In the process of helping to create and advise many hedge funds over multiple decades, I have seen some important trends develop. In the beginning, funds generally reported their investment returns before investment management fees. Then, as investors became more aware, it became essential to report returns, net of all fees.
The Tax Challenges of Hedge Fund Investments
In recent years, U.S. taxable investors, who still constitute the largest segment of hedge fund investors, frequently want to know investment return, net of all fees, and net of income tax.
Tax Inefficiency of Hedge Funds
Most hedge funds are tax-inefficient. They produce mostly short-term capital gains and ordinary income, taxed at rates (including state and local tax) up to 50%. However, we doubt that there is an average hedge fund. We have never met an average hedge fund manager.
Understanding the Tax Landscape
This time, we are assuming that the tax on an average hedge fund’s income is 35%, consisting of mostly short gain and ordinary income (or significant long-term capital gain but subject to substantial state or local tax). If you are a hedge fund investor or manager, the real income tax rate you or your investors pay on hedge fund income is probably higher.
Solutions for Mitigating Tax Burden
How can this ugly tax picture be improved? The cash value build-up within a life insurance or annuity policy is not subject to income tax so long as the investment remains within the policy. The death benefit of a life insurance policy is income tax-free. These tax benefits can be made available for hedge fund investments by the use of private placement life insurance and annuities.
How Private Placement Annuities Work
Under an annuity policy, the investment goes to a separate account managed for the insurance company by an investment advisor. The purchaser makes their investment as a premium payment which, after policy costs, is invested by the financial investment advisor either directly or through one or more hedge funds or separate accounts. When the policy owner withdraws funds from the policy, they pay tax on the income at ordinary rates (plus an excise tax of 10% of the gain if they are the age of 59.5).
Leveraging Life Insurance Policies
The life insurance policy works in the same way, except that to qualify as a life insurance policy for tax purposes, a certain amount of essentially term life insurance must be purchased, determined by the age of the investor and the type of policy.
Tax Benefits at Death
At that person’s death, the policy pays the amount of pure (term) insurance then in place, as required by the policy, plus whatever is in the cash account, to the beneficiary, free of income tax. The entire death benefit (including all the earnings from the hedge funds and/or separate accounts) is received by the beneficiary free of all income tax.
Additional Benefits
| Age | Single Premium | End of Year Cash Value | Death Benefit (Including Cash Value) | Taxable Account (At 35% Tax) |
|---|---|---|---|---|
| 50 | $5,000,000 | $5,398,996 | $17,782,027 | $5,390,000 |
| 53 | $6,561,573 | $17,782,027 | $6,263,632 | |
| 60 | $13,594,803 | $18,217,036 | $10,596,382 | |
| 70 | $39,928,676 | $46,317,264 | $22,456,663 | |
| 80 | $117,942,390 | $123,839,720 | $47,591,877 | |
| 90 | $343,582,426 | $360,761,548 | $100,860,340 |
Under certain policies, so long as the policy is not terminated, a substantial portion of the cash can be withdrawn as a loan on an income tax-free basis. The table above compares the return on a sample hedge fund life insurance policy purchased at age 50 for $5 million against a taxable investment of $5 million.
A Comparison of Investment Strategies
The chart assumes a 12% return per year on the hedge fund investment and uses the costs of an actual policy. The taxable account column assumes a 35% tax rate. Of course, the chart shows illustrated results. The ultimate results will depend, among other things, upon the actual charges imposed by the particular insurance company, the actual investment performance achieved by the hedge funds selected, and the investor’s actual marginal income tax rate.
In my experience in working with these policies over the last 30 years, generally, investors purchase these life insurance policies when they are already investors in hedge funds but would like to make the least tax-efficient portion of those investments more tax-efficient. On occasion, the purchaser also wants and needs life insurance coverage, and for that person, the policy is even more beneficial.
Hedge Fund Annuities and Asset Protection
Hedge fund annuities are similar to hedge fund life insurance but do not provide a sufficient death benefit to be considered life insurance for U.S. income tax purposes. Although annuities generally cost less than life insurance, annuities defer but do not eliminate U.S. income tax.
An additional benefit of the life insurance or annuity policy is that it generally is a good form of asset protection. The funds in the separate account of the insurance company are generally not exposed to creditors’ claims against the insurer arising out of any of the insurer’s other operations, and the separate account is usually protected from the claims of creditors of the policy owner.
Estate Planning and Wealth Transfer
One of the key elements of effective estate planning is to make gifts of assets in trust so that the assets in the trust will not be subject to estate tax in the estate of the person who makes the gift (the “donor”). The beneficiaries of the trust are often the donor’s spouse and issue (children, grandchildren, etc.). So long as the donor’s spouse is living and friendly with the donor if the assets in the trust are really needed, they can be “recaptured” by distribution to the spouse.
Since 1995, under a Treasury Ruling, the donor can keep substantial control over the trust by retaining the right to fire and replace the trustee. (The replacement trustee can be anyone the donor selects except a close relative or subordinate employee.) The best assets to give to such a trust are assets that will grow substantially over time. A number of our wealthy estate planning clients have felt that the best class of assets to select would be hedge fund investments within a life insurance policy, so the trust assets grow at hedge fund rates, free of income tax.
Case Study: Wealth Transfer and Tax Efficiency
For example, suppose a donor creates such a trust in December 2003, when they are 50 years old, and gives it $2 million. If the donor and the donor’s spouse have not used any of their gift tax exemption, this gift would be U.S. gift tax-free. Then, the donor loans the trust $3 million at the lowest interest rate for a long-term loan allowed without the loan’s being treated as a gift for gift tax purposes (these rates, announced by the IRS, change monthly).
Assume that the loan is kept in place for 40 years until the donor dies at age 90. At that point, the trust owes the donor’s estate about $21.1 million on the loan. The trust invested $5 million in hedge fund insurance. At the donor’s death (see table above), assuming a 12% return, the trust (or donor’s beneficiaries) would receive an insurance death benefit of about $360.8 million, which is about $350 million after paying the estate tax on the loan. This PPLI benefit would be free of income, estate, and generation-skipping tax.
Comparing Investment Strategies
In a number of states (including Delaware and New Jersey) that have repealed the rule against perpetuities, the trust could continue forever, free of estate and generation-skipping tax. Compare three much less favorable alternatives. For purposes of this comparison, we assume that the donor dies at age 90 (in the year 2043) and that the donor’s estate will be subject to a 50% estate tax. (Of course, the rate or even the existence of the estate tax far into the future is speculative, but we think it is very likely that there will continue to be an estate tax on very large estates, taxed at 50% or more.)
The Impact of Investment Choices
The first alternative is a direct investment in the hedge fund (not through the insurance policy) without any trust. If the donor invested the $5 million in the hedge fund directly, he or she would have ended up with about $100 million (see the “Taxable Account” column in the table above). The investor’s beneficiaries would end up with about $50 million after the 50% estate tax, about a seventh of where they end up with the optimal planning discussed above.
Wealth Transfer through Insurance
Under the second alternative, the donor would set up the trust, the trust would invest in the hedge fund directly, and the beneficiaries would end up with about $100 million. Under the third alternative, the donor would buy hedge fund insurance but not in a trust. Under this alternative, the beneficiaries would end up with about $180 million (the $360 million death benefit less a 50% estate tax). Under these assumptions, all three alternatives are much worse than the optimal planning (using the trust as the owner and hedge fund insurance).
Considerations for Hedge Fund Life Insurance
In any event, this exercise shows that hedge fund life insurance can add substantial value to estate planning. Hedge fund life insurance is not for everyone. Since insurance companies often require high minimum premiums (usually $5 million to open a separate account and $1 million in premiums for each policy, requiring, for example, five 1 million dollar policies or one $5 million policy to get started), it is generally appropriate only for wealthy individuals or families.
Balancing Control and Tax Efficiency
The biggest problem for a potential investor (other than the high minimum) is generally that there is some loss of investor control. Although the investment manager of the insurance company’s separate account can generally change investments or reallocate among hedge funds whenever they want to do so, the policyholder cannot hire and fire the investment manager, or move or reallocate assets whenever they want to do so. The insurance company ultimately has the power to hire or fire the investment manager.
Compliance with IRS Regulations
Some policies give policyholders some choice concerning the investment of the separate account, and, of course, the policyholder can always surrender the policy (with negative tax consequences) or move the policy to a different insurance company (incurring brokerage commissions and other costs). The investor control issue is one of the trickiest issues related to this type of policy since if the policyholder has too much investor control, the IRS might be able to claim that the investor should be taxed on the earnings currently. In 2003, the IRS released a proposed regulation and two revenue rulings, which place some restrictions on the tax advantages of private placement variable life insurance invested in hedge funds.
Complying with IRS Guidelines
The proposed regulation does not prevent such policies from investing in hedge funds nor change the income tax deferral and elimination (or estate tax planning) benefits of such policies. In order to meet the diversification requirement so that the policyholder will not be taxed on hedge fund earnings, the proposed regulation (which is not yet effective) requires that the insurance policies either: 1) invest in a hedge fund that is open to insurance companies only, or 2) invest in a diversified portfolio of at least five hedge funds, if the hedge fund investments are open to non-insurance investors.
Investment Strategies for Tax Efficiency
The revenue rulings also place restrictions on the insurance policyholder’s ability to choose the underlying hedge fund investments (especially if the hedge fund allows non-insurance investors). As a result of these recent developments, many hedge funds or funds of funds are forming insurance-dedicated funds, open to insurance companies only.
The Role of Insurance-Dedicated Funds
An insurance dedicated fund (sometimes called a “cloned fund”) often invests similarly. It receives the same or similar investment returns as the same manager’s existing hedge fund or fund of funds. Some insurance companies are issuing policies that allow investors to choose among many such insurance-dedicated funds. Properly structured, the IRS guidelines allow such investments, including the investor’s right periodically to reallocate the investment among a number of cloned funds.
Flexibility in Investment Choices
Alternatively, the policyholder can allow an independent manager appointed by the insurance company to allocate the insurance account among five or more hedge funds which are open to investors who are not insurance companies.
Frequently Asked Questions
What Are The Main Trends In Hedge Fund Investment Return Reporting?
Over the past 25 years, the trend in reporting hedge fund investment returns has shifted significantly. Initially, funds typically reported their investment returns before considering investment management fees. However, as investors became more informed and discerning, it became crucial to report returns net of all fees. This evolution reflects a growing emphasis on transparency and the actual value received by investors, aligning reported performance more closely with the real gains they experience.
Why Are Hedge Funds Considered Tax-Inefficient And What’s The Typical Tax Rate?
Hedge funds are generally considered tax-inefficient due to their tendency to generate short-term capital gains and ordinary income, which are subject to higher tax rates. The text assumes a 35% tax rate for an average hedge fund’s income, consisting predominantly of short-term gains and ordinary income, or substantial long-term capital gains subjected to significant state or local taxes. This high tax burden reduces the net returns for investors, making these investments less attractive from a tax perspective.
How Do Private Placement Life Insurance And Annuities Reduce Hedge Fund Tax Burdens?
Private placement life insurance and annuities offer a solution to the tax inefficiency of hedge funds. These vehicles allow the cash value build-up within a policy to be exempt from income tax as long as the investment remains within the policy. Additionally, the death benefit of a life insurance policy is income tax-free. This setup can significantly improve the tax efficiency of hedge fund investments by shielding them from immediate tax liabilities and providing tax-free benefits in certain circumstances.
What Is The Mechanism And Tax Impact Of Private Placement Annuities?
In private placement annuities, the investor’s funds are allocated to a separate account managed for an insurance company by an investment advisor. These funds, after deducting policy costs, are invested directly or through hedge funds. Withdrawals from the policy are taxed at ordinary rates, plus a potential 10% excise tax if the policy owner is under 59.5. This structure provides a deferral of income tax, allowing investments to grow tax-deferred until withdrawal.
What Are The Benefits Of Using Life Insurance Policies In Hedge Fund Investments?
Leveraging life insurance policies in hedge fund investments involves purchasing a certain amount of term life insurance, where the policy pays out the insurance amount and cash account balance tax-free to the beneficiary upon the policyholder’s death. This method allows the investments within the policy, including earnings from hedge funds, to be received by beneficiaries free of income tax, thus providing a significant tax advantage.
How Do Life Insurance And Annuity Policies Aid In Estate Planning And Asset Protection?
Life insurance and annuity policies are beneficial for estate planning and asset protection. These policies can be used to transfer wealth to beneficiaries free of income and estate taxes. Additionally, the funds within these policies are generally protected from creditors’ claims against the insurer and the policy owner. This makes them an effective tool for safeguarding assets while efficiently transferring wealth to future generations.
What Should Hedge Fund Managers And Investors Consider About Hedge Fund Life Insurance And Annuities?
Hedge fund life insurance and annuities are not suitable for everyone and are typically appropriate for wealthy individuals due to high minimum premium requirements. They offer tax-free growth, deferral, or elimination of income tax, and potential estate tax-free payouts. However, they come with limitations, such as loss of some investor control and compliance with IRS regulations. Hedge fund managers might find these policies advantageous for attracting and retaining investors by increasing after-tax returns and potentially deferring fees.
Benefits for Investors and Hedge Fund Managers
Although the lack of investor control and other limitations may be a problem, the degree of control permitted varies from policy to policy. The tax-free build-up with a successful hedge fund or investment managers and the income tax deferral or the income tax-free and possibly estate tax-free payout at death makes these policies very attractive to certain wealthy investors. Hedge fund life insurance and annuity policies also provide potential benefits for hedge funds and their managers.
Marketing Advantages for Hedge Fund Managers
These policies are often good marketing devices for hedge fund managers since the insurance provides a way for an investor to increase their after-tax returns substantially, a point worth making to a wealthy potential hedge fund investor. The funds placed in the policy are likely to grow faster (since, with income tax on the investment deferred or eliminated, the investor will not need to withdraw money from the fund to pay tax on their share of the fund’s income).
Considerations for Hedge Fund Managers
In addition, the investment is less likely to be withdrawn or switched to another hedge fund or other investment because of the tax or commission costs of making a switch. It may be possible, through these policies, for hedge fund managers to defer fees with respect to domestic investors.
The Role of Insurance-Dedicated Funds
Based on the recent developments discussed above, many insurance companies and potential policyholders prefer that the insurance or annuity’s cash value be invested in an insurance-dedicated or cloned fund. Since most hedge fund managers do not run insurance-dedicated hedge funds, hedge funds willing to form such funds may have a significant marketing advantage. Some hedge fund managers are unwilling to create an insurance-dedicated fund. Other hedge fund managers believe that the extra administrative difficulty of running an additional fund (or separate account for an insurance company) and “splitting tickets” is not a significant burden, or is worth the trouble for the additional insurance funds that can be raised.
The Future of Hedge Fund Life Insurance
Although hedge fund life insurance and annuities are not for everyone, in the right circumstances, they can provide very significant benefits to both policyholder investors and hedge fund managers. Recent developments have restricted some forms of hedge fund life insurance and annuities but have not limited the very significant tax advantages of properly structured policies.
Tax Clarity and Investor Attraction
The current IRS rulings and proposed regulation may increase the popularity of private placement life insurance and annuities invested in insurance-dedicated hedge funds. It is often difficult to market a financial product in the absence of tax clarity. The recent rulings and proposed regulation increase the tax safety of some of these policies and, in any event, make the position of the IRS clearer. This clarity should make a number of these policies attractive to investors.
