Offshore or up the creek?

Yet despite the recent upheavals, offshore providers and IFAs say that while care needs to be taken when considering investing client monies abroad, such products can still be beneficial for the right clients.

Offshore bonds offer the benefit of allowing gains to roll up tax-free, while also providing tax deferral benefits. Useful not only for investors living or planning to retire abroad, they can also play a role in estate and trust planning.

But the benefits come with risks, particularly for investors who make cash deposits through offshore bonds, as opposed to those making deposits directly into offshore institutions. This is an issue that has been brought into sharp focus by the collapse of KSF IOM last year.

Investors face two main risks when holding cash offshore in a bond. The first risk is the failure of the international arm of the life insurer they invest through. The second is if the underlying investment itself fails – something that can affect both those investing through an offshore bond or directly into a bank account in a foreign jurisdiction. It is the effects of this second scenario that KSF IOM investors are feeling currently.

Despite this, Worldwide Financial Planning managing director Peter McGahan believes high net worth clients should still consider offshore products as an investment option. “An offshore bond is simply a tax product that allows for very flexible tax planning, such as tax-free growth and tax-free distribution at the end – if planned correctly – as well as offshore residency relief on the growth,” he says.

“Its risk hasn’t changed. The key risks are investment fluctuation, corporate default such as the offshore bond provider going bust or the underlying fund going bust.”

McGahan says the big risk with offshore investment is holding cash, or external funds within the bond. This is because if a building society or bank goes bust within it, there is no protection via the UK’s Financial Services Compensation Scheme (FSCS).

“So an investor invests £500,000 in a bond and for safety and better returns he buys an Icelandic bank. The bank goes bust; he gets no money back at all. The offshore bond provider going bust would have meant that UK protection applied,” McGahan says.

To flesh out the FSCS scheme further, in situations where the life insurer itself fails, investors that are habitually resident in the UK when the bond was taken out and are invested in an offshore insurer based in the European Economic Area may be covered. The scheme covers contracts effective from December 2001 onwards. Many insurance companies on the Isle of Man have also signed up to this UK scheme.

Under the scheme individuals are entitled to 100 per cent of the value of their insurance contract reimbursed up to the first £2,000, with 90 per cent of the balance paid back. There is no upper limit.

Bloomsbury Financial Planning investment manager and branch principal Robert Lockie suggests collective funds are not so much of a concern in terms of underlying asset failure because they have independent trustees and custodians.

“Even if the manager went bust, another one would be appointed and if the trustee went bust, its assets are separate from the fund assets,” he says.

Prudential International head of development Richard Leeson points out that most offshore life companies are offshoots of large financial institutions, which can help to bolster consumer confidence.

“Ourselves and our competitors are financially strong, with very strong parent companies,” he says. “I don’t think there are any concerns in the market about the strength of the providers – clearly there is concern about the underlying assets.”

Aegon Scottish Equitable head of marketing for investment products Steven Whalley agrees: “The thing to think about at the moment is that insurance companies seem solid enough – but advisers should be very aware of their position in respect to where the money gets invested.”

The UK FSCS aside, the compensation available in offshore jurisdictions varies considerably. Currently the Isle of Man compensation scheme, for example, pays back up to 90 per cent of an offshore bond’s value, should an insurer there fall over.

Whalley explains: “The reason they say up to 90 per cent is that the money to pay out from these compensation schemes comes from making a charge against the remaining insurance companies.” As a result, if a particularly large company was to go bust, taking two per cent – the maximum allowable under the scheme – of the sum total of all the other companies is unlikely to cover the liability and may fall below the 90 per cent mark.

The downside for offshore bond holders with regard to the Isle of Man compensation scheme – as being experienced by investors in KSF IOM – is that the life insurers are recognised as only one investor when it comes to compensating for cash deposits; despite the fact potentially hundreds of investors have invested through them. To add insult to injury, there is a £50,000 compensation ceiling for individuals in the Isle of Man and only £20,000 for life assurers. That leaves those investing in cash via offshore bonds receiving very little in the event of a bank failure, particularly when Whalley says its average premium per investor is around £250,000.

“So as an individual, if investor protection was your only driver, you would be better off doing lots of accounts up to whatever limit there is in the chosen jurisdiction of the place you’re talking about,” Whalley says.

“You’d be better putting money individually into all these different accounts than you would be buying it through the offshore bond.”

In September last year the Irish government moved to make investing in its banks more attractive by guaranteeing 100 per cent of funds invested in the Allied Irish, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, Irish Nationwide Building Society and the Educational Building Society.

However, the strength of the guarantee is coming under scrutiny. “Already IFAs are raising questions as to the affordability of the scheme without limits,” Leeson says. “It’s very difficult going forward to know what is and what is not a true guarantee. It’s an unprecedented situation in my career. All we can do and all IFAs can do is provide factual information to the clients.”

In terms of other jurisdictions, McGahan suggests avoiding Jersey and Guernsey, due to the poor protection levels afforded. Meanwhile, some IFAs favour Luxembourg.

For Informed Choice joint managing director Nick Bamford, offshore products are “as safe as you make them”.

“If you are fairly diverse in the way in which you buy those products and you spread your money around the different investment asset classes, they’re as safe as an investment can be,” he says. However, he says he does feel more confident that the UK authorities will typically behave in a way that protects the consumer.

“I just wonder at times if people will start to sacrifice some of the tax advantages of being offshore for the perceived safety of being onshore. I could definitely see that starting to happen. The tax advantages offshore can be quite marginal at times for some tax payers,” Bamford says.

But Lockie believes offshore bonds are just as relevant as ever for high net worth clients. “The problems relating to KSF are not offshore bond problems, they are bank problems. Investors holding shares in a company that went bust would suffer a loss but if they held them in a bond that would not make the bond inappropriate either,” he says.

Meanwhile, Whalley asserts that investing offshore is still a very “robust” proposition, but admits that it can be a difficult trade off between competitive interest rates and security. “It’s still got a lot to offer and with due diligence and proper explaining to the client of the risks involved, it’s still a very viable and attractive part of the market.”

Adviser View – Luxembourg

Pharon IFA business development director Nicholas O’Shea favours using Luxembourg as an offshore home for his client money, when appropriate.

“Luxembourg has a very different licence process than everybody else. Every individual bank account, every individual wrapper will have its own license, which means it can’t be lent on to somebody else. So it means that your money is a pure deposit,” he says.

Investments are protected by the principality and there are no limits on what can be invested. Pharon uses a company called Lombard International Assurance SA to access Luxembourg and believes the way the system is set up means there is little risk for investors and “you don’t end up with a toxic situation”.

However, Pharon is very selective about using offshore products overall. “We don’t do a huge amount of offshore work because we struggle to see the real benefits of it to be honest. The reason we do it really is gross roll-up, but if you’re going to remit it back to the UK anyway, is it really going to make that much of a difference?

“For us the reason why we use Luxembourg is security of cash – that’s the critical reason.”

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