Volatility from geopolitical shocks, trade skirmishes and the start of the 2020 presidential election cycle makes it an opportune time for multi-family offices (MFOs) and registered investment advisors to focus on strategic repositioning of client portfolios. Given the directional biases markets have displayed post-crisis, investment advisors are increasingly looking at alternative investments as a way of diversifying client portfolios and potentially providing downside protection against any unforeseen or sustained volatility.
For forward-thinking investment advisors looking to provide premier wealth structuring solutions to their high net worth clientele, the use of insurance dedicated funds (IDFs) has long been a highly efficient way of accessing alternative investment strategies in a more tax efficient manner. IDFs, simply put, are investment funds offered exclusively through insurance carriers and available as underlying investment options through either a private placement variable annuity (PPVA) contract or a private placement life insurance (PPLI) policy.
Since their inception in the late 1990s, IDFs have been an attractive vehicle for investment advisors seeking exposure to alternative investments through tax efficient PPVA and PPLI structures. An IDF offered through an insurance carrier executes the investment strategy and objective as set by the IDF’s manager. Increasingly, however, ultra-high net worth individuals are looking for highly customized investments and investment advisors who can provide and adapt investment strategies on a continual basis.
So where can an investment advisor turn when the selection of IDFs available fails to provide options that appeal to a specific client? The answer is a Separately Managed Account (SMA). An SMA structure, also available through insurance carriers, is an alternative to an IDF that similarly acts as an asset allocation tool to tax optimize client portfolios. Importantly, however, some SMA structures bring the added benefit of allowing investment advisors to create bespoke programs of traditional and private investments, which, in many instances, may be tailored to each individual client’s risk tolerance and investment objective. The ability for investment advisors to customize investment solutions for their clients provides for more involvement in managing their clients’ tax efficient assets helping align interests with their clients for the long term. This is one of the driving forces behind the significant growth and adoption of these SMA structures over the past several years.
Like an IDF, an SMA is a variable product investment option available to a policy owner. An SMA is established through a contractual agreement between the insurance carrier and the investment advisor. That agreement governs the SMA’s investment program and includes provisions that ensure the investment advisor manages the portfolio in accordance with certain investor control and diversification requirements under federal tax law. Once the SMA has been established, and assets from the insurance contract have been allocated to the SMA, the account value of the SMA will increase or decrease over time based upon the performance of the underlying investments. Meanwhile, the client that holds the PPVA or PPLI contract benefits in that no current tax liability results from any investment activity within the SMA’s portfolio, including any reallocations that are made within the SMA, while the insurance contract is in force.
An SMA structure can provide investment advisors with the ability to create a customized portfolio based on a client’s individual needs – much like the traditional client-advisor relationship. The client’s investment criteria might take the form of geographic preferences, specific investment strategies, favored asset classes, target volatility exposure, etc. Given this flexibility, SMAs can offer a broader array of investment options for a client that holds a PPVA or PPLI contract, i.e., outside the limited number of IDFs already available on an insurance carrier’s ‘menu’. Furthermore, PPVA and PPLI policies significantly reduce the administrative burden on the investment advisor and client by eliminating the need for both subscription document completion, which is handled by the insurance carrier, as well as eliminating any annual K-1 reporting associated with the investments.
However, in order to comply with federal tax law requirements and obtain the tax benefits of PPVA and PPLI contracts, the client does have to relinquish personal control over the investments held in an SMA. The client may choose the investment advisor who will manage the SMA’s portfolio, but the client’s control over the specific investments being made ends there. The SMA’s investment advisor has total discretion over the portfolio and independently decides upon the specific investments within the SMA, with no input from the client, in order to meet the client’s investment objective – much like the traditional client/advisor relationship. One potential benefit of this type of SMA structure is that the investment advisor can modify the investment strategies of the SMA as the client’s risk tolerance and investment objectives change over time, giving full flexibility to adapt the portfolio as the advisors view on the market changes or there is a change to a client’s overall financial plans
Given that IDFs may limit an investment advisor to choosing from a set list of funds offered by a given insurance carrier, some SMA may structures offer a more holistic wealth management solution that afford client advisors the ability to do what they do best – offer tailored investment advice that fits the needs of their client.
C. Penn Redpath, Managing Director, Lombard International (USA)
Disclosure: This overview is not intended and is not to be construed as definitive legal or tax advice. Prospective clients should consult their own independent legal and tax advisors for advice in light of their particular situations. This is not an offer to sell or a solicitation of an offer to buy a security or insurance product.