Life for trustees is not what it used to be, and governing offshore trusts with US beneficiaries is becoming more difficult. Understanding the issues and identifying qualified service providers are critical to avoid regulatory, tax and counterparty risks – all of which can lead to maligned clients, smaller businesses and litigation.
Why be involved in the US market?
The US economy has rebounded from the 2008 crisis and US persons are becoming wealthier and more global, and will continue to move capital across borders. International families are increasingly looking to the US for residency, investment opportunity, education and safety.
From an investment perspective, the US economy represents 21 per cent of world gross domestic product1 and the US equity market represents 46 per cent of world market capitalisation.2 Opting out of the Foreign Account Tax Compliance Act (FATCA) and ignoring US securities can lead to serious investment underperformance in the longer term. Chart I shows how including US equities in a globally diversified index, over a 25-year period, improves performance by 45 per cent. In addition, over the same period, the S&P 500 has outperformed the MSCI World ex USA All Cap Index by 214 per cent.
Chart I. Comparison of equity market returns 1988-2013 in US dollars
While the cost of compliance is high, the US is full of opportunity, and retreating from this market is a bad long-term business decision.
Identifying the right custodian
Following events in Cyprus, it is clear that the risk profile of any contemplated jurisdiction needs to be considered. This episode reinforces the point that Switzerland, with its history of political and economic stability, is a safe domicile for bankable assets. Swiss banks, by and large, are well managed, but finding the right one for a taxable US client is another story. So what should you look for?
- Board-level commitment: find an institution that has actively decided to support US clients.
- FATCA-compliant/participating foreign financial institution: ensure the bank is prepared for FATCA and can produce full IRS 1099 reporting.
- Reporting: clear and comprehensive statements in English with asset-allocation data covering currency weights, position weights and performance data.
- A capital structure aligning shareholder interest with clients: find banks that have an ownership structure and culture that discourages risk taking. It is important to understand the legal structure, capital structure and credit rating of the entity servicing your client.
- Avoid undeclared US legacy issues: find a bank that has either addressed the issue or never had significant legacy issues. You do not want your clients in an institution indicted by the US Department of Justice.
- Competitive pricing: US taxable accounts have choice, and ofshore banks need to be price-competitive with international money centre banks. Look for banks that are willing to compete for the business.
- Main business is custody: shy away from big lenders, investment banks, derivative traders and banks focused on manufacturing and selling products. Find institutions where the main business is asset custody.
- Open communication policy: find banks willing to facilitate direct communication and online access.
- Sub-custody: check where client-free cash and non-segregated assets are held. What sub-custodians will hold your client’s segregated assets? Stick with counterparties in legal jurisdictions that you’re comfortable with.
Identifying the right asset manager
Regulation
The US Securities and Exchange Commission (the SEC) requires asset managers operating outside the US with more than 14 US-resident clients, or more than USD25 million in assets, to register under the Investment Adviser Act of 1940 (the Act). The registration threshold can include offshore trusts with US beneficiaries. Under the Act, SEC-registered advisors are required to publish what is known as an ADV form. This document explains what business the firm is in, the ownership structure and whether or not there have been any legal or regulatory violations. The ADV provides information often not found in promotional material, and firms are obliged to provide this to prospective clients.
Investment style
Once you have this information, it is important to understand the firm’s investment style, and how that style affects cost. The focus here is on how a firm invests. For instance, some firms offer multi-manager, fund-based solutions, effectively outsourcing securities decision-making to third parties, while others offer model-portfolio solutions, mechanically replicating the same portfolio composition across multiple client accounts. Some firms have a short-term performance culture focusing purely on pre-tax returns. In the following section I look at how different investment styles can affect a client’s after-tax return.
A) Owning direct securities rather than financial products
Why pay for the same thing twice? An asset manager has an obligation to manage assets prudently, and intelligent diversification is the key to achieving this. A firm selecting a series of actively managed US tax-compliant funds can achieve this, but subjects clients to unmanageable portfolio turnover – an additional layer of cost – and loses the benefit of timing gains and losses.
- High portfolio turnover can weigh on performance due to commissions, transaction charges and bid-ofer spreads. A study by Barra Inc, a division of MSCI, estimated that the average mutual fund with USD500 million of assets specialising in small- to mid-cap stocks will incur annual costs equal to 3 per cent to 5 per cent of net asset value (NAV) when turnover is 80 per cent to 100 per cent. This is an extreme case, but illustrates the point.
- Actively managed funds generally have total expense ratios of between 1 and 1.75 per cent per annum. These charges include fund management, administration, custody and accounting, and are embedded in the NAV of the fund. They are not always evident to clients, especially in multi-manager portfolios.
- Mutual fund managers have no way of knowing individual investor tax positions. They are incentivised to produce the pre-tax performance, and taxes are someone else’s problem. But the flow-through tax consequences can reduce the gross return by a meaningful amount, especially when considering the lost opportunity cost of the tax paid.
B) Compounding returns
Compounding is a powerful force for building long-term wealth. It requires time and patience – attributes ideally suited to a trust.
Have a look at Table I. The first portfolio manager is an aggressive trader, full of ideas, who loves to look at charts and follow ever-changing trends. He has little patience and wants to make money now. The second portfolio manager is steady and sticks to his ideas. Both managers achieved the client’s average rate of return. But has the trading manager really done a good job? Despite achieving the same average annual rate of return, the patient manager has achieved a compound annual growth rate 3.5 per cent higher and ended up with 14 per cent more capital than the trading manager.
Table I. Consistency and avoiding large drawdowns are keys to long-term wealth accumulation
Example: Client with USD1,000 desires a 15% average rate of return (ROR)
C) Tax optimisation for US beneficiaries
Long-term capital gains and qualified dividends are taxed at lower rates than short-term capital gains and ordinary income. Look at Table II. Once again, the patient manager who takes tax into consideration and turns the portfolio over infrequently has an inherent advantage over the trading manager who plays the market.
Table II. The highest pre-tax return may not always generate the highest after-tax return
D) Portfolio turnover
Portfolio turnover can be expensive. Assume the trading manager turns the portfolio over 100 per cent each year and the patient manager never sells. The period under review covers four years, annual returns each year equal 15 per cent, and federal and state taxes equal 40 per cent.
At the end of the period, the patient manager has 24 per cent more capital working for the client. Holding an investment pregnant with capital gains and allowing the embedded gains to compound on a pre-tax basis allows the investor to benefit by deferring the tax liability. This is illustrated in Table III.
Table III. Trading manager v patient manager: a comparison of portfolio end values
E) Understanding total costs
It pays to watch opportunity costs (transactions and tax), as well as real costs (asset management and custody). Look at Chart II for a simplified example of three portfolio options available to investors. The chart shows that the patient manager, investing in direct securities accompanied by low turnover, has an advantage over the other two management styles.
Chart II. Portfolio management style cost comparisons
Conclusion
The trust community is being subjected to increasing regulation and oversight. Good governance practices are now more important than ever, especially when dealing with offshore US wealth. The US Treasury has rewritten the rules with FATCA, and the US Department of Justice has become increasingly aggressive on extra-territorial enforcement. Mistakes can be costly.
Fortunately, many offshore banks and asset managers have dedicated significant resources to equipping their businesses to compete in these new circumstances. Finding regulation-compliant, tax-efficient, cost-effective solutions for clients is easier when you understand the issues and know where to find solutions.
