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. Caution is warranted when considering one of these investments.

Compensation

The first thing you need to know is how much the IFA companies are paid to sell these plans. 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).

More established advisory companies also receive a bonus 40% on top of the base commission (called an 'override') – making the total commissions $12,600 ($9,000*1.4). The fees within the plans are the same regardless if the insurer pays the override. For a $2,000 per month 25-year plan, total commissions including the override would be $25,200. Amazingly, these commissions are paid to the IFA companies in full upfront.

All these commissions ultimately must come out of your savings. Do you feel that a fee like that is reasonable? Do you think that kind of money can affect how the IFA presents the product to you, or how they answer your questions about 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 is that they exclude a number of plan fees and external fund charges, and also assume you never miss a payment.

A bit of legwork 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 to your account. Unfortunately, bonuses serve little purpose other than confusing people trying to figure out net cost.

Some advisers will 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. Ask them to show you exactly where that is spelled out in the contract (it's nowhere to be found).

Where the Tax Train Comes Off the Tracks...

Expats typically lock into offshore pensions for long periods of time - sometimes under the assumption these investments are intrinsically tax free. The problem is that regardless if an investment account 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 mobile expats, these factors can change considerably over time.

If an offshore pension does not qualify for favorable tax treatment in the country you reside in, you could have a problem. For example, Australia taxed its residents owning foreign unit-linked life insurance on the annual increase in value, without a deferral in 2009. People that become tax resident in Spain or France may not get favorable tax treatment, as these are not typically structured to comply with foreign tax rules.

For Americans, David Yen, CPA, a Shanghai based US tax adviser points out, “US tax laws are clearly designed to discourage US taxpayers from investing in mutual funds or insurance policies outside the US.” The IRS has requirements for any insurance policy to qualify for tax deferred treatment. If the offshore investment is not recognized as life insurance, it may essentially be characterized as foreign mutual funds – making it subject to complicated and strict tax guidelines by the IRS under Passive Foreign Investment Company (PFIC) rules. If you have over $10k offshore, these must also be reported on TD F 90-22.1.

Unscrupulous 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.

An Alternative Approach

For non-American expats, consider an offshore brokerage account - a flexible, tax efficient (depending on your circumstances), and cost efficient solution. American expats are usually best served keeping their investments in the US, taking advantage of products and strategies specifically designed to minimize US taxes.

If you own an offshore pension plan - the first step is to very carefully read the terms and conditions - and don't assume anything (for example, 'initial charges' are in fact charged every year). When it comes to investing - simplicity, flexibility and cost efficiency are important regardless of where you live.

Anyone interested in further information can also check these resources:

"Beware the Mis-sellers," by Naomi Rovnick, South China Morning Post

"The Truth about Offshore Pensions," by Geoff Birch

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

"Who Took My Pension?" by Panorama on BBC