Not understanding a financial product can cost you dearly, either in poor returns or hefty penalties if you bail out before the investment matures.
Before you make a decision you will later regret, have your financial adviser complete our investment checklist.
In terms of the Financial Advisory and Intermediary Services (FAIS) Act, anyone who provides you with financial advice or sells you a financial product must undertake a financial needs analysis to assess your financial goals and requirements and determine how suitable any such products are for you.
Although a financial needs analysis safeguards you to some extent, it does not guarantee that you will have the slightest clue about the product you are advised to buy.
Much product information - particularly that relating to costs - is often obscured in a morass of jargon. This is despite the requirement of the FAIS Act that information should be disclosed "in plain language, avoid uncertainty or confusion and not be misleading".
When you realise that your money has been invested in a high-cost, high-commission-paying product that knocks the stuffing out of your investment's performance, it is too late to cancel the investment because you will be slapped with a confiscatory penalty that could reduce your savings to zero.
In other words, you find yourself between a rock and a hard place.
However, you can avoid this situation if you make sure that you thoroughly understand a product before you invest in it, and ask the right questions about such things as costs, penalties and tax.
To help you assess a product, I have drawn up a questionnaire that you should have your financial adviser complete for each financial product that you are advised to buy.
Ideally, your financial adviser should fill out a questionnaire for each of the products in the range from which he/ she would have you choose so that you can make a comparison of all the products.
You should keep the completed questionnaires, along with your financial needs analysis, in case something goes wrong in the future and you wish to complain
to one of the ombuds or adjudicators. Keeping them in your files will also serve to remind you why you originally invested in a particular financial product.
The questionnaires, along with a financial needs analysis, will help to ensure that financial advisers have fully disclosed to you the essential details of the product/s that they have recommended to you.
You should consider taking your business elsewhere if your financial adviser refuses to complete the questionnaire, or a product provider refuses to provide the information called for in the questionnaire.
For additional security, you should check your policy document or other contract against the questionnaire and immediately take up any discrepancies with your adviser, and, if necessary, with the product provider.
A detailed list of questions follows which provides more detail on the points raised in the investment questionnaire on the right.
Step 1.
About the product
A great variety of products are available, and new ones are coming on to the market all the time. In many cases, new products are designed around investment fads. Such products often come on to the market when the market or sector in which they invest is already on the wane or an investment bubble is about to burst. These fad products also often come with high costs.
Few people realise that the costs attached to foreign investment products are excessive, and this contributes to the often poor performance of these products.
If more than one company is involved, it is important that you understand which one is responsible for the product, which one for meeting its investment objectives and which one will manage the risks associated with it.
Product company.
There are numerous financial services companies - some large, some small. You need to be cautious when investing with, or buying products from, lesser-known financial services companies.
You need to exercise extreme caution if the company is not listed on a reputable stock exchange and the investment is via shares or debentures issued by an unlisted company.
You should always check whether a company supplying a product is registered with the Financial Services Board (FSB), which is the regulator of financial services in South Africa.
Product name.
This is required merely for reference purposes.
Product type.
There are many types of products, ranging from unit trust funds and life assurance endowment policies to stress debt hedge funds. You should compare different types of products because they may have the same objective.
For example, a unit trust fund with underlying investments in a general equity fund has much the same objective as a life assurance endowment with investments in general equities. The differences are in the costs and the way the returns are taxed.
So, you must compare products of the same type, as well as different types of products that have the same investment objectives, and understand the differences between them.
Date of quotation.
You need this for your records and also because timing can affect a quotation.
For example, if interest rates change, this will have an impact on a guaranteed annuity (pension).
Underlying asset type.
In which asset class or classes will the product invest? For example, will it invest in shares, cash, bonds or property? You need to know this information so that you can assess your exposure to risk, the level of returns you can expect from your investment and whether the costs are reasonable. The asset class in which your product invests can affect the costs. For example, cash investments are normally cheaper than equity investments.
Capital growth/income.
Is the product going to give you capital growth or an income?
If you are seeking capital growth, most of your investments should be in ownership investments, such as shares (for example, a general equity unit trust). If you want an income, the bulk of your investments should be in interest-earning or high-dividend-earning investments, such as high-dividend-earning shares, bonds or money market funds.
Single premium (lump sum) or recurring premium.
With most products, you either pay recurring premiums or invest a lump sum, although you can often invest additional lump sums.
You need to know whether making further investments will result in additional costs and, if so, what they will be.
Level of risk.
Risk is an extremely important factor. The question you need to ask yourself is, "How much can I afford to lose?" and not, "How much can I make?". Financial advisers and product providers often fail to properly spell out the risks, particularly when they are punting high-risk products, such as property syndications and currency trading investments, which incidentally, often pay higher commissions.
Step 2.
Guarantees
Guarantees normally cost more and they are often ill-defined. You also need to know whether the guarantee is on your capital and/or return and whether it is before or after costs and/or tax.
Capital guarantee.
Does the guarantee apply to all your capital or only a percentage of your capital?
Income guarantee.
You should find out whether this a proper income guarantee. Many people have bought income guarantees only to find that their capital has been whittled away. In other words, their own capital was being used to provide the guarantee for their income.
Cost of guarantees.
When you ask about the cost of any guarantees, do not accept the excuse that these costs are "embedded". The actual cost must be disclosed to you. Normally, it will be a percentage of your returns or your capital.
Step 3.
Investment terms
You need to check minimum investment periods very carefully, particularly if you are investing in a life assurance product.
Commissions and the costs of life assurance products are calculated by multiplying your premium by the term of the investment and then by a factor. This factor will be between 2.5 and 3.5 percent in the case of recurring premiums, and about three percent in the case of a single premium.
You will often face confiscatory penalties if you want to break the terms of a life assurance contract.
Step 4.
Premium flexibility
One of the major problems with the life assurance industry is that if you do not adhere to its terms, the life industry will levy excessive (and often arbitrary) penalties, which can result in you losing all, or a large part of, your savings.
Before you sign a contract, you need to ensure that any penalties that may be applied are precisely spelt out to you. Normally, the penalties decrease over the term of the contract.
Step 5.
Commissions/fees
Commissions and fees are often disclosed in ways that are designed to confuse you - if they are disclosed at all. But intermediaries are bound to declare commissions and fees in terms of the FAIS Act and the Policyholder Protection Rules for long- and short-term insurance contracts.
In some cases, commissions and fees are negotiable. Most often, commissions and fees are only declared as a percentage of your capital. The percentage may seem small, but it can translate into a substantial amount of money over time.
You need to ask for the commissions and fees to be expressed in a number of different ways, so that you are in a position to judge whether you are being placed into a particular product because of the size of the commissions and fees and/or the way they are paid.
The question is not whether you should pay commissions and/or fees. Instead, you need assess the effect the commissions and fees will have on your investment and whether the amount is justified.
Is the commission negotiable?
An adviser needs to be paid, but the commission should always be negotiable. It should not be more than three percent of your premium.
Commission or fee or both.
With some products, you are charged both commission and fees. The commission is normally a percentage of your premium. Fees are normally paid as a percentage of your invested assets on an annual basis.
You should not pay a fee in addition to commission unless you are receiving regular advice from someone who is properly qualified to give asset management advice (preferably someone who has the Certified Financial Planner or the Certified Financial Analyst accreditation).
Is commission paid upfront?
Upfront commission is one of the biggest problems in the financial services industry.
Upfront commission is an incentive for unscrupulous advisers to persuade you to cancel an existing product and take out another one after a few years, so that a new round of commissions can be generated.
It is also a significant contributor to confiscatory penalties, which are levied if you reduce your premium or make an investment paid-up.
Is commission paid on each premium?
This is the practice in the unit trust industry, and it is preferable to upfront commissions.
Other commission/fee structures.
Some companies pay "secret" commissions and fees to financial advisers. You must ask your financial adviser whether he or she is receiving any other fees, commissions or kickbacks, either directly or indirectly, from the product provider or an associated company.
Other incentives.
Will the sale of the product contribute to the adviser receiving other incentives, such as a luxury foreign trip? If it does, you should not deal with the adviser, because such perverse incentives have resulted in significant mis-selling, particularly of living annuities.
Initial commissions/fees.
Ask your adviser for the actual rand amount of the commission that he or she is paid when you make your investment.
Annual commissions/fees.
These are fees over and above any initial commission on your investment and are usually a percentage of the value of your assets.
Reduction in yield calculation.
This is the best way to judge the effect of total commissions/fees on your investment. It gives you an indication of the amount by which your investment will be reduced by commissions/fees.
Step 6.
Costs
Commissions are only a part, albeit a large part, of the total costs of investing. The costs levied by financial services companies can sometimes also be exceptionally high.
Companies are adept at disguising costs, presenting them in confusing language and often hiding them, particularly in what are called layered products, such as multi-managed products, where only the top layer of costs is disclosed.
Full costs are often excluded from performance illustrations, so you do not get what you see.You must make sure all costs are fully disclosed.
List of costs/fees.
It is imperative that you are provided with a list of all the costs that will be deducted from your investment. The costs, particularly on life assurance products, come under a startling array of names.
Initial costs are normally a percentage of your investment amount. Initial costs should be below six percent of your capital.
Annual (ongoing) costs.
These costs are over and above any initial commission on your investment and are usually a percentage of the value of your assets. To an increasing extent, they also involve performance fees.
Reduction in yield calculation.
This is the best way to judge the effect of total costs on your investment.
(If you are being charged a performance fee, you should assume different growth rates of, say, five, 10 and 15 percent. You need to make these assumptions so that you can see the effect that the performance fees will have on your investment.)
Step 7.
Tax
Tax will also affect the performance of your investment. It is important to know what rates you will pay and how the tax will be structured.
In the case of life assurance products, the life company pays tax on your behalf (income tax of 30 percent and capital gains tax of 7.5 percent). If you are on the highest marginal tax rate, having the tax paid on your behalf may be to your advantage, because the tax rate may be lower.
On the other hand, you lose out on the exemptions, such as those on interest and capital gains, that apply to individual taxpayers.
Investment questionnaire
1. About the product
1.1. Product company
1.2. Product name
1.3. Product type
1.4. Date of quotation
1.5. Underlying asset type
1.6. Capital growth/ income-producing
1.7. Single premiums or recurring premiums
1.8. Level of risk
2. Guarantees
2.1. Capital guarantee
2.2. Income guarantee
2.3. Cost of guarantees
3. Investment terms
3.1. Investment period (years)
3.2. Investment amount (rands)
4. Premium flexibility
4.1. Variation in premiums permitted (yes/no)
4.2. Early surrender penalties:
4.2.1. Year 1
4.2.2. Year 2
4.2.3. Year 3
4.2.4. Year 4
4.2.5. Following years
5. Commissions/fees
5.1. Negotiable (yes/no)
5.2. Commission or fee or both
5.3. Commission paid upfront (yes/no)
5.4. Commission paid on each premium (yes/no)
5.5. Other commission/fee structure
5.6. Other incentives
5.7. Initial commissions/fees:
5.7.1. Percentage of premium
5.7.2. Rand amount
5.8. Annual commissions/fees:
5.8.1. Percentage of assets
5.8.2. Rand amount
5.9. Reduction in yield calculation:
5.9.1. Total amount invested
5.9.2. Less total commissions/fees paid in rands
5.9.3. Annual percentage reduction
in yield
5.9.4. Total percentage reduction
in yield
6. Costs
6.1. List of costs/fees:
Commissions/fees
Administration fees
Policy fees
Asset management fees
Underlying asset management fees
Performance fees
Other
Total initial costs
6.1. Initial:
6.1.1. As a percentage of premium
6.1.2. As rand amount
6.2. Annual (ongoing):
6.2.1. As a percentage of assets
6.2.2. As a rand amount
6.3. Reduction in yield calculation:
6.3.1. Total amount invested
6.3.2. Less total costs paid in rands
6.3.3. Annual percentage
reduction in yield
6.3.4. Total percentage
reduction in yield
7. Tax
7.1. Taxed within investment
(life assurance)
7.2. Taxed in your hands
(collective investments)
7.3. Tax deduction (for example, retirement annuity premiums)
7.4. Income tax
(applicable marginal rate)
7.5. Capital gains tax
(applicable effective rate)
7.6. Estate duty
7.7. Retirement fund tax (18 percent)