The Real Costs of an Offshore Pension Plan

Throughout Asia, the majority of '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

Most IFAs are paid commissions by insurance companies to recommend these products; so 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 insurance company would be losing money on each plan sold.

The commission formula is {3% * Number of years in the plan term * 1 year sum of contributions}. For example, someone signing up for a $1,000 per month, 25 year plan would generate $9,000 in commissions (3% * 25 years * $12,000 = 75% * $12,000). As you can see, 5-year plans pay IFAs relatively less, and 25-year plans generate massive commissions.

More established IFA companies also receive a bonus 40% on top of the base commission (called an '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.

Surprisingly, these commissions are paid to the IFA companies in full upfront, when you start the plan.

Do you feel that an upfront fee like that is reasonable? Do you think that kind of incentive can affect how the IFA presents the product to you, or how they answer your questions about it?

It does, and the insurance companies are counting on it.

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 and external fund charges, 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 the Tax Train Comes 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 even just 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 those rules into consideration.

For American expats, these are an unmitigated 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, we typically recommend an offshore brokerage account - 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 what some say, you do not need to go offshore to invest in foreign securities.

If you own an offshore pension plan, carefully read the terms and conditions - and don't assume anything (for example, 'initial charges' apply to 'initial units' - but are charged every year for the full term, and not just the 'initial period'). Do not let the 'surrender fee' influence your decision on continuing too much, as that fee is largely related to the upfront commissions discussed earlier. Over time or all at once, the insurance company will make you pay your fees either way.

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:

"Five Things to Consider Before Buying Offshore Pension Schemes," by Peggy Creveling, CFA and Chad Creveling, CFA

"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 (subscription required)

"Cost in the Mists of Time," South China Morning Post