Positive Returns?

Absolutely, with Offshore Variable Annunities
By Mark Smallwood, TEP, Smallwood Insurance Company Ltd.

In the last few years, the offshore financial sector has been undergoing dramatic changes. The Turks & Caicos Islands (TCI), albeit a relatively small boutique financial jurisdiction, has been playing its part in introducing a braod array of laws and regulations to ensure a propertly regulated and safe environment in which to conduct offshore financial services business.

Indeed, as a British Overseas Territory, TCI is now more heavily regulated and has more laws in place to ensure the proper conduct of business than many of the “onshore” territories, including the United States and the United Kingdom. In this changing environment, we are seeing a change in the profile of individuals who utilize these offshore financial products and commensurately, we are seeing a change in the products they are seeking. This change is being driven by two factors: increased regulation on the home front making it difficult and expensive for onshore investors to gain access to onshore products that meet their needs, and an increasing level of sophistication of offshore centers, where these needs are being identified and products that are able to meet investors’ objectives are being created.

During the roaring bull market of the 1990s, investors became somewhat complacent in their choice of investment vehicle to access stocks and other investment instruments. On many occasions I met with overjoyed investors who had made significant capital gains on their portfolios and who wanted advice on how to realize those gains without realizing a significant tax charge. In particular, U.S. clients were concerned–especially in the dizzy heights of late 1999 and early 2000–that many of their gains were short term and that they were going to have to pay 40% of their gain in taxes to realize the position.

In the event, many investors who might have taken their profit decided to hold on. The end result has been that in many cases, rather than taking a profit and paying the taxes, they held and paid more in losses in the ensuing collapse.

In addition to these tax issues, investors were (in my humble opinion) duped by the Wall Street money machine and the talking heads of CNBC and other media channels that the road to riches simply involved buying a few stocks and sitting on them for the long term. If you fundamentally believe that this is true, then have a chat with a Japanese investor, who is seeing their stock market hit 19 year lows, and who will have to see the Nikkei index rise by over 400% simply to get back to where it was in 1989! Of course if you believe the commentators, this simply cannot happen in the U.S., just as they would have pronounced in early 2000 that you would have to be mad to think that with the Nasdaq trading over 5,000 it could possibly fall to 1,000–well, we are nearly there. Whether I am right or wrong, the point is: Can you afford to take that risk?

Clearly I am not denying that if you buy stocks, in the long term they will go up. The question is, will it be you or your children or your grandchildren who see this benefit? Furthermore, if you are putting your faith in asset managers who base their investment philosophy on relative performance then you are bound to be doomed. Imagine the phone call from your asset manager in 10 years time: “Hello, Mr. Client. You will be delighted to know that we have outperformed the S&P 500 by 10% in the last 10 years.” It sounds good, but not if the S&P 500 is down 30% and your portfolio is down 20%!

Inept financial institutions selling the glory of equity investment to the unsophisticated general public propagate the “Buy for the Long Term” mantra. The very fact that 80% of equity fund managers underperform their benchmark indices would at least indicate that if the investor wishes to invest in the stock market, then they should do so through an index-tracking fund.

This argument is, however, directed mainly at those investors currently seeking relative performance. It is an amazing quirk of current financial expectations that the average investor will pay in the range of 3% per annum of their money to the 80% of fund managers who underperform their index. What is even more amazing is that most private investors will pay a manager to try and outperform an index that itself may collapse and lose them money. Surely one would pay a manager to make money irrespective of market conditions.

Indeed, if you have a look at Mr. Warren Buffet’s Berkshire Hathaway, at the time of writing the stock in this company is trading at around $74,000, on a Price to Earnings ratio of 82, whilst the net asset value of this company (i.e. the actual value of the underlying stocks held by this fund) is $40,000. Clearly the bear market cannot be over when “investors” are still ignoring the fundamentals despite nearly three years of a bear market.

Most clients who I talk to agree wholeheartedly that they wish to make money and they are not greedy. “If I could make 10% per annum in the markets, with interest rates on bank deposits at just over 1%, I would be very happy.” So what the client is really saying is that they want absolute returns. I have never had a client say to me, “I would be really happy to outperform the S&P 500 by 5% per annum.” Yet that is what the investment industry offers to most private clients, and all private clients are not happy with that when the S&P 500 is down 25% year-to-date.

So, to summarize the issues above, we might conclude the following:

* If we could wrap our investments in a tax-free umbrella, we could be more flexible with them, which in the long run could help enormously in taking profits and allowing re-investment into emerging opportunities.

* If we could gain access to money managers who focus on absolute performance, we might never have to go through the pain again of seeing our funds track the S&P 500 and Nasdaq etc. down and down and down.

* If our actively trading absolute return managers are not constrained by tax issues in their trading, then they can buy and sell at will without creating a large tax liability.

To this end we therefore need two products. Firstly, we need a recognized tax-efficient wrapper that shields the underlying investments from the tax consequences of active trading. Secondly, we need a trading fund whose managers are paid to make money irrespective of the direction of the stock or other markets.

In the first instance, for U.S. tax payers, the tax-efficient wrapper is the single premium deferred variable annuity contract. In the case of substantial investors whose net asset base is at least $5 million and who are looking to invest at least $1 million, the private placement variable life insurance product is the product of choice, but for the purpose of this article I will focus on the variable annuity.

The offshore variable annuity is structured in exactly the same manner as the onshore U.S. version. Utilizing this approach ensures that one is not trying to be clever with the mighty Internal Revenue Service. We are simply cloning the product available onshore and are respecting the rules and requirements laid down by the IRS and the U.S. Treasury.
The essential characteristics of the product are as follows:

*A single premium is invested.

* Funds accumulate on a tax-deferred basis.

* Withdrawals can be taken from the contract after the age of 59 1/2 without penalty. (The IRS imposes a penalty of 10% of gains on withdrawals taken before 59 1/2).

* On withdrawal the gain in the amount withdrawn is taxed at the marginal income tax rate of the owner.

The result is that funds, which would in the short term have been paid in taxes, are allowed to carry on working for the investor, thus resulting in a significantly greater accumulation of assets in the long run.

So why invest in an offshore deferred annuity when there are onshore versions available? The answer is two-fold:

Firstly, from a cost basis, offshore annuities are much cheaper to purchase and manage for the larger investor. The onshore versions are designed for an average investment in the $10,000 range, whereas the offshore minimum investment is in the $100,000 range, and these versions are not structured to pay the substantial commissions that onshore annuities pay (ranging from 5% to 15%!).

Secondly, and most importantly, the offshore annuities are not constrained by primarily State-imposed rules and regulations governing where the funds can be invested. The typical onshore annuity issuer provides a selection of standard mutual funds covering the common array of investment styles, from U.S. large capitalization stocks to emerging country funds. What they do not provide is the flexibility for the investor in the annuity to determine a more flexible investment position, choose his investment advisor to manage the funds, or seek access to alternate investment vehicles that focus on absolute return performance.
Therefore, for our U.S. investor clients what has worked extremely well has been the combination of this U.S. approved tax deferral vehicle, underlying which is a portfolio of alternative investment vehicles focusing on absolute return performance.

Within the industry, these underlying vehicles are very loosely referred to as “hedge funds.” We do not like or approve of this definition as it is in most cases grossly misleading, in that the underlying assets of these funds are not hedged. “Alternative Investment Vehicle” seems far more appropriate as the funds are able to invest in asset classes not normally available to the private investor through domestic funds. These asset classes will incorporate the normal ability to access stocks and bonds, but will also allow access via stock and bond index futures and options, foreign exchange markets, base metals such as copper and aluminum, precious metals such as gold and silver, grains such as wheat and corn, and the meat markets such as live cattle and pork bellies.

The managers of these funds therefore have a much larger selection of investments to choose from and are not constrained by the requirement to buy the investments long, but can also sell the investments short so as to profit from declining prices. The managers may also employ leverage to enhance the gains experienced from relatively small moves.

One has to be extremely careful to select managers who have a proven ability to manage these types of strategies and who have the proven ability to make money in declining as well as rising markets. For example, there are many former mutual fund managers who are trying to become “hedge fund” managers when they have no real experience of trading. The most effective funds tend to employ former proprietary traders from the world’s major banks, where they have had extensive experience in trading and the risk management techniques necessary to manage these funds effectively. For this reason, we focus on selecting fund management groups with extensive experience in this area of investment with proven performance in both up and down markets, in order to measure their correlation to the more traditional markets.

In selecting the investment managers to undertake these programmes, it is entirely possible to put together a portfolio of funds that have achieved compound annual returns in the 10% to 20% per annum range over a period of at least 5 to 10 years. Ideally, we look at structuring a group of funds in order to diversify risk, lower the volatility of the portfolio, and meet some of the diversification rules of the Treasury Department that relate to variable annuity products.

In addition to selecting funds that have sound track records in all market conditions, some of the larger groups issue closed-end funds that have guaranteed minimum returns assuming the investment is held for the entire duration of the holding period. For example, one fund group which issues closed end funds on a regular basis and has achieved historical returns in the 15% per annum range is issuing new funds with a guaranteed minimum return of 120% of the amount invested so long as the investment is held for the full term (usually 10 years). Leading international banks such as Royal Bank of Scotland, Bank of America and Lloyds TSB provide the guarantees.

So in conclusion, the offshore world has a great deal to offer the onshore investor who is seeking a tax efficient means of accessing alternative investment programmes with the aim of targeting absolute returns. With the bursting of the stock market bubble and the ensuing bear market, investors are realizing that preserving capital is just as important as making money, and millions of investors who have been let down by investment managers targeting relative performance are unaware of the opportunities available to select managers focused on absolute returns.

So, if you want to play it safe, is now the time to target absolute returns? Absolutely!

Mark Smallwood is Managing Director of Smallwood Trust Company Ltd. and Smallwood Insurance Company Ltd., based in Providenciales since 1994. Smallwood Insurance Company Ltd. issues a deferred variable annuity called The Sanctuary Investment Plan, details of which can be located on the company’s website at:

Mark Smallwood has extensive experience in using insurance products to mitigate tax liabilities for high net worth investors. Mark Smallwood is a full member of the Society of Trust and Estate Practitioners and is President of the Association of Licensed Trustees of the Turks & Caicos Islands.

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