The Next Investor’s Dilemma: Reduced Returns in the Years Ahead

It Is Essential to Review Investment Strategies, Tactics & Administration

Background:

This recent publication by the McKinsey Global Institute is essential reading for any investor and I am pleased to bring it to your attention. The MGI research examines in depth the history of equity and bond market returns in the United States and Western Europe and persuasively argues that the interplay of many forces - low inflation, low economic growth, low interest rates and global uncertainties, both political and environmental - are likely to result in lower future returns on these asset classes.

The cover of the document and three of its exhibits can be found as a pdf on our site. They highlight the history of equity and bond returns and lay out the assumptions supporting the conclusion that future equity returns will range from 4.0% to 6.5%.

McKinsey’s work validates my own assessment. After a far less comprehensive examination of historic and current economic and financial market evidence I intuitively reached similar conclusions over the past year. 

This view of the coming investment environment stimulates a fairly fundamental question: How should a smart investor modify his or her investment policy and management practices in this new world of diminished expectations? This question has been implied, but not explored or answered in the MGI document.

Where We Are and Where Do We Go:

There are no "cookie cutter" answers to this question. Each investor's circumstances, risk appetite or tolerance, investment objectives and future prospects will shape the conclusions reached. However, a few broad principles are fairly obvious, whether future returns are lower than in the past or higher. A sensible set of guidelines will always provide the framework for a more granular examination of alternatives and a comparative assessment of suitable actions, but rewards for success are proportionately much higher in a low return environment. Three that have been the focus of my advice to the HNW individuals and families I represent are: 

  1. Accepting more investment risk
  2. Reducing investment management costs
  3. Reducing the taxes paid on investment returns

Each of these goals can be achieved in multiple ways:

  1. Accept more investment risk:
    1. Increase allocations to U.S. & developed market equities.
    2. Add an emerging market equity manager to actively manage a modest fraction of the allocation to equities.
    3. Search for managers who combine option strategies and either high quality debt or diversified equity exposure.
    4. Consider less liquid investments if anticipated returns are credible and sufficient.
  2. Reduce investment management costs:
    1. Shift the management of the core equity exposure to one or more index funds with comparable investment strategies and lower fees.
    2. Revisit allocations to hedge funds and challenge the cost/benefit ratio of hedge fund 2% & 20% fees in a lower return environment.
  3. Reduce investment taxes:
    1. Change trading practices to increase the % of returns that are taxed as long term capital gains. 
    2. Invest in tax advantaged investment products.

PPLI - The Ultimate in Tax Avoidance:

Private placement life insurance (PPLI) is a versatile and highly effective tax advantaged investment product. It is particularly appealing in the lowered expectations world portrayed by MGI's research. Its virtues include:

  1. Serving multiple purposes:
    1. Fund an endowment
    2. Build a bigger estate
    3. Be on call as a tax free reservoir of retirement income
    4. Lock in a surviving spouse’s ongoing life style
    5. Leverage the charitable gifting and naming opportunity potential of one’s capital
  2. Maximum investments, e.g., $20MM or more, are materially greater that 401(k) and other tax advantaged investment shelters.
  3. Investment gains accumulate with no immediate tax consequences.
  4. A higher net return after all charges than a taxable portfolio with the same investment strategy.
  5. Access to a medley of funds covering a wide range of investment strategies.
  6. Freedom to shift the contract’s cash value from one fund to another with no tax impact.
  7. Payments at death amounting to several multiples of the invested capital and, at the outset, as much as $85MM.
  8. The PPLI broker’s compensation is negotiable and materially lower than the commissions paid on retail insurance products.

My readiness to encourage PPLI investments is conditional: 

  1. The PPLI investment must be demonstrably superior to taxable alternatives.
  2. It must fit within the client’s overall investment policy and objectives.
  3. The client’s financial and legal advisors should sign off on its suitability.
  4. The client’s financial assets portfolio should exceed $20MM.
  5. The investment should be a modest fraction of that portfolio, say, from 10% to 25%.
  6. The PPLI account should be treated as a core portfolio position and invested in one or more low fee equity index funds.
  7. The client must be insurable.
  8. The contract should be designed to NOT be a Modified Endowment Contract (MEC), as defined in IRC Sect. 7702.

PPVA – Appealing, But Flawed:

Private placement variable annuity (PPVA), another ostensibly tax advantaged insurance product, has recently attracted substantial amounts of HNW capital. Its principal appeal – deferral of tax on investment gains – comes with a back end bear trap – taxation at ordinary income rates on all gains transferred, withdrawn or bequeathed. It serves well the purposes of only two investor types:

  1. Successful day traders. All of their investment gains are currently taxed at full ordinary income rates. Within a PPVA tax shelter those gains can be deferred for many years.
  2. Charitably inclined individuals and families. They can gift the PPVA’s investment gains at their discretion, transfer ownership of the PPVA contract while living or bequeath it to a tax exempt entity and offset the consequent tax obligations with matching and concurrent charitable deductions.

For a typical taxable equity investor, especially one who pays income tax rates mainly on dividends and whose capital gains are taxed primarily at long term rates, a PPVA investment accomplishes little or nothing.

PPVA investing shares with PPLI a few of the “virtues” noted above – see #s 3, 5 & 6, but is a poor resource for investors pursuing the objectives identified in PPLI “virtue” #1.

Comparing PPLI & PPVA:

One can say with assurance that the after tax annualized return from a PPVA investment will be materially lower than the return on a well-designed PPLI contract.

This example speaks powerfully to the point: Suppose that a man 48 years old, taxed as a Connecticut resident and in good health, invests $1.2MM per year for five years in a PPVA contract and has a gross return averaging 6.75%. His after tax annualized net return will be 3.56%. The same money, if invested in a PPLI contract and enjoying the same gross return, will have an “after all charges” annual return of 5.15%, an improvement of 1.59% in absolute terms or nearly 45% above the PPVA contract’s net return. Furthermore, the PPLI contract will include a death benefit of $28,680,000.

Decoding the PPVA Pitch:

Why then, have some investment firms been promoting PPVA instead of PPLI investing? The possible explanations include:

  1. Immediate investment. (Under IRC Sect. 7702 rules full first year investment in a PPLI policy intended to be a non-MEC forces up the death benefit and the related increase in mortality charges deducted from the PPLI account will reduce the policy’s net investment return. This problem is avoided by spreading the full investment over the first three to five years.)
  2. Unlimited investment amounts. (The amount invested in a PPLI contract is constrained by the insurance company’s retention and reinsurance limits.)
  3. Convenience. (The upfront appeal of PPVA’s tax deferred accumulation of gains can encourage careless thinking about the eventual taxes and quicker, unwise acceptance of a PPVA proposal.)
  4. Comfort. (Relationship managers with portfolio management skills, but limited experience with the life insurance underwriting process will be more at ease promoting the PPVA story.)

My advice to most clients is to avoid or exit any investments in PPVA, unless the contract is already owned by or has been promised to a tax exempt entity.

Finding a PPVA Exit Strategy:

For taxable PPVA owners I recommend a two-step technique for minimizing the tax obligation on all gains transferred to a new owner, withdrawn while living or gifted to a beneficiary.

  1. Promptly gift ownership of the contract to a tax exempt entity. Any investment gains at the date of ownership transfer will be taxed as ordinary income. The full cash value of the PPVA contract will qualify as a charitable contribution.
  2. Invest the net amount recovered (the tax savings associated with the charitable contribution less the tax paid on the investment gain) in a non-MEC PPLI contract.

A Deeper Look at the PPLI Concept:

Our 2015 booklet, Private Placement Life Insurance: The What, Why, Who, How, How Much and Why Not of It, describes the PPLI story and demonstrates persuasively its comparative advantages over PPVA and conventional taxable investing. The text and exhibits from the booklet are password protected on our website. To access, you must register as a qualified purchaser here. The underlined words in the document link to each of the booklet’s 15 Exhibits.Call or email us if you want a hard copy of the booklet.

Closing with a gloomy final observation:

Another important and disturbing reality identified by MGI relates to defined benefit pension plans and the actuarial assumptions currently being used to measure their liabilities. The investment assumptions underlying these calculations are typically around 7.0% and even as high as 8.0% for some plans. Using more realistic assumptions would materially increase those liabilities and the annual cost to fund a plan’s benefits. The implications are particularly dire for plans covering public employees. Higher taxes to cover those costs, forced reductions of benefit levels, political fallout and even bankruptcies are likely consequences.

As always, I will welcome your comments and questions about my views on strategies for optimizing net portfolio returns in the coming years.

With my regards,

William A. Dreher, F.S.A.
Consulting Actuary
Compensation Strategies, Inc.