Finally, someone in the financial services industry has proved what Personal Finance has been saying for years: that costs are ripping the heart out of the retirement savings of many people.
Actuary Rob Rusconi's research was sparked by his search for the most cost-effective retirement savings instrument and evolved into an exposé of what costs can do to your potential retirement savings. By Rusconi's own admission, the research is "imperfect", but this is apparently because of the manner in which costs are hidden from us, the consumers.
It is apt that the delivery of his paper at the annual convention of the Actuarial Society of South Africa (ASSA) 10 days ago, came virtually on the eve of the national seminar for retirement fund trustees, which is in Johannesburg next Friday and Saturday. Rusconi's report should be placed high on the agenda.
Research raises questions
Rusconi's findings raise numerous questions from which one could make the following assumptions:
- If retirement annuities (RAs) are so costly, particularly in comparison to unit trust retirement products, then it is safe to assume that all life assurance investment products are expensive in relation to unit trusts investments. So, before investing in a life assurance product, you should consider a unit trust investment carefully. There may still be reasons for choosing a life assurance product over a unit trust fund, such as a more favourable tax regime, but make sure that you take costs into account.
- There is a lack of transparency in the life assurance industry. If an actuary (Rusconi) struggles to get all relevant information about costs in an understandable format, what chance do we ordinary consumers have of understanding cost structures?
The Financial Services Board (FSB) needs to reconsider the way it allows companies to declare costs. Personal Finance has been recommending for a number of years that the best way to declare costs is on what is called a "reduced yield" basis.
In simple terms, what this means is that you calculate how much money you will have at the maturity of the investment product without taking costs into account. You then have a second calculation, using the same investment return and term assumptions, but deducting the costs to show you how much money you will actually have at maturity.
Retirement product providers, particularly life assurers, express costs as a mishmash of fixed-rand costs, as a percentage of assets, as a percentage of premiums, on an annual basis and upfront. In fact, costs are deducted in just about every way possible.
The costs may be disclosed, but they are absolute Greek to consumers ... and, it appears, also to the people in the best position to know. I will be dealing with "reduced yields" in more detail in the weeks ahead.
- Small pension funds pay dearly. Rusconi's research indicates that there must be many small employer-sponsored funds that have exceedingly high costs. There must surely be an obligation on the trustees of these funds to recommend to the sponsoring employers and the members that a more cost-effective vehicle be found.
It would be better to take members into an umbrella fund. Umbrella funds are structured so that a number of employer groups can cost-effectively join one fund. However, as the life assurance industry manages these funds, the trustees of the existing small funds will have to consider costs very carefully.
There are other problems with umbrella funds, which Personal Finance has dealt with in detail in recent months, but these problems are about to be overcome.
This week the FSB circulated, to interested parties, draft legislation aimed at giving umbrella fund members better protection.
- Distribution costs. This is the life industry's euphemism for what it costs to sell its products in terms of the commissions it pays to sales people. Some ASSA delegates attempted disingenuously to excuse the high costs of life products by referring to these as distribution costs.
Sales people prefer to promote life assurance products because they receive commissions upfront on life assurance products, and not on an "as-and-when" basis, as they do with unit trust funds. In other words, the calculation for commission on an RA is 2.5 percent of the premium multiplied by the number of years you contract to pay into the policy, with a maximum of 25 years taken into consideration for commission purposes. Your adviser receives the commission for the entire period upfront with 75 percent of the commission paid in the first year and the 25 percent balance in the second year.
With unit trusts, the commission is calculated on each premium as you pay the premium, and commission is paid on that premium only. It does not take a genius to understand why sales people prefer to sell life assurance rather than unit trust products.
Bad news
In light of what Rusconi reveals, I have some bad news for life assurance companies. There is now an Act of Parliament in force called the Financial Advisory and Intermediary Services Act. This Act requires financial advisers, including sales people, to provide you with appropriate advice in your best interests.
The Act also requires that you be provided with all relevant information in writing in an understandable format. If anyone providing you with advice or selling you a product does not meet the requirements of the Act, they can be forced to pay you compensation and they can lose their licences to be financial service providers.
I would suggest that anyone who sells you a life assurance product without providing you with a comparison with a unit trust product and an understandable assessment of costs, could be in trouble on two grounds, if you take a complaint to the Ombud for Financial Services and/or the FSB.
To prove my point, let's take the following example: Say today you are advised to take out a life assurance retirement product instead of a unit trust product. Let's assume the life assurance product has an underlying investment portfolio that mirrors a unit trust option offered by the same holding company. Let's say at maturity, after saving for 40 years, the value of your investment, before costs, would be R2 million. But now let's look at the effect of costs, in other words, the reduced value.
Using Rusconi's average figures on costs, the actual amount you would receive from the life assurance product would be R1 280 000, while the actual amount you would receive from an investment in the unit trust product would be R1 480 000. So you receive R200 000 less in the life product. This is a lot of money.
At current annuity rates, R200 000 would give you an additional R1 300 a month in pension.
So the person who advised you to buy the life assurance product as opposed to the unit trust product, can be taken to task for failing to give you:
- Appropriate advice. It should not be difficult to argue that you have received inappropriate advice if your adviser failed to inform you that a life assurance product would yield a pension of R1 300 less (per month) than a unit trust product. (Remember, however, that other issues such as tax would have to be considered.)
- Understandable information. If you are not provided with calculations based on a reduced value basis, there is no way you can make the appropriate comparisons between products, and importantly between companies.
However, you should not allow the issue of appropriate advice to be left until a financial product matures.
For your own protection, you should demand that all information about costs is provided to you on a reduced yield basis. You should also be provided with the tax effects (both income and capital gains tax) on the same basis.
If you put pressure on financial advisers for full and understandable disclosure of costs, they will in turn put pressure on the product providers to provide them with understandable information, instead of the current gobbledygook.
Health warnings
- Accept that there will always be costs involved when you buy a financial product . It is the level of costs that is important. Investigate costs properly before making a decision.
- Avoid generalisations. For example, a unit trust fund will not always have lower costs than a life assurance product. It depends on the cost structure of each product provided by each financial services company.
- Consider other issues, such as tax, estate planning and security, when making an investment decision.
- Ensure you always get information on costs in a manner that you can understand. Remember that what appears to be a low percentage, over time, will amount to a lot of money in rand terms.