Charitable endowments all over the country are at a critical juncture. Many have experienced a considerable reduction in assets due to the stock market downturn. Students, sent home from campus as a result of the COVID-19 crisis often, have had fees for room and board refunded. And ongoing support from alumni may be in jeopardy as everyone grapples with the economic fallout of the pandemic.
As we near the third quarter, endowments are gauging the extent of the damage so far and grappling with uncertainty about the upcoming fall semester and impact on revenue. To recoup losses, many institutions will need to find higher-yielding investments, particularly as the bond market has faced a significant shift in terms of yields and efficiency.
If history is any lesson, alternative investments and distressed debt funds, which currently provide higher returns than more conventional investments, will flourish. But endowments may be reluctant to move forward with this strategy due to obstacles presented by rules for unrelated business taxable income.
Alternative investments like distressed debt funds can trigger UBTI if they involve pass-through entities that generate K-1 forms or debt financing, as is the case for most distressed debt funds
Recently, chief investment officers of some institutions have increased the tax efficiency of alternative investments by using offshore tax blockers. However, given the current political climate, many high-profile endowments are now concerned with the perception of being associated with these entities, which also tend to be burdensome to deal with in terms of administration.
In contrast, a domestic institutional annuity contract can achieve the same or better returns with much less complexity (e.g., no K-1 forms, just an annuity return) than an off-shore tax blocker, and the treatment of tax-exempt institutions using these contracts has long been codified by the IRS. Without careful planning, an endowment's active business income will be taxed as UBTI rather than tax-free passive income.
An annuity contract provides institutions with investment options included on the insurance company's investment platform. The endowment gets the returns and performance of the investments tax free over an annuitization period chosen by the endowment. These annuity contracts deliver tax-efficient solutions as institutions like endowments are treated as holders of an annuity contract rather than interests in the underlying investments.
These contracts aren't new, but only independent private placement insurers offer this structure and the open-architecture platform that most CIOs require. To mitigate the ongoing impact of the coronavirus pandemic on their operations, an increasing number of CIOs are asking outside consultants that work with their endowments to look into this option, or are going directly to distressed debt funds and requesting that they partner with a private placement insurer to create an annuity contract.
In doing so, these CIOs can ensure their endowments benefit from higher-yielding investments without having to deal with complex accounting or inefficient tax structures.
For example, if an endowment makes a $5 million investment into a UBTI-generating distressed debt fund with an eight-year horizon and an assumed yield of 9.1%, it'll face a 21% income tax rate and a value of $8.95 million at exit, unless it takes measures to address tax efficiency. This reduction in value is why many endowments find they have to avoid such investments — despite the high gross returns. If the endowment uses a traditional leveraged offshore blocker, the exit value goes up to $9.11 million, but that number doesn't include the legal and accounting costs associated with the corporate structure.
However, by investing in the distressed debt fund through a private placement annuity, institutions can achieve complete tax efficiency with an exit value of $9.63 million, which takes into account the small annuity fee. That's an extra $500,000-plus relative to the offshore blocker, which can go toward programming, retaining staff and maintaining financial aid.
By maximizing the returns of alternative investments like distressed debt funds, an annuity can help ensure that programming supported by endowments continues undeterred, even in these challenging times.
Perry Lerner is co-founder and CEO of Crown Global Insurance Group LLC, Philadelphia. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.