The Real Costs of an Offshore Pension Plan

Throughout Asia, most 'Independent Financial Advisers' (IFAs) catering to expats are selling 'unit-linked life insurance,' commonly referred to as an offshore pension plan. These types of investments should be avoided due to enormous fees and potential tax problems.

Compensation

The first step in understanding an offshore pension is to learn about commissions. Keep in mind that any commissions your adviser receives must ultimately come out of your savings. If they did not, the product provider would be losing money on each product sold.

IFAs are paid commissions by insurance companies to recommend offshore pensions. The base commissions formula I am familiar with is {3% * total anticipated contributions). For example, someone signing up for a $1,000 per month, 25 year plan would create $9,000 in commissions (3% * 25 years * $12,000/year = $9,000). As you can see, a 5-year plan pays advisers relatively less, and 25-year plans pay advisers much more.

On top of the base commissions, many companies also receive a 40% bonus (sometimes referred to as a 'marketing override') – making the total commissions on a $1,000 per month 25-year plan equal to $12,600 ($9,000*1.4). For a $2,000 per month 25-year plan, total commissions including the override would be $25,200.

These commissions are paid to the IFA companies in full upfront, but must be given back to the insurer if the investor quits during the initial period (typically 18-24 months).

Do you think a payment like that could affect how the product is presented to you?

The insurance companies decided to pay commissions like this for a reason.

Cost Matters

Numerous studies have shown that cost is the best predictor of returns. Marketing materials for offshore pension plans acknowledge the fact that cost matters, and go on to present what look like very reasonable fees - 'Your investment only needs to grow 0.3% a year to break even!' The problem with these fee illustrations (which they call 'Reduction in Yield') is that they actually exclude many of the plan's fees (e.g. investment admin charges of 1.2-1.5%) and external fund charges (e.g. 1.5-2.5% total expense ratios), and also assume you never miss a payment for the entire term.

Some serious number-crunching is required to get a clear look at an offshore pension's cost. Most charges are listed in the contract terms and conditions. Further research is required for fund fees. Some plans include bonuses, where it looks like money is generously credited back to your account. Unfortunately, bonuses serve little purpose other than confusing people trying to figure out net cost (a warning in itself).

Advisers will often tell you that your contributions for the first 18-25 months are 'ring fenced' or 'locked up' for you until the end of the term. Challenge them to show you exactly where it says this money is returned to you in the contract. The fact is that since IFA commissions are paid in full upfront - your fees must ultimately reflect that. The surrender fee is bigger than the total commissions because the insurers 'locked up' some of their profits early as well.

Where Taxes Come Off the Tracks...

Offshore pensions based in places like Guernsey and the Isle of Man were originally structured from a British expat tax perspective. Due to the commissions involved and lack of regulation, they are sold to expats from all backgrounds.

The problem is that regardless if an investment is based in a tax haven, tax treatment is driven by where you are considered a tax resident, along with the associated rules of that country. For some people the tax treatment might be favorable when signing up, but the factors affecting tax treatment can change considerably when you move, or as laws change over time.

For example in 2009, Australia taxed its residents owning foreign unit-linked life insurance on the annual increase in value, without a deferral. Countries in Europe also have requirements for these types of investments to qualify for tax advantages, and the companies making them are typically not taking foreign tax rules into consideration.

For American expats, these are a tax disaster no matter where you live, as explained by a US tax attorney, here. And this article from the AICPA provides additional information on PFIC treatment.

Misguided financial advisers claim tax authorities cannot find offshore accounts. This comes as cash-strapped governments are increasing penalties for tax evasion, and getting a lot more aggressive in their pursuit of undeclared offshore accounts.

*2012 Update - Guernsey, Jersey and the Isle of Man are signing FATCA.

An Alternative Approach

For non-American expats in China, an offshore brokerage account may make sense - a flexible, tax efficient (depending on your circumstances), and far more cost efficient solution.

Our American expat clients typically keep the bulk of their investments in the US, as we take advantage of products and strategies specifically designed with US taxes in mind. Despite some claims, you do not need to go offshore to invest in foreign securities.

If you own an offshore pension plan, keep in mind that the surrender penalty is not some arbitrarily made up punishment for quitting early - these are the fees you agreed to pay when the plan was sold to you (but made visible). The surrender penalty is related to the adviser's commissions.

When it comes to investing - simplicity, flexibility and cost efficiency are important regardless of where you live.

Anyone interested in learning more about these investments:

"The Truth about Offshore Pensions," by Geoff Birch

"Offshore Pension Basics," by David Colvin CPA, CFP

"Who Took My Pension?" Panorama on BBC

"Beware the Mis-sellers," June 20, 2011, South China Morning Post