Five Things to Consider Before Buying Offshore Investment Schemes
By Chad Creveling, CFA, and Peggy Creveling, CFA
At some point, those of us living overseas may consider investing in one of the many offshore investment schemes that are actively marketed to expatriates. And it’s understandable why—the promotional literature for these plans can be pretty compelling. The sales pitch might go something like this:
You have the opportunity to invest in an offshore savings scheme offered by a leading provider of sophisticated financial products in a low-tax offshore jurisdiction with world-class standards of regulation and transparency. Premium multi-currency savings plans are available, with built-in flexibility, easy access, and a wide-range of investment funds. Depending on how much you choose to invest, allocation rates of 110% and higher are possible. Unlimited switching between funds is allowed with no charge, and there’s no bid-offer spread.
The above offer may also be accompanied by a hypothetical graph showing how much your plan could be worth over time. But what’s not disclosed is that the calculation is based on an unrealistically high rate of return given the significant fees involved in the scheme.
Based on this type of marketing, it’s understandable that many expatriates are tempted to purchase such a plan. Even Americans married to foreigners who wouldn’t personally benefit from an offshore tax structure may wonder if they should purchase a scheme for their non-U.S. spouse. But before taking action, it really pays to do your homework. To help you evaluate whether these schemes make sense for you, we’ve put together the following list of things you should know:
1. You’re not just buying an offshore investment; you’re buying investments inside an offshore insurance wrapper. Although this point may be glossed over in the marketing, you should understand that you’re actually investing inside an insurance structure as defined under the laws of an offshore jurisdiction, and you should also understand why this may not be a good deal. The assumed attractiveness of investing inside an insurance wrapper is the tax-deferral benefits that might accrue to the buyer. But depending on your situation, these benefits may not be of much use to you. Unfortunately, there are several drawbacks to using an insurance wrapper to house investments:
The buyer must enter into a long-term obligation (usually between 5 and 25 years) that can only be undone at great expense.
The insurance policy structure makes it easier to hide fees. Significant costs can be buried in the policy’s layers, making it difficult to work out how much is regularly being deducted from your savings.
Depending on your situation, you may find that you already can invest at a low-tax rate using an offshore brokerage account, without the insurance wrapper.
When you return home, you may find that your home country does not recognize the offshore structure as being insurance, so the tax-deferral may be lost.
For U.S. citizens: Generally, most offshore schemes don’t meet the IRS definition of an insurance policy, and so U.S. citizens who are taxed on global income may not get any tax-deferral benefit from the insurance policy structure even while they’re living overseas.
2. The scheme’s fees really add up. The specifics can vary between insurance firms and plans. However, one thing they all have in common is that the fees involved are significant—and not all are transparent. For example, if you total up all the fees that are deducted over the life of your plan, you may find that your end investment is worth 30–40% less than if your investments had not been held inside an insurance wrapper. As a general overview, here are some of the fees that can be involved:
Charges on initial units: Also called expense recoupment, this fee can range between 1% to 1.5% per quarter, or 4% to 6% per year. It’s applied during the length of the plan against the initial units purchased in the first 12–18 months.
Scheme fund administration or mirror fund charges: Ranging from 0.7–1.2% per year, this fee is deducted in monthly increments from fund NAVs and is not expressly spelled out in your statement
Scheme ongoing management fee: Some insurance companies charge an additional fee of up to 0.75% per year for management
Broker’s fees: Some IFA salesmen receive an additional 1% of the plan value per year for selecting funds on your behalf
Initial commission: Depending on the plan and the amount you’re investing, you may also be charged an upfront 5–7% every time you pay a premium into the plan
External Fund Charges: Charged by the investment fund and not shown on your statement, these include management fees and administration charges. These fees are deducted from the fund’s NAV and can range up to 3.5% per year, easily averaging 2% across all funds in a typical scheme.
3. You’ll pay most of the surrender charge, even if you don’t surrender the plan. The cost of surrendering a plan is based on a percentage of the initial units purchased, with the percentage declining over time. The high apparent cost of surrendering a scheme can act as a psychological barrier to prevent expatriates from quitting their schemes early. Yet in reality, the high ongoing fees applied to the initial units (layers of fees that can total more than 8% per year) means the the net present value of what’s left at the end of the plan is not worth much today. In both situations, a significant amount will be deducted—either in an up-front surrender charge if you quit the plan early or in ongoing fees over time if you keep it until the term end.
4. There are better options. The marketing literature may suggest that offshore investment schemes using insurance wrappers are the most cost effective way to structure an offshore investment portfolio. That may have been the case many years ago. Today, however, there are much more cost effective ways for expatriates to invest offshore. For example, if you expect that overall global markets can return 9% per year on average over the 25 years you plan to invest, consider the following two choices:
Offshore scheme inside insurance wrapper with $1,000 monthly contributions for 25 years. No upfront commissions or explicit fees for advice, 1.2% per year in imbedded mirror fund charges, 1.5% quarterly initial unit charges, and 2% per year average external fund charges. Total contributions: $300,000. End plan value: $596,158. Internal rate of return: 5.29%.
Offshore investment portfolio held in a brokerage account with $1,000 monthly contribution for 25 years. Total portfolio costs averaging 0.56% per year including custodial fees, brokerage trade commissions, and fund total expenses. Total contributions: $300,000. End of plan value: $978,146. Internal rate of return: 8.74%.
Based on the above numbers, you end up with far more in your pocket after 25 years if you choose the offshore investment portfolio without the insurance wrapper.
5. For Americans: Punitive PFIC rules may apply to offshore investments. Not only are offshore insurance wrappers unlikely to qualify for U.S. tax-deferral benefits from the IRS, worse, the investments they house may be considered Passive Foreign Investment Companies (PFICs). Unlike U.S.-incorporated mutual funds, where capital gains are deferred until realized and which are subject to preferential long-term capital gains rates, PFICs are subject to a particularly punitive taxation regime. Annualized tax rates on PFICs can add up to 50% or more. Luckily, there are much better ways for Americans to invest globally.
In summary, before you buy an offshore investment scheme, it’s important to carefully read all the terms and conditions of the plan. Consider whether you receive any tax benefit from using an offshore insurance structure versus simply investing in an offshore brokerage account. Build a spreadsheet to model the plan over time, and include all fees, hidden or otherwise. What the sales literature does not expressly tell you may become clear—once you agree to purchase the scheme, your investment is subject to a layered fee structure that can lower your investment earnings significantly, perhaps by 30–40% per year, and thereby dramatically lower the value of your overall investment over time. Your money will no longer be your own; your investments are locked inside the insurance wrapper for up to 25 years, and the policy can only be surrendered at great expense. It really pays to do the analysis first. You may find that you can end up with far more over time if you choose carefully.