The phone rings, and it’s someone you don’t know claiming they can help improve your financial situation. As you wonder how they got your name and number, they ask you to schedule a meeting with one of their advisors. In China, these companies are usually selling unit-linked life insurance, sometimes referred to as an offshore pension plan. As with most aggressively marketed products, caution is warranted when looking into these investments.
Cost Matters!
Numerous studies have shown that cost is critically important when investing. Marketing materials for offshore pension plans recognize this fact, presenting what look like reasonably low fees over the life of the investment. Unfortunately, you cannot take marketing materials at face value. BBC’s investigative show Panorama recently ran “Who Took My Pension?” – highlighting how pension fees claimed to be 1.5% a year could cost 80% of investor contributions.
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 fees like bid-ask spreads and fund expenses. 1% here and there might not look like much, but it quickly adds up. Most plans include ‘bonuses,’ where it seems like money is generously credited to your account. Unfortunately, bonuses serve little purpose other than making it a bit more time consuming to figure out net cost.
Some plans charge fees on ‘assumed’ contributions, so that even if you stop, charges continue to increase as if you were making payments. Other plans may use mirror funds, which are an insurance company’s copycat version of the funds you would normally invest in. Over the long run, mirror funds frequently lag the funds they were designed to track.
Where the Tax Train Comes off the Tracks…
Unaware of how complicated taxes can be, expats lock into offshore pensions for long periods of time. Some of them mistakenly believe these investments are intrinsically tax free. The problem is that regardless of where an investment is located, tax treatment at the individual level (the type you directly owe) is driven by where you are considered a tax resident, along with the associated rules of that country. These are factors that 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 in 2009, without a deferral. Rules change over time, and wherever you are a tax resident, you will need to periodically reconfirm treatment.
For American expats, “US tax laws are clearly designed to discourage US taxpayers from investing in mutual funds or insurance policies outside the US,” explains David Yen, CPA, a Shanghai based US tax advisor with Expat CFO. The IRS has requirements for any insurance policy to qualify for tax deferred treatment. If the offshore pension 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.
Unscrupulous financial advisors claim tax authorities cannot find these offshore accounts. Aside from the ethical issues of such a strategy, cash-strapped governments are increasing penalties for tax evasion, and getting a lot more aggressive in their pursuit of undeclared money offshore.
Aren’t these good for some people in some situations?
It is a good idea to minimize your tax bill; however, it rarely makes sense to lock into an investment with high fees and surrender charges. Of the offshore pensions I have analyzed, fees quickly negated bonuses and ate through investor savings. Costly strategies can make tax benefits irrelevant, and inflexibility can cause problems whenever your situation changes. Simplicity, cost efficiency, and flexibility are important principles to keep in mind no matter where you live.