The announcement by the Life Offices Association (LOA) that it intends to move away from a commission system that involves financial advisers being rewarded upfront, based on the premiums that you will pay as much as 40 years later, is indeed good news.
Personal Finance has been fighting for the scrapping of the upfront commission system for the past nine years. However, in my view this is only step one.
Upfront commissions contribute to much that is wrong in the life assurance industry.
This is how the commissions are calculated on recurring premium life assurance policies: First the premium is multiplied by the number of years or term of the policy (to a maximum of 23 years). Then this is multiplied by a factor of between 2.5 and 3.5 percent, depending on the type of policy.
The type of policy also determines whether the broker is paid between 75 and 85 percent of the commission in the first year with the balance paid in the second year. By contrast, the commission paid on a unit trust to an adviser is up to three percent of every premium as and when you pay it.
There are three major wrongs with upfront commissions. These are:
- They contribute to the confiscatory penalties that the life assurance companies impose on your policies when you reduce your premiums or surrender your policy, as the life companies simply recover what they have already paid out to the broker (plus interest) from you.
- A hit-and-run culture has developed among advisers who sell life assurance products. As a consequence of the payment of upfront commissions, they have no incentive to give you advice into the future.
- Upfront commissions contribute to massive mis-selling. Every year financial advisers encourage thousands of South Africans to cancel existing policies and take out new ones (known in the industry as churning). One of the main reasons for this, is that after two years there is a perverse incentive for an adviser to sell a new policy in order to generate a new round of commissions. And the life assurance industry has been a willing co-conspirator in this.
In brief what the LOA is now proposing is:
That commissions be split into an advice and a sales element. The sales commission will be paid in advance at five year intervals. The advice element will be paid upfront annually.
You will always have to pay the sales element the commission, but if you change advisers, you will be able to transfer the advice element of the commission to another adviser.
This should encourage financial advisers to regard you as a long-term client and to advise you accordingly.
But the commission restructuring is but part of the solution to the problems ofconfiscatory penalties and bad sales behaviour in the industry.
The reason why I say that upfront commissions are only part of the solution is that many in the life assurance industry do not care one hoot for you. The companies lose nothing when you cancel a policy or reduce your premiums. Many still make a profit out of you cancelling your policy. In other words, the life companies carry absolutely no business risk.
It is important that the industry and its shareholders assume a substantial portion of the risk that you may not be able to continue paying your premiums, particularly when it is through no fault of your own. If they bear significant financial pain as well, then they will make a far greater effort to ensure that you are sold a policy properly in the first place.
For example, no woman aged 20 should be sold a retirement annuity policy for which premiums must be paid until age 55. No one can predict whether in five or 10 years' time she may take time off work to have children and whether she will then be able to afford the premiums.
At the moment, life companies take no steps that I know of to stop this type of sale. The reason is that they know they will recover all their costs and some profit from the penalties they will apply should you cancel the contract or reduce your premiums.
If the life companies are forced to accept a major portion of the financial risk, they will take greater care to ensure that the policies sold are appropriate to your needs.
Remember the horrendous confiscatory penalties on retirement annuities that Vuyani Ngalwana, the Pension Funds Adjudicator, has exposed recently are not unique to retirement annuities, but apply to the vast majority of life assurance investment policies - regardless of whether you pay a single premium (a lump sum) or by way of recurring premiums.
Ngalwana's rulings, if upheld in the High Court, may stop the practice of applying confiscatory penalties on retirement annuities, but the life companies also need to take some financial risk for the sale of endowment (investment) policies - either voluntarily or by regulation.
To back this argument we only need look at the latest statistics produced by the Financial Services Board. These show that 31 percent of all endowment, risk and retirement annuity policies sold in 2003 lapsed without investors receiving a cent back, while a further 39 percent of new life assurance contracts were terminated and the policyholders also incurred significant losses.
On average, it seems that the upfront commissions account for about 40 percent of the penalties that are imposed. The rest of the money that the life assurers levy in penalties is taken to pay for the administration costs of setting up the policy, as well as for the costs the company has not yet incurred and even future profits.
As a result individuals, who cancel policies or reduce premiums are losing billions of rands every year.
It is not good enough for the life industry to say that competition will bring down costs for policyholders.
Back to the move away from upfront commissions: there are two main problems that I see in the new commission proposals. These are:
- The new structure will only apply to investment products. It is important that the new commission structure is also applied to life assurance risk products for death and disability. The reason is that amassive churning is taking place on these products.
- Many policies have what are called premium escalation clauses to counter the effects of inflation on your benefits. However, the escalations are often not based on the inflation rate but on a fixed percentage of the premiums (maximum 20 percent) which are far higher than the inflation rate. Also, you cannot predict what will happen to your income in the future. In my view, this means you should be given the choice of escalating your premiums on an annual basis.
Currently your original adviser receives a new set of commissions as the escalations take effect, without any obligation for him or her to provide any advice.
The result is that if you consult another adviser, the only way that new adviser can be recompensed for giving you advice, is to get you to cancel the entire existing policy and take out a new policy incurring surrender penalties and new costs for you.
The LOA is proposing that when you agree to an escalation in your premiums, this should be regarded as part of the initial sale, and the sales element of the commission under the new structure should still be paid when the escalation is effected, to the original adviser who signed you up.
However, you will be able to switch the advice element of the commission earned on the escalation to a new adviser. You will not be entitled to cancel the sales commission element.
I do not see why someone who has disappeared from the scene should still be profiting, even if it is only from the sales element of the commission.
On balance, however, this proposed commission structure is a major advance on what we now have. It should go some way to changing the behaviour of those financial advisers who do not serve your best interests, and it should reduce the confiscatory penalties applied to cancelled policies and premium reductions.