The chickens are coming home to roost for the life assurance industry with its high cost structures that are eating into investment returns. Even popular magazines are now joining the hue and cry.
Many in the life industry, however, do not seem to have received the message about policyholder discontent. Instead of dealing with the issue of costs and poor investment performance, it is resorting to: maligning journalists who dare reflect policyholder discontent; using red herrings to detract from the issue; and generally talking past the issue.
The life assurance industry simply will not grasp the nettle. For example, it resists dumping upfront commissions (and along with that the horrendous surrender penalties it uses to confiscate the savings of individuals) that reduce the potential to receive a sound return on your investments.
This is not something new. Personal Finance has been writing about these problems for years. The life industry simply thinks because it got away with it in the past, it will get away with it in the future.
Until the life assurance industry comes to its collective senses, individuals and their financial advisers must simply consider the cheaper alternatives, offered by the unit trust industry, and exchange traded funds, such as Satrix. These investments also allow you greater flexibility, because without penalty, you can access your money and stop paying premiums if your financial circumstances change.
Things to consider before bailing out of an investment
However, exercise caution before you bail out of an existing life assurance investment. Here is what you should consider, preferably with the help of a well-qualified financial adviser, such as a Certified Financial Planner:
1. Investment performance. Is your policy really under-performing? Many life assurance investments have actually provided sound investment returns (despite high costs). Inflation is the most important benchmark that you should use to assess the performance of your investment.
If your policy has beaten inflation, then you have been receiving a real return. Although you may have done better (with the wisdom of hindsight) in another investment, you cannot be sure that you will be better off in that investment in the future.
Many older policies are what are called reversionary bonus policies. This means that if you hold onto the policy until maturity, it normally comes with what is effectively a terminal (maturity) bonus, which will give you a much better end value. The problem, however, is you do not know what this bonus will be.
2. Surrender penalties. Most life assurance policies apply surrender penalties if you do not stay invested for the full contract period. The longer the policy has to go until maturity, the higher the surrender penalty will be. The penalties can apply whether you cash in the policy or make it paid up (pay no further premiums). What you need to do is work out what is called the opportunity cost of surrendering your policy or policies. So, say you want to use the proceeds and/or future premiums to either pay off debt and/or make a new investment, you will need to calculate and compare:
- The cost (the potential loss) of staying invested and continuing to receive poor or negative returns (as a result your capital is reducing in value); and
- The cost of cashing in your investment; the returns you will receive from paying off debt (in that you will reduce the amount of interest you will pay in total on the debt); and/or the costs of any new investment.
In making these calculations, you will have to take into account the actual costs and past investment performance of the existing policy and the costs of any new investment. You will obviously have to make a number of assumptions about such things as the future investment performance of the underlying investments, both of the existing policy and any new investment, and future interest rates, if you intend paying off debt.
3. A universal policy. These policies have both an investment part and a risk part, against death or disability. These policies are often complex. They are structured so that financial advisers get the maximum amount in upfront commissions. These policies can be a nightmare for policyholders.
Many, but not all, universal policies are designed to give a life assurance company the freedom to dip into the investment portion of your policy, without consulting you, to allocate more of your premium to the risk portion of your investment. Although your premiums will remain the same, this has an adverse effect on your investment.
Many of these policies also have premium escalation clauses, which can be linked entirely or partially to upping the risk premiums on an annual basis, without necessarily adding anything to your investments, or increasing your risk cover (the amount that would be paid if you died or were disabled).
This all means that you must take extra care when considering whether to cash in a universal policy. There are numerous issues you need consider, including:
- How much of your premium has gone to pay for risk.
- The guarantees on your risk premiums. Find out if they are guaranteed and for how long.
- Ask your life assurance company to tell you what the investment return has been on the investment portion.
- Do not cancel any risk assurance until you are sure you can get it replaced at the same or a lower premium. Your age and health will affect what you will pay on any new policy. If your health has deteriorated, you may be refused life assurance cover or may have to pay a loading (a higher premium). You also need to check on the guarantee period of the risk premium. If your premium is guaranteed, say for 10 years, it may not be wise to switch to a cheaper premium where there is no guarantee and the premium could escalate rapidly on an annual basis in the future.
- If the investment performance has been particularly poor, but if you want to retain the risk part, establish whether you can make the investment portion paid-up and what penalties will be applied.
4. Investment guarantees. Many life assurance policies have guarantees on both your capital and returns (normally up to 4.5 percent a year). So although the current value of your policy may be low, the life company will have to pay the guaranteed amount on (and only on) maturity.
5. Retirement annuities (RAs). If you have an RA, you cannot cash it in until you reach the age of 55. When you do "cash" it in, you will have to take two-thirds of the amount as a monthly pension. If you decide to make the RA paid up before the age of 55 or before maturity (and pay no further premiums), there are likely to be penalties involved, which could see you losing all or part of your savings.
As you can see, surrendering or making a policy paid up is no easy decision and it should definitely not be a knee-jerk reaction to the bad publicity the life assurance industry is currently receiving on costs.
***
The National Treasury's 77-page document on the proposed reform of the Pension Funds Act has been long in coming, but it has been worth the wait. It is comprehensive, it is innovative, it will be controversial and it will be debated long and hard.
Hopefully, the reform will achieve a system that will: encourage individuals to save for their retirement; make retirement saving more accessible to people on low and indeterminate incomes; and ensure that retirement savings are no longer treated by many in the life assurance industry as some type of piggy bank that can be dipped into without restraint, undermining your potential for a financially secure retirement.
To surrender or not
Last week I reported on the Old Mutual investment of Reader M, and asked Old Mutual and/or the Life Offices' Association to advise Reader M on whether he should maintain his policy or surrender it.
The case of Reader M:
- Seven years ago, Mr M took out a 10-year endowment policy with Old Mutual.
- The policy's underlying investment is in Old Mutual's World Wide Equity Fund.
- The premium is R100 a month. He has invested R8 400 to date.
- Mr M has paid R1 883 in costs so far (or 22.4 percent of each monthly premium).
- Mr M's policy should be worth R10 089 today to have retained the value of his money after inflation at an average rate of 5.14 percent over the past seven years.
- The current value is R6 559.
- The surrender value is R4 756, which is all Mr M will receive if he cuts his losses and cashes in the policy.
Old Mutual's response
Old Mutual claims that he will probably achieve the same results staying where he is or surrendering the policy and paying the money into his home loan (if he has one).
Old Mutual says: Any decision on any investment should be taken not only by looking back at what has happened in the past, but more importantly looking forward at reasonable expectations for the future. These expectations must take into account all four factors that drive investment returns, namely:
- Behaviour of the underlying markets.
- The performance of the asset managers in relation to these markets.
- The choices made and actions taken by investors and their advisers.
- The costs of investment and disinvestments.
In reaching a decision it is even more important to take a prospective view and not only a retrospective view. The lower the surrender value of a policy in relation to its actual value, the more important this is.
- If the policy is surrendered and this surrender value and the remaining premiums of R100 a month are applied, for example, to the policyholder's mortgage bond, this investment of R9 383 will have reduced his bond by R12 164 on the policy's maturity date of October 1, 2008. This assumes a present bond rate of nine percent a year remains constant for the next four years.
- If he leaves the policy to run through to maturity, it will give him the same amount of R12 164, provided Old Mutual earns an average of 7.45 percent a year on the portfolio he is invested in over the next four years. He could then pay this into his bond and would be in the same position.
The choice of the Worldwide Equity Fund means that the investor has been exposed to the combined effects of the most severe global equity bear market since the early part of the last century, as well as a rand that weakened initially and then strengthened beyond all expectations.
This, combined with the relatively high charges on the very small premium of R100 a month, has accounted for the disappointing performance to date.
The question Reader M needs to ask is whether prospects for the rand and for global equities over the next four years are likely support a 7.45 percent return or, if he switches to a local equity portfolio, whether South African equities would deliver something similar.