Judging by some of the requests and complaints from Personal Finance readers, it seems that some financial advisers have not got the message from the Financial Advisory and Intermediary Services (FAIS) Act.
Hopefully, when the Financial Services Board (FSB) punishes errant financial advisers for providing inappropriate advice in terms of the FAIS Act, it will give them a wake-up call. And, hopefully, that wake-up call is not too far off.
The FSB is conducting an investigation into the financial advisers who put their clients' money into Leaderguard, the failed currency trading company. If the investigation results in action being taken against some financial advisers, others, who are not putting your interests first because they are basing their advice on the potential to earn commissions, will take a lot more care.
Two areas in which it is clear that a lot of inappropriate, commission-driven advice is being given are second-hand policies (also known as traded endowment policies) and matured life assurance policies. And to make matters worse, the two products are often mis-sold together.
1 Matured policies
A matured life assurance investment policy is a valuable asset, because it can provide you with a low-tax income. How this works is that a life assurance company pays income tax on your behalf on any interest, foreign dividends, net rental income and capital gains that may be generated by the underlying investments.
The life company pays income tax at a flat rate of 30 percent and capital gains tax (CGT) at an effective rate of 7.5 percent. You do not pay any tax on the benefits.
This can be a significant saving for anyone on a marginal income tax rate of more than 40 percent, depending, of course, on your tax situation and other investments.
For example, you need to take account of your tax exemptions on income from interest. If you have not used up your interest exemptions (R15 000 for people under the age of 65 or R22 000 for people over the age of 65), it would not make sense to have underlying investments in interest-earning financial instruments being taxed at 30 percent. It may be better to invest in an RSA Retail Bond.
The point is that when your investment policy matures (reaches the end of the contract period), you do not have to cash it in. Instead, you can roll over the policy and make what are called partial surrenders every year to generate an income, which is tax-free in your hands. The partial surrenders should preferably be equal to, or less than, the investment growth you received in the previous year to preserve your capital.
Many financial advisers do not tell you about partial surrenders because choosing this option does not generate new commission for them.
But you will not only pay extra commission if you reinvest the money. You will also pay a whole new round of investment costs. And, if you invest through a new life assurance policy, you will be subject to new policy conditions that will wrap your money up for at least five years and may subject you to confiscatory surrender penalties if you need your money before the new maturity date.
However, if you roll over your policy, you must ensure that:
- You will not, in fact, pay any new commissions;
- You have historically received a rate of return in excess of the benchmark (for example, the JSE All Share index) or inflation. But remember that past performance is no guarantee of future performance.
- You will not be charged any surrender penalties for making the partial surrenders.
2 Second-hand policies
Although the trade in second-hand policies has been around for quite a while, the South African Revenue Service (SARS) regards it as a bit of a tax dodge.
Second-hand policies are also a happy hunting ground for scam artists.
SARS does not like second-hand policies, because people use them to reduce their income tax. If you buy a second-hand policy, it immediately generates an income that is tax-free in your hands.
In an attempt to stop the trade in second-hand policies, Finance Minister Trevor Manuel introduced penalising CGT on them. Depending on how the policies are structured, you may pay three times the amount of CGT you would normally pay on any other capital gain.
There are two types of second-hand policies. They are:
- Unmatured policies.
These policies are sold by policyholders who want to surrender their policy, but if they did so, their policy would be subject to the confiscatory surrender penalties levied by the life assurers.
So intermediaries offer to buy the policy at a better price than you would have received if you had surrendered it. The intermediary then finds someone else to take over the policy. You cede the policy to the new owner at a discount to its actual value. The new owner of the policy continues paying the premiums, if it is a recurring premium policy. Apart from the CGT consequences, the original policyholder seldom knows what the new owner paid for the policy, and the new owner does not know what the previous owner was paid for it. Often, the intermediary earns a mint on the difference between the two amounts.
To make matters worse, there have been awful scams involving second-hand policies.
Scam operators tell you that you are buying into a portfolio of second-hand policies. They then sell the same pool of policies many times over.
- Matured policies.
The "value" of these policies lies mainly in their tax advantages, but you pay a pre-mium to cover the costs and commissions. In other words, you will not get the full value of the policy.
Matured policies are sold either individually or in a pooled arrangement. The pools are normally provided by life assurance companies themselves. In most cases, the tax consequences and the costs simply do not make the investment worthwhile.
What I find particularly galling is that some Personal Finance readers have been encouraged to cash in their matured policies and then purchase a matured policy or a stake in a pool of matured policies provided by the same life company. In effect, some policyholders may land up buying back their own policies at a greater cost and with adverse tax consequences, because their matured policy has been put into the portfolio.
The general rules of thumb are:
- Hold on to a matured policy unless there are very cogent reasons to cash it in. Taking out a new investment because your old one has not performed well may not be a cogent reason. Often you are permitted to switch the underlying investment into something that will perform better and may be more appropriate to your needs for minimal cost.
- Avoid the market in second-hand policies, unless you really understand it and the costs involved.