The first variable annuity (VA) was conceived in 1952. At the time, Dr. William C. Greenough, an executive vice president at the Teachers Insurance and Annuity Association of America (TIAA), was alarmed that “the factor of inflation has pretty generally been disregarded in past planning for retirement income.”
Dr. Greenough and his TIAA colleagues conducted an exhaustive economic study covering the years 1880-1951 that examined the impact of inflation on college professors’ retirement plan income. TIAA was greatly concerned that the “purchasing power” of retired teachers’ fixed-dollar annuities had been halved as the result of inflation’s toll. TIAA sought and received a ruling from the Bureau of Internal Revenue (now Internal Revenue Service) that a participant “… would not currently be taxed… on dividends or capital gains on his share of Equities Fund.” This set the stage for tax-deferral growth of variable annuity account values.
TIAA’s pioneering research helped remove the fear of owning stocks to fund long-term pension obligations. TIAA launched the first variable annuity on July 1, 1952, when it began operations for the College Retirement Equities Fund.
Years of Avoidance
Over the past 65-plus years, annuity issuers and distributors have strayed far away from the original purpose of a variable annuity to provide tax-deferred growth and purchasing power protection. They added early withdrawal charges and bells and whistles in the form of optional living and death benefit riders to variable annuity chassis. An unintended consequence of these chassis modifications is that VA costs and complexity have ballooned.
While some VA “enhancements” may appeal to select annuity buyers, their added cost and complexity has caused many fiduciary advisors to avoid variable annuities like the plague—particularly with their more affluent and ultra-high-net-worth (UHNW), cost-conscious investors.
Most fiduciaries, such as trust officers or Registered Investment Advisers (RIAs) avoid VAs because of upfront commissions, hefty surrender fees, high mortality and expense (M&E) charges, costly riders and opaque terms. But there was another formidable obstacle that held back investment fiduciaries from considering variable annuity allocations.
The IRS made life especially difficult for fee-based advisors who recommended variable annuities. Up until August 2019, the IRS considered money withdrawn from an annuity account to pay an advisor’s managed account fee to be a taxable distribution—even though the money was never pocketed by the investor. This tax was levied solely on fee-based annuities. Fortunately for fee-based advisors, the IRS ended this unpleasantness on Aug. 7, 2019, in a private letter ruling to Lincoln Financial and Nationwide Insurance. The IRS ruling stated that an advisor could receive a wrap-account fee as much as 1.5% of the annuity's value, annually, as a fee without requiring clients to report it as taxable distribution.
Fresh Look for Fiduciaries
Private placement variable annuities (PPVAs) return to the VA inventor’s original idea—tax-deferred growth and purchasing power protection. This return to the future amounts to a simplification of the retail variable annuity design that’s especially attractive for HNW households and UHNW investors. The PPVA has been stripped down to its most basic elements and its raison d’etre—potential for capital growth on a tax-deferred basis.
One way to contextualize private placement variable annuities is to illustrate what it isn’t! It’s not a retail VA with high costs, added riders ad infinitum, surrender fees and opaque language. It’s not a tax avoidance loophole. PPVAs are authorized under Internal Revenue Code Section 72. PPVAs don’t require medical exams or underwriting. Unlike 401(k) plans’ $19,500 annual limit in 2020 (and other caps on executive benefit plan contributions) there are no limitations on the amount of premiums invested. It’s important to note that there are no guaranteed death benefits, leaving the selection of life insurance coverage to individual choice. The PPVA owner accepts the investment risk and benefits of the underlying investment sub-account.
UHNW investors, “qualified purchasers” (defined by the U.S. Securities and Exchange Commission as $5 million of investable assets) and investors with exposure to traditionally tax-inefficient asset classes (hedge fund/private equity; quant-strategies with high turnover; exposure to emerging markets or high yield debt) represent the ideal beneficiaries of the PPVA. Generally, affluent investors with multi-asset class portfolios in high income tax states (think California, Oregon, Minnesota, Iowa, New Jersey and New York) can also benefit. There’s an added benefit of owning partnership investments in a PPVA package-no K1.
PPVAs have historically been organized by sophisticated insurance professionals who work in the HNW space. For the typical Registered Investment Advisory firm however, with no history or capacity in the insurance product area, PPVAs are almost anathema, simply because of the word “annuity” which in the fiduciary world is one of the most put-upon terms in the lexicon. That said, it’s hard to imagine a complete wealth management offering without insurance product capabilities. Moreover today’s PPVAs can’t be compared to retail annuities. PPVAs are really tax-alpha generators attached to otherwise taxable investments.
PPVA Conquers the Tax Drag.
When given a choice to invest in alternative investments on a tax-deferred or taxable basis, most affluent and UHNW investors will choose tax-deferral (or tax-free, if available). The reasons are twofold. First, tax-deferred accumulation of dividends, interest and capital gains grow much faster than taxable returns (think back to the Rule of 72). Second, many of the alternative asset classes described above are considered “tax-inefficient.”
A 2014 Deutsche Asset & Wealth Management report, published in Trusts & Estates magazine, found that many hedge fund and emerging market strategies have an “Annual Tax Drag” of 3.50-2.50%. That means investors who own these strategies in taxable accounts forfeit 3.5-2.5% of annual returns to the “tax man.” By owning these potential profitable (and non-correlated) assets in an PPVA chassis, investors have an opportunity to beat the Tax Drag on current income taxation and select hedge funds’ inefficient tax treatment. (See illustration below.)
Assumptions Results
1,000,000 investment Taxed
7.00% net return $1,508,958, 4.22% CARR
10 year hold Deferred
40% federal and state tax $1,967,151, 7.00% CARR
Added Benefits
There are two added benefits for PPVA policyholders. If the PPVA purchaser is dissatisfied with the performance of the asset manager(s) in the variable account, IRC Section 1035 offers an attractive escape clause so that the policyholder can transfer account values to another PPVA without triggering a taxable event. Because there are no upfront fees or nuisance withdrawal charges, Section 1035 transfers are frictionless transactions.
One final reason to consider “Back to The Future” variable annuities: the PPVA allows charitable donors to control ownership and distribution of assets earmarked for future bequeaths to non-profit charities and foundations. A philanthropist can name his favorite charity as the primary beneficiary of the PPVA while still controlling ultimate disposition of the assets. Conversely, an individual can name a charity or foundation as the contingent beneficiary of the PPVA. That way, the PPVA policyholder maintains the option of the VA’s primary beneficiary to change the terms and disallow any part of the PPVA account value to be disbursed to the designated charity.
The PPVA is by and large an undiscovered gem, particularly as it relates to fiduciary advisors seeking solutions for their HNW clients.
*Opinions are solely those of the author and Little Harbor Advisors LLC.
Rick Roche, CAIA is a partner at Little Harbor Advisors LLC.