With the stock market on a tear, "success" for chief investment officers at endowments increasingly means generating returns of at least 12% — without engaging in overly aggressive trading practices.
In the past six months, more and more CIOs are looking into the use of institutionally priced annuity contracts to access alternative investments while minimizing exposure to unrelated business taxable income, or UBTI.
Why the recent interest?
Stock market gains aren't necessarily reflected by a jump in endowments' returns — this year, FAANG stocks (Facebook, Amazon, Apple, Netflix and Google's parent company Alphabet) have accounted for 50% of the S&P 500's gains, but CIOs need to stay diversified and can't just concentrate assets in five tech companies. While the economy is booming, however, CIOs are facing unprecedented pressure to boost returns accordingly.
Alternative investments like real estate and infrastructure are attractive, but can trigger UBTI if they involve pass-through entities that generate K-1 forms or they involve debt financing, as is the case for most real estate investments.
In the past, tax-exempt institutions shied away from these kinds of investments because the traditional way of minimizing UBTI involved offshore corporate blockers — entities that are complicated to set up and maintain, involve complex accounting and lead to more scrutiny from regulators. Last year's Paradise Papers generated considerable controversy around the use of offshore accounts by endowments.
In contrast, institutional annuity contracts are efficient, involve much less paperwork (e.g., no K-1 forms – just an annuity return), and the treatment of tax-exempts using these contracts has long been codified by the IRS.
When issued by a private placement insurer, these annuity contracts are a type of insurance product that provide institutions with investment options added to the insurance company's investment platform. Institutions like endowments get the returns and performance of the investments chosen from that platform. The investments are annuities because the institution has the option, but not the obligation, to convert them into a fixed stream of payments over a period of time.
Among other benefits, these annuity contracts deliver tax efficient solutions for institutions, which are treated as holders of an annuity contract rather than interests in the underlying investments.
These contracts aren't new, but many CIOs are hearing about them for the first time because retail insurance carriers don't offer this structure — they'd much rather manage the money using their own products. Private placement carriers tied to fund companies sell group annuity contracts, but don't provide an open-architecture platform — the fund company exerts a measure of control and investment influence.
As a result, independent private placement insurers are an attractive solution to CIOs looking to deploy new capital effectively. An increasing number of CIOs are going to alternative investment funds and asking them to work with a private placement insurer to create an annuity contract, and the funds are more than happy to do so to become part of the endowments' portfolios. CIOs are also asking outside consultants who work with their endowments to look into this option — a process that often requires some conversations with the consultants about how private placement works. Once they're on the same page, however, they quickly recognize its benefits.
Take this simple scenario: A $100 investment into a UBTI-generating real estate fund with an eight-year horizon and assumed rate of return of 9%. With no measures to address tax efficiency, the tax-exempt institution will face a 21% income tax rate, resulting in a value of $179 at exit. This haircut in value is why many tax-exempts find they simply have no choice but to avoid such investments — no matter the attractiveness of the gross returns. If a tax-exempt uses a traditional leveraged corporate blocker, it can expect an exit value of $182.15, but this figure doesn't incorporate the weighty and ongoing legal and accounting costs of the corporate structure.
Meanwhile, by making the investment through a private placement annuity, institutions can achieve complete tax efficiency with an exit value of $192.50, which takes into account the small annuity fee.
Early adopters, including one university endowment with more than $15 billion in assets, are already using institutional annuity contracts to access alternative investments while minimizing UBTI. With CIOs continuing to face unprecedented pressure to perform, these structures will only gain in popularity.