Think before you sign

2013-09-11 10:00

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Understand the retirement annuity you have signed up for and don’t let penalties catch you unawares should you wish to cancel the contract

When Neil* could no longer afford to keep up with his retirement annuity (RA) contributions, he was shocked to discover that by cancelling his monthly premium, the value of his policy would be reduced from R342?000 to R284?000 – a reduction of R58?000.

He further discovered that if he wished to transfer his RA to another product provider, he would pay further penalties and his retirement nest egg would fall by a total of R90?000.

Werner*, a small business owner, was equally shocked to discover that his staff would stand to lose 12% of their retirement contributions

when he sold his business.

“As a small business, I could not offer my employees a pension fund but I was worried about their retirement options. So two years ago, I insisted they take out a retirement annuity,” says Werner, whose business has been bought out by a larger company.

The staff will be transferring to the new company’s pension fund.

Unable to afford to contribute to both the RA and the pension fund, many staff members will have to make their RAs paid up and will pay early termination fees equal to 12% of their fund value.

Both these cases highlight the importance of understanding what kind of investment you have signed up for and the implications if you can no longer continue with your contributions.

Not all RAs are the same

There are two types of RAs – one is a policy issued by an insurance company, which can carry an early termination fee, and the other is an investment-linked RA where termination fees are not levied and the underlying investment is usually a unit-trust fund.

A policy RA

With a policy RA, the policyholder effectively signs a contract to contribute to the retirement fund until a certain age, usually 55 years old.

If the policyholder breaks that contract, the insurer has the right to deduct certain upfront costs they would have recuperated over the term of that contract.

This is a similar concept to a cellphone contract, where the individual effectively pays off the handset over the duration of the contract.

Investment-linked RA

Under an investment-linked RA, there is no such contract and if the client decides to stop contributions, there is no financial loss.

»?What to do if you can no longer afford your premiums

If you have already bought a policy-backed RA and face financial constraints, there are several options open to you.

The following examples are based on Sanlam’s RA products, but can apply to other funds, so it is worth finding out what rules apply:

»?Stop your escalation

Nearly all clients have a yearly escalation on their RA so that their contributions keep up with their salary increases.

Most RA products allow the client to cancel the yearly increase without any penalties.

»?Take a holiday

Many product providers include a premium holiday of up to 12 months over the lifetime of the policy where no penalties or charges will be subtracted.

Be aware that some funds may lengthen your retirement date if you take a premium holiday.

»?Reinstate your premium

If you make your policy paid up but then reinstate it at a later stage, a portion of the early termination fee could be refunded.

»?Challenging status quo

Unfortunately, Neil entered his RA contract in 2008.

This means the maximum early termination fee of 30% could be applied and the adviser received the full commission upfront. Therefore, a portion of the early termination fee is the adviser fee, plus interest.

With the advent of the Financial Services Board’s Treating Customers Fairly programme, many of these products could face challenges as they are clearly not fair to the customer.

Also, the product provider would have to justify how the client received R58?000 worth of services.

»?Understand implications of moving to a new fund

Clients who have had a poor experience with their financial adviser may be tempted to cash in their policy RA and move to an investment-linked product where they pay a new adviser a more transparent yearly fee of between 0.5% and 1%.

Remember, however, that this means from the first year the adviser receives a fee on assets you have accumulated over several years and for which you have already paid someone else for advice.

Why do policy-backed RAs exist?

One could ask why, in the current economic environment where people could lose their jobs at any time or face financial constraints, policy retirement annuities (RAs) are even sold when investment-linked policies are far more flexible.

The simple answer is that it is a mechanism to pay for the advice you receive.

Most retirement and investment products are bought through advisers.

There are very few people who will take their retirement provision into their own hands and actively seek out their own investments.

Advisers therefore remain an important link in retirement savings and they need to be remunerated for their advice.

With an investment-linked RA, an adviser only receives what can easily be termed “as and when” commission when the premium is deducted each month. An adviser who sells an RA for R500 would, at most, make R15 commission each month.

The adviser could also charge an annual fee of 1% on the value of the investment. But it would take a long time to build up sufficient asset value to pay for the initial advice provided – after one year, the adviser would have earned a total of R240.

With such a slow rate of return, many advisers are, understandably, reluctant to sell these products.

A policy RA currently allows the adviser to receive an upfront commission based on the value of the premiums the client has contracted to pay.

On a R1?000 RA for 35 years, the adviser would receive, for example, an upfront commission of R3?800, which would cover their fees for the initial advice given.

They would then receive R25 per month on the contract to cover ongoing advice.

The commission that is paid upfront is effectively borrowed from the client’s future investment with interest charged and therefore, should the client stop contributions, some of these costs need to be recouped.

It is also important to note that this upfront cost is not limited to the advice fee. It also includes the administration costs of the product provider, which means the initial costs could be substantially higher.

For individuals who do not wish to take out a policy-backedRA, they could either pay the adviser an advice fee or invest directly in a unit trust RA with no advice.

The current status of policy RAs

Policy-backed retirement annuities have come under heavy criticism from the National Treasury. Over the last eight years, reforms have been introduced to limit the termination fees and increase disclosure. The advice fee is only a portion of the total costs and it is the lack of transparency around these costs that have raised concerns.

Changes were introduced in 2006, limiting the maximum early termination fee that could be charged to 30% of the fund value. This was further reduced to 15% in 2009 when commission structures were also changed so that the adviser could only receive half of the commission upfront.

The remainder of the commission is paid “as and when” the client makes their monthly contribution. If the policy is cancelled within five years, the adviser has to repay a portion of the upfront fee.

All documentation provided to the client stipulates the percentage one would pay in early termination fees. For example, if you cancelled your premiums after two years, you would pay 12% of your policy value in fees; after five years, that falls to 7.5%; and after 10 years, no early termination fee applies on a retirement annuity with a 20-year term.

The future of policy RAs

The treasury has made it clear that it is uncomfortable with early termination fees and these products may become a thing of the past. The question for the industry, advisers and clients is “how do you pay for advice?”

A client will need to either pay the adviser upfront or create a separate loan account with the product provider, which is paid off over time from the fund.

This is, in essence, the same structure as we currently have, except that it is far more transparent and the client will have to sign a separate agreement and fully understand their liability in terms of what they owe the adviser.

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