Last week I wrote about the need for financial advisers to be paid an hourly rate to give you advice and not to receive commissions/fees paid on your behalf by financial services companies (particularly upfront commissions on premiums you may or may not be paying 20 years down the line). This week's column is a continuation on the theme.
One of the main causes of dissatisfaction with life assurance investments is the industry's insistence on paying upfront commissions on most recurring premium policies.
Mostly when you buy a recurring premium policy, commission is calculated by taking the annual premium, multiplying it by 3.25 percent and then by the number of years of the contract, with the minimum contract being five years. Most life assurers nowadays, however, restrict the number of years for which the commission is calculated to 15 years.
You can have a longer contract, but the adviser will only receive commission for 15 years. You must, however, check this.
For example, if you have a 10-year policy on which you are paying a premium of R1 000 a month, commission is calculated like this: R12 000 (annual premium) x 3.25% x 10 = R3 900. Of this R3 900, 85 percent (R3 315) is paid to the adviser in the first year and the remaining 15 percent (R585) in the second year.
On a unit trust investment and increasingly on new generation life assurance products, you pay a maximum of three percent broker commission on each investment you make and only when you make the investment. (Some unit trust funds and most new generation life assurance policies have, however, now also introduced an annual fee, based on a percentage of your assets, which is payable to advisers. You should not agree to pay this if you are not receiving on-going advice. This is yet another incentive to mis-sell.)
Disadvantages to life assurance commission structures on recurring premium investments include:
- There is no incentive for an adviser to give you on-going advice.
- There is a perverse incentive for unscrupulous advisers to get you to cancel an existing policy after a few years for a "newer and better" one to generate a new round of commissions. This is a major reason for "churning" in the industry.
- If you cancel or reduce your premiums on a policy that includes investment, the life company will reduce the value of your investment to recoup the pre-paid commission from you. In other words, the life company penalises you for the commission it has paid upfront to the adviser.
See the accompanying letter below to a Personal Finance reader who discovered to her horror the implications of reducing a premium. In this instance, Old Mutual has acted honourably and the alternatives it has offered the reader are fair. The solution, however, is for all life assurers to stop paying upfront commissions on recurring premium investments.
- The commission structure has been a perverse incentive for the life industry and financial advisers to sell you products which combine life assurance and investments. By combining risk and investment, financial advisers get bigger commissions. If you only had risk assurance with no investment attached and you cancelled the risk assurance, the life company would not be able to claim anything back from you. If both risk and investment assurance are combined, the commission already paid on the risk assurance as well as the commission on the investment portion is deducted from the investment.
Due to competition, the cost of risk cover (without investment) has been reducing and it is worth looking out for cheaper life cover. (Note, however, you should never cancel any life cover before you have new cover in place.)
As a general rule you should not:
- Combine risk and investment assurance. Apart from the commission consequences, you should keep the two separate as you never know how your financial circumstances may change in the future. If your finances take a downturn it would be preferable to cancel or reduce the premiums on your investment policy while maintaining your risk cover.
Some companies are now marketing a new generation of universal-type products which separate risk cover and investment within one policy. For example, your policy can have an investment portion for which you pay a recurring premium for five years, and a risk portion for which you pay a premium for 20 years (term cover) or for "whole of life" (the rest of your life).
The main selling point is that you pay one policy fee (a monthly rand amount on any policy issued) instead of two, and you can add and subtract elements as you go along. However, you still need to check:
- The full costs to ensure that the single policy is not costing you more than two policies (separate risk and investment) would cost.
- The guarantees on the risk premium and how the risk premiums will be adjusted. With the older universal policies if the risk premium was guaranteed for only five years, the life companies would reduce the percentage of your premium going to investment to increase the risk premium (if it needed to be increased). With the new generation universal products, you will probably have to increase your premium to cover any increase in the risk premium.
- The penalties if you reduce or cancel the premiums on either the risk or the investment portion. For example, if you cancel the risk portion, will costs be recouped from the investment portion or not?
In my view you should avoid taking out a recurring premium investment life policy with a contract period of more than five years.
In the case of a retirement annuity the maturity date should be 55 (the minimum age by law at which you can mature an RA).
At the maturity of either policy you can extend the term. This is safer as you can never predict the future.
It is best to negotiate an hourly advice fee with commissions payable offset against the fee, then there is no incentive for an adviser to sell you a product purely for commission.
Definition
Recurring premium life assurance investment: This is any amount that you pay on a regular basis (normally monthly but also quarterly and annually) for a life assurance policy. All risk policies, which pay out on death or disability, are recurring premium policies. However, with investment policies you have a choice between making a single (once-off) investment or recurring premium investment. With both a single premium as well as a recurring premium, your investment is locked in for a minimum of five years.
How Old Mutual placated an aggrieved policyholder
Dear Mrs Y
I wish to apologise most sincerely for the poor service you have received. The events you have detailed do not portray the type of service that Old Mutual can feel proud of.
From my assessment of the situation, we should have made sure that you had received the documentation detailing the cost of premium reduction before executing your request.
Had you received the necessary documentation after requesting the premium reductions, you would have been informed that these changes would cost you R32 352.98.
These costs are determined by the size of your premiums and the term of the policy, in your case R1 475 a month over 33 years. On reducing the premiums, outstanding costs, which would have been recovered over the term of the policy, became payable immediately.
Your retirement annuity policy was issued on May 1, 2000 with a monthly recurring premium of R1 475. In October 2002, you requested a premium reduction and your premium was adjusted to R250 a month. We received a second request in December 2002 and your premium was reduced to R145 a month.
Because your request for a premium reduction was made more than two years after your policy was issued, we were unable to write back to your policy a portion of the commission.
The practice of "claw backs" is standard industry practice only where premiums are reduced or discontinued during the first two years of a retirement annuity policy. We are therefore unable to reverse the intermediary's commission without written consent.
But because our poor service caused you to make an uninformed decision, which resulted in a substantial loss, we propose three options, one of which will return you to the position you were in before you requested the premium reduction.
The aim is to enable you to make an informed decision about the future of your retirement annuity.
The options we are proposing are as follows:
- Option 1. You could resume premium payments at the original level of R 1 475 a month, in which instance the full impact of the cost levied would be written back to the policy. From a cost perspective, this would mean that we would treat the policy as if the premiums were never reduced. No arrear premiums will be paid and there would be no penalty at all.
- Option 2. We can treat the request (from a cost perspective) as if the request for the premium reduction to R145 a month was only received now - the current date. The cost in reduced value would then be R29 870.47 instead of R32 352.98.
Should you wish to proceed with this option, Old Mutual would write back the original cost of change at the time this was levied - the fund account would then be adjusted with the amount of R29 870.47 from October 1, 2004.
- Option 3. Finally, we could reverse the full impact of the cost of change upon the payment of the arrear premiums. As the premiums were reduced from R 1 475 a month to R145 a month with effect from December 1, 2002, the shortfall in the premium contributions (calculated up to and including September 2004) would be (R1 475 - R145) x 22 = R29 260.
This means that the contract would then continue at a premium level of R1 475 a month.
I trust that our proposals will at least go some way towards restoring your confidence in Old Mutual.
I would also like to offer compensation for the administrative burden this has placed on you. The Office of the External Ombudsman has advised us that a fair amount would be R2 500.
Should you wish to proceed with any of the suggested options, or have any questions, I would like to extend the invitation to contact me personally.
Piet Spreeuwenberg
Client Service Manager