Currently, an arbitrage opportunity presents itself to sophisticated investors whereby interest bearing loans (interest paid currently and loans retired in less than ten years) made to a trust for the benefit of family members can create guaranteed Internal Rates of Return (IRR) that far exceed those available from most portfolio assets. As the accompanying study illustrates, if trust assets grow at a modest 6% annual rate, the underlying trust will have grown terminal value to in excess of $16,145,000 in year 27 (the joint life expectancy of the hypothetical couple used in the study).
That equates to a 12.5% tax-free IRR for the trust assets (19.3% pre-tax).
This program is not a riskless arbitrage. Risk may be associated only with the trust’s ability to achieve annual growth of 6% during the loan period and longevity of the investors. To the degree that growth rates fall below 6%, loans may be extended beyond 9 years and, correspondingly, IRR’s will not be as high as illustrated. Additionally, because the trust matures upon the death of the investors, if the trust outlasts actuarial assumptions, IRR’s may be less than indicated above (see accompanying schedules).
This program is Internal Revenue Code (IRC) compliant. Rates of interest charged to and paid by trusts using program are based on the Applicable Federal Rate (AFR) for mid-term loans and are published monthly. Once established, loans will bear that AFR for the term of the loan.
Perhaps a successful individual is not interested in further estate planning. This approach understands that position and posits that the Privately Financed Guaranteed UL Program, aside from offering a superior investment experience, may enable investors unique opportunities to expand both charitable and non-charitable goals that previously weren’t possible or were deferred.
For most wealthy clients, estate planning is an ongoing process. Growing estates rely on sophisticated financial planning strategies which might include family limited partnerships, personal residence trusts, GRAT’s, GRIT’s, GRUT’s, life insurance trusts and old fashioned gifting to succeeding generations to achieve financial goals for heirs. At some point, many clients say, “enough is enough”. The children and grandchildren will be well positioned for the future and additional planning may have diminishing importance as estates get larger.
Paradoxically, while the importance of estate planning may decline as estates grow in size, the importance of conservative investment returns grows with greater wealth accumulation. It is common to see investment portfolios structured with large exposures to municipal and government bonds and lesser positions in equities and more exotic investments such as private equity, hedge funds or distressed security funds.
It appears that ongoing investing is part of our DNA and that, despite the fact that future asset growth may not affect a client’s comfort in a meaningful way, prudent and wise investment is a goal that we pursue throughout our lives. What motivates us to take this path varies from person to person but it is undeniable that very few successful individuals ever stop searching for good investment opportunities.
Basics of Concept:
Loans between individuals or individuals and trusts, in order to be considered a valid loan, must be interest bearing at a rate at least as high as the Applicable Federal Rate (AFR) for the term of the loan in question. This rate is published monthly and is applicable for the term of the loan. For mid-term loans (9 years or less), the current rate is 1.21%.
Guaranteed Universal Life insurance is a form of life insurance policy that allows for variable premium funding strategies while preserving guarantees of death benefits for the life of coverage. By employing premium flexibility, various goals can be accomplished that might otherwise be unattainable.
A loan to a trust by a grantor is not considered a gift from the grantor to the trust as long as the AFR is the stated rate of interest and interest is paid at least annually (some practitioners may disagree and posit that accrued interest at the AFR is a legitimate alternative). Interest received by the grantor is taxable as ordinary income.
The borrower/trust may invest or deploy borrowed funds depending on the investment powers granted in the trust document. In the scenario considered by this memorandum, it is assumed that part of the borrowed funds will be used to purchase a guaranteed survivor universal life insurance policy on the life(s) of the grantor(s) and the majority of the funds will be invested at an assumed rate-of-return of 6% for a period of 9 years.
At the end of the 9 year loan, it is assumed that the loan will be repaid to the grantors and will be invested for the remainder of their lives at the assumed rate of 6%. The trust will retain any funds in of the repaid loan and invest those funds at the assumed 6% rate.
Interpretation of Sample Case:
The first spreadsheet for consideration is titled “Private Finance Illustration”. It is assumed that the grantor and his wife (both age 60) loan an irrevocable life insurance trust (ILIT) created for the benefit of heirs, $5,000,000. It will bear an annual interest rate of 1.21% for the term of the loan. Interest will be paid by the trust to the grantors annually.
The trustee will receive the funds and do two things: (1) Invest $4,900,000 at an assumed compound rate of 6% and (2) use $100,000 to purchase a guaranteed survivorship life insurance policy on the grantor and his wife with a face amount of $4,630,868 from a major life insurer. This annual premium will be payable for 9 years.
The premium will guarantee that no additional premiums will be required until year 45 (age 105). Should the grantors have the good fortune to be alive at that time, annual premiums will be calculated to continue the policy. These premiums will be substantially larger than years 1-9 and may be prohibitive in their scope.
The far right column titled “Net Trust Benefit” refers to the trust value in the event of death of both insureds after the repayment of loans and interest. It will decline in early years and then increase to reflect the EOY fund balance plus life insurance death benefits. Year 27 (yellow line) represents joint life expectancy.
The next spreadsheet, titled “Supplemental Comparative Life Insurance Summary”, contrasts a basic guaranteed premium policy to the privately financed guaranteed premium policy (True Cost Analysis). While the Guaranteed Premium side of the analysis examines the performance of nine $100,000 premiums invested into a $4,630,868 policy, the right side of the spreadsheet analyzes the true cost of the program to the grantor.
The assumed rate of interest for the loan to the trust is 1.21%. In the open market, the grantor could likely realize a greater rate of return. In this case, it is assumed that 5% would be a reasonable rate of return on invested funds. The differential between the actual rate (1.21%) and the assumed rate (5%) as adjusted by a 40% tax rate would represent the true cost to the grantor. In this case, that would amount to $113,700 per year over the term of the loan. Of note: This is an opportunity cost to the grantor and not a taxable gift to the trust.
Estates, at joint life expectancy (year 27), the tax free IRR for this program is 12.52% which would equate to a taxable IRR of 19.3%. Should the grantor and his wife have the good fortune to live until age 100, the tax free and equivalent taxable IRR’s are 7.52% and 11.6% respectively.
Privately Financed Graded Premium Universal Life may be a solution to issues facing many successful investors and families today. Through the use of a minimal risk arbitrage technique, estates can be secured, charitable gifts accelerated and a variety of other planning and/or investment goals satisfied very efficiently.