Understanding SMAs and IDFs in PPLI: A Comprehensive Guide

Over the past year or so, if you have chatted with someone who is from the investment community, works at a family office, or is themselves an affluent individual, you probably discussed Private Placement Life Insurance (PPLI). And it’s easy to see why.

PPLI is receiving this buzz because it is a powerful financial tool, offering successful individuals and families the ability to manage their wealth with significant tax advantages. And certain changes to the tax code made PPLI even more attractive, especially for those who invest in, or manage, alternative assets.

A key component of PPLI is choosing the investment option for the policy, either a Separate Managed Accounts (SMA) or an Insurance Dedicated Funds (IDF). Understanding these components is essential for anyone looking to maximize the benefits of PPLI.

In this blog post, we’ll briefly explain PPLI, delve into the intricacies of SMA and IDF, and explore how IDFs were historically the popular investment choice under private placement products, but the investment option growing in popularity is the SMA.

First, A PPLI Primer?

At the most basic level, PPLI is simply a variable universal life (VUL) contract. As such, there is a cash value component of the contract that can be allocated to variable subaccounts. Unlike a VUL, PPLI provides access to alternative asset classes via IDFs and SMAs.

This means that PPLI is actually the use of a life insurance chassis to overlay, or wrap, highly tax-inefficient investments in order to recharacterize those investments as part of a cash value life insurance policy. In this structure, the investments receive the more desirable tax treatment of life insurance – income tax-free growth, the ability to obtain income tax-free loans and, if held until death, the ability to pass the investments along to heirs along with additional policy death proceeds income tax-free.

All of this makes PPLI attractive to high net worth families and individuals who face high tax exposure from certain investments such as hedge funds, private equity, and other alternative assets. In addition to the tax savings, the life insurance component of PPLI makes it a powerful tool for traditional estate and wealth planning.

While there are limits on who can purchase a PPLI policy, as well as requirements around investment diversification and prohibitions against investor control, this piece will focus largely on the investment options available in a PPLI policy - SMAs and IDFs.

Separate Managed Accounts (SMA)

SMAs in PPLI policies are permitted by IRC §817(h)(5), allowing for the use of an independent investment manager with a discretionary mandate to choose and manage the investments under a policy. SMAs under a PPLI policy can be identical to a managed account held outside of a policy and are growing in popularity with clients who wish to recreate an already successful strategy inside of a life insurance policy. SMAs permit direct investment into a broad variety of asset classes, from funds to LP interest in private equity to LLC interest and even investment into third-party promissory notes.

Spearhead is an approved administrator of SMA programs on behalf of RIAs and Multi-Family Offices. Spearhead provides administrative services to each RIA's SMA program, allowing our partners to focus on managing bespoke, customized investment solutions for their clients on an individualized basis. We enable our partners to create tax-efficient offerings that leverage their investment skills, knowledge, research, and “edge.”

Working with Spearhead, here is an overview of how an SMA is structured:

Benefits of SMAs in PPLI

Customization: Investment advisors have the ability to create a customized portfolio based on a client’s individual needs – much like the traditional client-advisor relationship.

Optionality: SMAs can offer a broader array of investment options for a client’s investment manager rather than having to pick from a “menu” of IDF offerings.

Flexibility: The investment advisor can modify the investment strategies of the SMA as the client’s risk tolerance and investment objectives change over time, giving full flexibility to adapt the portfolio as the advisors view on the market changes or there is a change to a client’s overall financial plans

Tax Efficiency: The tax-deferred nature of PPLI means that the gains within an SMA grow without the immediate burden of taxes, enhancing long-term growth potential.

Insurance Dedicated Funds (IDF)

An IDF is an insurance version of a publicly available fund, such as a hedge fund, that only a life insurance company or a life insurance policy can invest in. Often these investment choices will include liquidity restrictions limiting a policyholder’s access to the funds. A manager may offer an IDF for investment by the PPLI policy of a single client or a select group of clients or make the IDF open for investment to a broader universe of PPLI policies.

Spearhead operates a Delaware multi-series LLC structure that enables asset managers to seamlessly and efficiently create and launch new IDFs. Each IDF series is ring-fenced with its own assets and liabilities and operates independently of the other series. Our structure is built to lift up an asset manager’s traditional fund strategy and drop it within a tax-efficient asset location.

Working with Spearhead, here is an overview of how an IDF is structured:

Benefits of IDF in PPLI

Access to Expertise: By pooling resources, IDFs provide access to top-tier investment managers and strategies that might be out of reach for individual investors.

Cost Efficiency: The collective nature of IDFs can lead to lower investment management fees and operational costs compared to individually managed accounts.

Compliance and Simplicity: IDFs are designed to meet the compliance standards of insurance regulations, ensuring that the investments are appropriate for the PPLI structure.

SMA vs. IDF: Choosing the Right Approach

The choice between an SMA and an IDF within a PPLI policy depends on the individual policyholder’s needs, preferences, and investment objectives. As we mentioned above, while IDFs have historically been the preferred choice of investment under a private placement contract, recent years have seen a sharp rise in popularity, especially as the RIA and family office market has grown.

An IDF is generally a preferred option when a client and their advisors want to invest in a single fund, say a private credit fund, and an IDF fits the bill. With an investment in an IDF, the client does not need to worry about meeting the Diversification Test for PPLI policies, as the IDF will be internally diversified to meet that requirement.

Where an investment manager has an effective strategy for their client (which includes tax inefficient investments) and they would like to replicate that strategy in a PPLI, an SMA may be the better option. This is one reason why, over the past few years, PPLI has experienced an increase in adoption of SMAs by RIAs and family offices who prefer to retain the management of client funds.

With an SMA, it is important to remember that the SMA must meet the Diversification Test and avoid running afoul of the Investors Control Doctrine. We will cover both in future posts.

Both SMAs and IDFs play crucial roles in enhancing the flexibility and efficiency of PPLI. By understanding the unique benefits and considerations of each, policyholders can make informed decisions that align with their financial goals and preferences. Whether you opt for the bespoke nature of an SMA or the diversified efficiency of an IDF, PPLI remains a powerful tool for wealth management and tax planning.