Many years ago I warned of the dangers of retirement fund members being offered a wide range of choices about how they wanted their money invested.
Although the financial services industry claimed that members wanted this array of options, it seems that the industry was creating products merely to serve its own interests.
This so-called freedom of choice was foisted on retirement funds and their members both in the build-up to retirement and at retirement.
Linked investment companies were at the forefront of offering members a range of product choices - mostly unit trust products. They flogged these choices by, among other things:
- Telling the trustees of retirement funds that they would no longer have to carry the responsibility for making investment decisions; and
- Telling members that greater choice would allow them to get the best out of the markets, and that they could switch between investments.
But the linked product companies failed to highlight the negatives, including that:
- Members would incur higher costs. One of the advantages of retirement funds is that they can negotiate for their assets to be managed at fairly low fees. This advantage is lost when an individual's retirement savings are managed. Instead, you have a triple layer of costs:
- You have to pay a financial adviser - many of whom do not have the skills to advise on asset management;
- You have to pay the costs of the linked product companies; and
- The underlying costs of the unit trust companies.
So, instead of costs being less than one percent, they jumped to well over six percent.
- You, as an individual, do not have the time or, in most cases, the expertise to properly exercise this new-found freedom.
- There are costs and risks involved in switching investments.
In addition, the linked product industry did not properly explain the investment risks, and nor did it educate members about the products they were being sold.
The linked product industry further covered itself in glory by getting involved in some very dubious practices - many of which still continue. These practices include:
- Using life assurance policies as umbrellas for investments. This allows the regulations governing the prudential (wise) investment of your retirement savings to be side-stepped.
- Using life assurance policies to lock people into contracts. This has happened particularly with living annuities: once you are locked in, the linked product companies are able to limit your investment choices and raise costs without you being able to do anything about it. Many linked product companies have simply refused to allow you to move. The Financial Services Board (FSB), which is supposed to protect our interests, responded in a wishy-washy fashion to this practice.
- Giving favoured status to the unit trusts of management companies that were prepared to pay kickbacks to the linked companies. In many cases, linked product companies refused to include in their portfolios the unit trusts of management companies that spurned kickbacks.
- The introduction of wrap funds, for which you pay additional costs for another set of experts to protect you from unskilled financial advisers, and through which underlying investments are wrapped together in different risk/return options.
- Increasingly higher commissions, fees and other rewards, including luxury trips abroad, being paid to financial advisers as incentives to get you to sign up.
Although many of the products and even the choices on offer were sound, the problem lay with the indiscriminate approach of "sales at all costs", with little concern about the dangers to which ordinary investors were being exposed. The result is that there is now overwhelming proof that many peoples' retirement savings have been seriously undermined.
The good news is that the FSB is finally reacting.
At the Institute of Retirement Funds' annual conference this week, there was a good deal of discussion about proposed changes to Regulation 28 of the Pension Funds Act. This regulation covers the prudential investment of our retirement savings. Among other things, Regulation 28 stipulates that no more than 75 percent of retirement fund savings can be invested in share markets.
But the regulation has been wide open to abuse, and has been flouted by not only the linked investment companies, but also by many other players in the retirement industry.
One example is the sale of structured funds that offer guarantees on the capital as well as growth linked to an offshore market index, by making use of derivative products. By wrapping these investments in life assurance policies, those selling these products sidestepped the prudential guidelines and exchange control regulations while leaving retirement funds exposed to unknown tax liabilities.
The FSB has now recommended to Finance Minister Trevor Manuel that Regulation 28 be overhauled.
The draft of the new regulation proposes that trustees of retirement funds cannot abdicate their responsibilities by allowing individual fund members to choose how they want to invest their savings.
In terms of the regulation, trustees will have to ensure that members have the necessary financial expertise, or will be able to receive advice from someone with that expertise, before giving you the right to choose.
And once the Financial Advisory and Intermediary Services Bill (FAIS) becomes law, you will also be protected to some extent from receiving bad advice. Anyone giving you inappropriate advice will suffer penalties, including being banned from being a financial adviser.
Jeremy Andrews, the chief actuary of the FSB, says the FSB also sees FAIS as the answer to the mis-selling of living annuities. He says that living annuities are good products, but they must be sold appropriately.
Living annuities allow you to select underlying investments, offer you a compulsory pension based on between five and 20 percent of the capital value, and enable you to leave the residue to your heirs. However, you take the risk that the capital will last you until you die, and this risk can be considerable, particularly when markets are highly volatile.
My view is that you must be very careful about taking on investment choice. There are sound arguments for using living annuities to save for retirement, but there are no sound arguments for allowing you to make complex investment choices while building up your retirement savings.
The only choices you should have are simple ones concerning the risks you are prepared to take. For example, whether you want to be investment in a smoothed/stable bonus capital guaranteed product, which should give you steady appreciation in your investments, or a balanced portfolio (invests in different asset classes) linked to the market (that is, the value is equivalent to the underlying investments).
At the very least, wait until the new legislation/regulation is in place before you make the decision on individual investment choice. That way you will have greater protection.