A WME Interview with Perry A. Lerner,
Managing Director, Crown World Services LLC

Wealth Management Exchange: What would you say are the three greatest investment challenges facing affluent investors?

Perry Lerner: Affluent persons are concerned with several issues. Most important is the preservation of capital. Individuals who have accumulated wealth probably worked very hard to get it. So, their principal concern is to preserve it. Given the choice between investment strategies that risk the erosion of capital to perhaps double their wealth, or preserving what they have, their inclination is to preserve their wealth. Many people consider that their main priority.

Another challenge related to preservation is liquidity. Those who have wealth, like to feel that they have access to it. Their needs change. Their priorities change. Having your wealth tied up and unavailable is almost the same as not having it. For example, a number of wealthy people have investments in hedge funds which have long lockups. Similarly, persons who own shares in public companies are insiders, and are subject to restrictions on the sale of securities.

Liquidity is almost equal to the wealth itself. Without it, wealth cannot be enjoyed or maximized.

The third concern is access to independent thinking on how to invest. Having wealth and wanting to preserve it still leaves the question: how do I best invest? The most important thing is that having access to independent thinking permits you to make tailored or customized allocations of your wealth to various investments and structures of investments.

To a large extent the financial planning industry is commissioned based which means there are strong incentives to allocate your capital in a way that may not be consistent with your personal needs or your best interests. So you need access to independent advice.

It is easier to buy things that everyone else is buying and selling. Your access to ideas that everyone else is pursuing is always greater. But as we now know most bubbles originate from this herd mentality.

WME: Please describe your strategy for wealth preservation?

PL: The best strategy for wealth preservation is based on several factors. One is the diversification of investments. Diversification has generally been proven to be the most effective way to preserve wealth.

The second is to find ways to minimize your current taxation. Our tax system is an annual system which doesn't always pay attention to the ups and downs of investment returns.

We have been advising people how to use insurance products as a way to defer or eliminate income tax in their investment portfolios. Because both life insurance and annuities, if structured under existing rules, are used as vehicles of investment, the gains inside the policies grow either tax free or tax deferred. So that over a long period of time the tax burden is either greatly reduced or eliminated.

So simply by finding a way of structuring part of your portfolio through life insurance or annuity products is going to be extremely beneficial in terms of maximizing returns on capital.

We advise on the use of private placement, variable life insurance. This is a vehicle which uses life insurance policies and annuities in a way to, in effect, wrap investments in a tax free envelope. It is an effective way to have both insurance protection, if you need it, and defer or eliminate income taxes on the earnings of the portfolio.

This strategy works well with income that is highly taxed which is to say-income generated from portfolios which are traded in a short term manner so there is no long- term capital gain. It also makes sense for portfolios with a high component of interest income which is taxed at higher ordinary rates.

WME: Do you think tax on the wealthy will increase?

PL: As you know, the current favorable long-term capital gain rates may actually expire in the next year. There is also a great possibility that rates will increase. Current tax rates are to be phased out some time near the of end next year. So you are in effect hoping that Congress would extend the current tax rates, which is highly unlikely. Some in Washington have already announced their interest in increasing rates for high earning individuals and families. One way or another the prospect of higher tax rates is something most people are only beginning to take into account. Investing through insurance products becomes an even more beneficial way to invest. I would bet regardless of what happens there will be some form of tax increase in the next few years.

I might add that one of the other advantages of private placement insurance is that all private placement policies have separate accounts for the investments so there is no risk of insurance company illiquidity. People who buy insurance will be very concerned that they have separate accounts rather than general account liabilities.

WME: How does the wrap around with insurance and hedge funds work?

PL: Briefly the way the private placement insurance works is that a large percentage of the premium, 95% or more is simply invested by the insurance company to create the fund necessary to pay whatever the death benefit is. And that fund is often available for borrowing during the accumulation period.

In private placement insurance, there is a great degree of flexibility in selecting the way that cash value is invested. There are several hedge funds-funds of funds-now dedicated to insurance products so that in effect you can allocate it or ask the insurance company to allocate a set portion of the policy to one or more of those funds or even to select a third party advisor to create a portfolio of hedge funds. So that in effect you can directly or indirectly invest in hedge funds through private placement insurance products.

Hedge fund returns have declined recently. But, most affluent people invest for the long-term so there is reason to be optimistic when these markets stabilize, returns will be more comparable to historic returns of diversified portfolios. That means hedge funds will continue to be attractive investments.

WME: Can risk be minimized?

PL: One of the things we are learning during this period is that many hedge funds and funds of funds can be tested for their correlation to the market. Many of them are making a very good case for themselves because they are showing the lack of correlation which has always been the argument for hedge funds. This is a good time to sort out who is correlated and who isn't.

As a form of risk minimization this period of time is probably the best laboratory we've seen in many years.

Also, one should mention that insurance itself is risk minimization because it is risk shifting. One of the things people use insurance for is to shift the risk of loss in the event of premature death. If you have tax needs or needs for your family, life insurance has always been a very effective tool for this and by having an overlay of insurance on your investment portfolio. In addition, if you have a portfolio that is illiquid, life insurance is immediate - it provides liquidity at death.

WME: Do you have evidence that affluent investors and their advisors are satisfied with this private placement insurance as a wealth preservation approach?

PL: As far as I know those who have purchased private placement insurance are satisfied. Our company has been involved in many transactions. We have had no negative reaction from advisors or families themselves. They have been happy with their decision to do it. There are relatively few people who use this strategy. It could be because it is not well known. It could be because the process itself is time consuming. It requires some estate planning, and physical examinations, so there are some intrusions.

But as we enter a period when people will be more sensitive to taxation, there clearly will be more interest in this product.