors have developed the skills needed to wade through the complex world of life insurance products and strategies. Many investment advisors consider life insurance only for specific business or estate planning goals, but they generally view these products as expensive, needlessly opaque, or outdated.
The emergence of fee-based insurance that offers compensation for RIAs and fee-based advisors removes the financial disincentive to consider the use of life insurance as an alternative to traditional investments to meet client goals. Tim Rembowski, vice president at DPL Financial Partners, expects other fee-based insurance products to enter the market in the coming year.
Like an ETF or a mutual fund, life insurance is simply a financial product structure with its own set of regulations and tax rules. Tax laws on life insurance allow assets held within the structure to grow in a tax-deferred environment that can more efficiently meet long-term legacy goals than investments held in other product structures.
In a recent blog post, Rajiv Rebello, principal and chief actuary of Colva Capital, compares the structure of life insurance to a “Super Roth” that “allows for a more optimal risk-adjusted and tax-efficient portfolio solution that protects clients from current and future tax increases.”
Rebello points to the efficiency of using tax-inefficient investments to power the growth in cash value and death benefit in life insurance products. Basic principles of asset allocation do not consider the frictions of ongoing tax drag.
Investors can receive a higher after-tax return on their portfolio by paying attention to the relative tax efficiency of assets placed in various accounts and products. Fixed income investments in particular are well suited to accounts or products that are not subject to annual taxation on growth.
Being creative about fixed income investments is even more important in a low-interest-rate environment, particularly when reaching for higher yields by investing in longer-term bonds or taking greater credit risk — which is fraught with the potential for a loss if interest rates rise or the economy contracts.
Rebello notes that after-tax return on annually taxable bonds (held in non-qualified accounts) will likely be negligible or even negative after advisor fees. The most recent yield on a Vanguard high-yield municipal bond fund is 2.18%.
Advisors can generate “tax alpha” by allocating fixed income and other tax-inefficient investment strategies within a life insurance wrapper. Rebello lists high-yield debt, life settlements, hedge fund strategies such as long/short, and high-turnover investments as examples of investments where tax alpha can be achieved using life insurance.
The illiquidity of the life insurance wrapper also can improve access to an illiquidity premium on fixed income investments that may not be captured in a mutual fund or ETF.
Private placement variable universal life (VUL) insurance may be particularly attractive to ultra-high-net-worth investors. As a reminder, variable universal life contains a separate investment account that funds the cost of life insurance (roughly the probability of dying multiplied by the death benefit plus expenses).
Most large life insurance carriers offer private placement VUL with lower expenses than other VUL policies as well as a broader array of tax-inefficient investments.
Life insurance costs traditionally include large upfront commissions, but private placement VUL substitutes a small trail commission for the agent who manages the policy and offers investment advisors the ability to apply an investment fee on assets held within the policy.
“Due to the lower-cost nature of private placement contracts, they have larger cash values, especially near the inception of the contract,” DPL’s Rembowski notes.
Another advantage of products developed for the high-net-worth market is the reduction in mortality expenses. Higher-income Americans, on average, live longer.
According to Rebello, private placement life insurance is appropriate for clients who have at least $1 million to $2 million to commit to premium payments over four years and have more than $5 million in investable assets.
The products also provide estate tax benefits, so in addition to higher after-tax growth, life insurance can provide estate tax alpha — particularly in states that impose their own estate tax. Rebello notes that private placement VUL also can offer “significant improvements over existing grantor trust strategies that ultra-high net worth clients use for estate reasons.”
An important difference between life insurance and investments is expense disclosure. The cost of a death benefit is a function of mortality expectations, investment performance and fees.
Mortality costs can be lower for UHNW clients in products developed for this audience, such as private placement and business-owned policies. Investment fees are clear in variable policies and opaque when investments are managed in-house by the insurance company.
Expenses often are lumped in with mortality costs in a category known as “cost of insurance,” or COI. Steve Parrish, adjunct professor of advanced planning at The American College of Financial Services, says: “Mortality costs are the great mystery with life insurance. First, COIs on universal life products are not mortality. They are a mishmash of mortality and expenses.
So don’t look to COIs to tell you much of anything.”