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How to Craft 'Super Roths' for Wealthy Clients

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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specific business or estate planning goals, but they generally view these products as expensive, needlessly opaque, or outdated.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.

Tax Efficiencies

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.

Cost Matters

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.”

Further, private placement life insurance may not provide the lowest level of insurance, according to Rembowski: “A lot of times COIs on private placement products are higher because private placement companies are using reinsurers instead of holding the insurance themselves.

The primary reason to choose private placement is the investment choices. You have access to private alts and hedge funds — the ugliest of the tax stuff. However, standard VUL products will have a list of ’40 Act Funds as well as a lower level of insurance. Advisors can select a portfolio of assets that work well within the product.”

General Account Portfolio

Life insurance companies invest premiums in a general account whose performance historically follows yields on intermediate-term corporate bonds that represent the bulk of their holdings.

In fact, the Federal Reserve estimates that life insurers hold 6% of credit market instruments in the United States. Life insurance products such as whole life and universal life accumulate cash value over time that reflects the performance of the insurer’s general account.

In a presentation at the 2021 AICPA conference, I compared the relative benefit of investments held in various product structures. At today’s favorable capital gains tax rates (which aren’t guaranteed to remain low), the optimal structure for investing in passive equities is generally an ETF. Stocks also benefit from favorable tax treatment on long-term gains, a step-up in basis at death, and the ability to make gifts of appreciated assets.

Income on bonds is taxed annually at ordinary income rates, which can significantly reduce after-tax growth over time. This is particularly true for high-income investors. And higher-yielding fixed income investments held within ETFs and mutual funds are particularly inefficient when held within taxable accounts.

A famous ad notes that Guinness beer “only has 125 calories — not on purpose.” Similarly, life insurance whose cash value is tied to the performance of the general account is exactly the type of investment that benefits the most from being held in an insurance wrapper.

The purpose of the general account portfolio is to provide the highest returns on safe investments used by insurance companies to fund intermediate- and long-term liabilities. In other words, the insurance company hires professional investors to build a broadly diversified portfolio of bonds that capture both credit and mortality premiums for policyholders.

Ross Junge, a chartered financial analyst and partner at McGill Junge Wealth Management in Clive, Iowa, is an expert in working with high-net-worth clients to leverage the benefits of whole life insurance products that incorporate a general account portfolio.

Junge notes that whole life helps “improve tax efficient accumulation, portfolio diversification, and multigenerational estate tax planning outcomes when integrated with traditional investments for the benefit of HNW clients.”

How does a whole life policy integrate with traditional investment portfolios? Growth in the cash value of the policy rises over time but, unlike a bond mutual fund that holds similar intermediate-term corporate bond-like assets, does not fall when interest rates or credit spreads rise. This steady growth can reduce the volatility of a client’s total wealth, allowing a higher optimal allocation of equities — particularly in taxable investment accounts.

A common criticism of whole life insurance policies is the high upfront commission, but the present value of advisor compensation can be lower for a commission product than a fee product when held for a long period of time. Agents also can structure the policy costs to increase competitiveness.

Junge notes that “fiduciary financial advisors who understand the benefits of permanent life insurance (PLI), how to appropriately size the allocation to PLI relative to a traditional investment-only diversified stock and bond portfolio, and how to structure policies designed to reduce the cost of insurance and maximize the tax-efficiency benefits, can significantly improve the financial planning outcomes for clients.

For HNW clients, the longer-term tax-advantaged accumulation and death benefit generally outweighs the early years cost of insurance.”

Building a Plan to Transfer Wealth

Most ultra-high-net-worth families have two primary goals: lifestyle and legacy. An advisor’s job is to develop a legacy plan that most efficiently transfers wealth at death.

Parrish recommends taking advantage of the historically high current estate and generation-skipping trust (GST) exemptions today to buy a life insurance policy under the exemption limit: “If the wealthy individual has an unused $12 million estate and GST exemption, use it to pay a single premium for a life insurance policy that may buy, say, a $28 million death benefit,” he says.

“Put it in a GST trust, and you’ve already skipped a generation, perpetuating the dynasty trust. Add in more sophisticated techniques like private split dollar and generational split dollar, and there is potential to further leverage up the gift. The bottom line is that you avoid estate tax on two generations through an asset that also is income tax free,” Parrish explains.

Both Parrish and Junge also recommend the use of life insurance within an irrevocable life insurance trust (ILIT) for wealthy clients. According to Parrish, “the good old fashioned ILIT with Crummey power gifts remains one of the most powerful estate planning tools for HNW individuals. Done properly, you completely avoid gift tax, estate tax and income tax on your bequest to future generations.”

Junge sees the ILIT as a transition for an insurance policy that initially serves the purpose of protecting against premature death, but in the long term becomes a valuable part of estate planning when HNW families shift their primary objective to estate planning.

According to Junge, “if the irrevocable trust is properly structured as a Generation Skipping Trust (GST) Trust, clients also can avoid estate tax on multiple future generations thus perpetuating multi-generational wealth transfer strategies.”

If estate planning strategies that involve the use of life insurance sound complicated, they are. An advisor needs to understand income and estate tax laws, asset location, insurance products, and how to implement a strategy without making mistakes. And advisors who work with UHNW clients need to recognize when life insurance does a better job of meeting client estate planning goals than traditional investments.

Many wealthy clients already use an insurance agent that specializes in comprehensive wealth management who can integrate investments and insurance. There is an attractive niche for advisors who make the investment in understanding when to use sophisticated life insurance strategies to manage wealth across generations.


Michael Finke is a professor and Frank M. Engle Chair of Economic Security at The American College of Financial Services. He can be reached at [email protected]