Investing in tax-sheltered hedge funds
Supplemental executive pensions and deferred bonus programmes of US corporations, although recognised on corporate balance sheets, have typically not been funded in advance of their distribution dates. CFOs have been convinced corporate assets would earn a higher after-tax rate of return if invested within the company than in a diversified portfolio of marketable securities. Further, they would say, the returns on a portfolio of marketable securities is taxed at ordinary income rates and will fluctuate in response to market conditions, very likely causing undesirable blips in corporate earnings. When offered the tax umbrella of variable life insurance contracts, their reply usually was: “Yes, avoiding taxes on investment returns is good and, yes, we can use the death benefit features to give us key man insurance coverage on our top people and fund supplemental life insurance benefits. But, and a big but, equities will still fluctuate in value and cannot beat our internal rates of return on corporate capital. Also, I know that variable life contracts high costs for premium taxes, commissions to insurance agents and charges by the insurance companies. Thank you, no.”
Corporate financial officers have been regrettably slow to recognise that these limitations no longer exist for big ticket buyers. Fortunately the situation is gradually changing. Influenced by the favourable experiences of universities, private foundations and endowments and, struggling with the impact of three years of negative returns in their pension trust portfolios, they have moved up the knowledge curve and begun investing pension trust assets in hedge funds, anticipating higher risk-adjusted returns and lower market volatility in those portfolios. They are becoming aware of a life insurance product innovation first designed and brought to the market about 10 years ago: private placement variable life insurance contracts with minimum premiums of $1m to $5m that allow high net worth individuals and families to employ tax sensitive hedge fund investment strategies while avoiding the taxes they would otherwise pay on the investment gains.
Telephone interviews we conducted late in 2003 with home office executives of a dozen private placement insurers, including several located outside the US, confirm this trend. The guidelines for successful execution of this appealing financial strategy were clarified in the summer of 2003 by two Proposed Rulings of the US Internal Revenue Service and a Notice of Proposed Rulemaking.
A corporation that systematically funds its supplemental executive pension and deferred compensation obligations by investing in carefully selected hedge funds through private placement variable life insurance contracts will enjoy many advantages:
o Good prospects for earning investment returns that compete successfully with the returns on capital invested in its primary business;
o By emphasising long/short equity strategies and absolute return strategies, little risk that fluctuating market values of the underlying hedge fund assets will destabilise the pattern of corporate earnings per share;
o Highly efficient transaction costs due to economies of scale;
o Low, negotiable and fully transparent commission payments to the insurance brokers;
o Key man life insurance coverage on the executives whose benefits are being financed in this fashion and;
o Most important, the opportunity to hand each retiring executive the private placement contract on his or her life, transferring a cash value equal to the corporation’s liability for that executive’s supplemental pension benefits and deferred compensation account balance.
No other financing technique provides a tax sheltered investment, insurance and retirement planning vehicle of equivalent significance for the departing executive’s future economic security.
William A Dreher is a Fellow at the Society of Actuaries and a managing director at Compensation Strategies in New York, part of the IBN Network