This is the second half of the story '10 things you should know about linked-investment service providers'.
5. Risk of bad advice
One of the major problems of investing through a Lisp is that the products on offer are often complex and are subject to the vagaries of investment markets, as well as good or indifferent advice. In the early days of Illas, the investment advice handed out by many financial advisers was appalling, leaving many pensioners facing destitution.
One of the difficulties with the wide choice of underlying investments provided by Lisps is that sound investment structuring becomes critical. Investors need to decide the asset classes and the proportion of each asset class to be used, as well as the underlying product and the product provider.
Instead of taking both risk and returns as well as the capital growth versus income needs into account, many advisers simply chased the latest top performer, while pensioners envisioned their retirement tills ringing up thousands or even millions of extra rands.
There is plenty of evidence that ill-trained advisers followed the herd instinct, pushing their clients holus bolus into high-risk sectors, such as technology unit trust funds, or emerging company funds. They compounded the fragility of the investments by placing a maximum amount into offshore sectors on the basis of a weakening rand. And this drive into these volatile market segments came when they were trading at or near the top of their cycles. Then, when the inevitable collapses occurred, the advisers urged their frightened clients to bail out into the next flavour of the month.
The Lisps also encouraged bad advice by rewarding financial advisers with luxury foreign trips, such as yacht trips in the Mediterranean and being ferried to the best golf courses in Ferraris and helicopters.
The result was that people who should not have been put in Illas were mis-sold the product as if it were some sort of magic potion that would make up for shortfalls in their retirement savings.
And then there was and is a far more insidious practice of unit trust management companies paying backhanders to financial advisers to steer investors into their underlying suites of funds. Often investors are totally unaware that they are being placed in funds where the backhanders are paid. The payments are frequently made to a company associated with the financial adviser so that the adviser can avoid telling you about the payment. These payments were and are still often facilitated by Lisps, which may or may not inform you explicitly of the practice. The problem with this practice is that an adviser is being incentivised to put you into the unit trust that is paying the highest kickback rather than the one that is in your best financial interests.
But the FAIS Act is putting the brakes on this type of cavalier advice and behaviour. In terms of the Act, your adviser is required to have certain minimum qualifications and to give you "appropriate" advice.
The Ombud for Financial Services Providers was created to back up the enforcement of the Act. The ombud will hear any complaint about advice given after October 1, 2004, when the FAIS Act was fully enacted. The FSB can remove the licence of any financial services provider that does not meet the law's fit and proper requirements.
These changes are focusing, although in some cases too slowly, the collective minds of the Lisp industry and many responsible financial advisers. More and more financial advisers now see their roles as planners and leave the work of investing to expert asset/portfolio managers.
The Lisps themselves, albeit under pressure from the South African Revenue Service (SARS), are doing something about limiting investment risk and ensuring a better standard of advice. SARS has threatened to get tough with the industry unless it does more to ensure that Illa annuitants receive a sustainable income until death.
Many companies that have their own sales forces are insisting their employees meet qualification standards that are better than those required by the FAIS Act. Companies that use independent financial advisers are being a lot more discerning about whom they will allow to sell their products and are spending time trying to increase levels of knowledge.
There are indications that one problem resulting from the FAIS Act holding intermediaries responsible for the advice they dispense is that some investment advice being provided is too conservative. This can create long-term problems if an investment does not keep ahead of inflation.
To find a suitably qualified adviser, go to www.fpi.co.za and www.findanadvisor.co.za
6. Choice
A major advantage of Lisps is the wide range of underlying investments they offer. Initially, Lisps offered only unit trust funds - and sometimes a limited range at that. Some of the bigger companies excluded the products of their major competitors.
The range of underlying investment options is changing significantly. Some companies permit you to hold your own share portfolio or the cheap exchange-traded funds (ETFs), which are index-linked collective investments that are similar to unit trust funds with the exception that they are listed on a stock exchange.
However, the choice, particularly of unit trusts, is still often limited for various reasons. These include:
- The increasing range of choices. For example, although more than 700 unit trust funds are available, many of them will simply disappear.
A large number of the funds that will disappear are what are called white-label funds, which include the potentially dangerous broker funds, where a broker puts together a fund of funds without necessarily having the expertise. These funds, which had a disastrous history in the United Kingdom, enable advisers to skim off another layer of fees (from your pocket).
It is simply not prudent or cost-effective for Lisps to offer the full range of unit trusts.
- The practice of Lisps demanding kickbacks (or what they politely call rebates) from underlying unit trust companies. Personal Finance has proof that if the lesser-known unit trust companies do not pay up, they do not get listed on a Lisp's platform. This practice means that an attractive investment may not be made available to you. Some unit trust management companies, such as Piet Viljoen's Re:CM, are not listed on Lisp platforms. Viljoen simply refuses to pay rebates. Others, such as Allan Gray, don't need to pay because of the public demand for their funds. If a Lisp did not list the Allan Gray funds, it would lose its customer base.
But you may not be able to access some small boutique investment managers that produce sound and consistent returns.
Former Lispa chairman Emile Wessels, the head of Sanlam's SP2 Lisp, says South African Lisp fees are low by international standards. On top of this, South African investors score because unit trust management companies also have comparatively low charges by international measures, even after paying rebates to the Lisps.
Wessels argues that investments made via Lisps into unit trust funds are more profitable for unit trust management companies because they do not have to do as much work as they would if every Lisp customer invested directly.
However, the rebates are disappearing because unit trust funds are increasingly making "industrial" or "wholesale" funds available to the Lisps at much lower costs and with no need to pay rebates.
- Many of the Lisps' associated companies offer risk/return portfolios so that you do not need to make the underlying investment choices yourself. (See table Your underlying investment choices.This is very much the case with companies such as Citadel which take full responsibility for making all the underlying investment decisions, leaving you to choose only the portfolio.
- The ability of the administrative platform to accommodate a wider range of products. For example, a number of Lisps do not offer ETFs because their computer systems cannot accommodate them.
Costs
Costs can hit you from many sources. Firstly, there are the Lisp's own charges to you. Then there are the financial adviser fees and, finally, there are the costs of the underlying investments.
The typical fee structure of a Lisp product is:
- An initial administration fee of up to 2.84 percent. This is reduced on a sliding scale according to the amount invested. A number of companies have dropped initial administration fees altogether for larger investments (about R500 000).
- An initial, negotiable commission/advice fee of 2.5 percent (subject to maximums by the Lisps).
- An annual administration fee of 0.5 percent.
- An annual commission/advice fee of up to one percent (negotiable).
- Asset management fees charged on the underlying investments. These costs can include initial and annual fees, as well as performance fees. Most unit trust management companies are phasing out initial fees in favour of higher and more profitable annual fees, which range between one and two percent.
- VAT on all fees.
Another factor you need to take into account is how the costs will be deducted. Some companies sell your underlying units on an ongoing basis to fund a special fee account, or they take their cut on a monthly basis from a special fee "account" held in your name to which interest and dividends are paid.
The costs are over and above your monthly pension drawdown and are not included in the allowable drawdown percentages.
Commissions/fees are negotiable and should be treated as separate from the Lisp fees.
Some Lisp companies, such as Citadel, are more than a Lisp. Their total offering is limited to clients to whom they also provide overall financial planning advice. In cases such as this, you also need to take account of the additional costs above the Lisp fees, including performance fees, which can become complex and expensive.
To give you an idea of the effect of annual costs, Personal Finance asked a number of the leading Lisps how their fees could impact on your capital. (Please note this excludes initial costs, but includes the underlying costs of a balanced wholesale fund at one percent a year and maximum annual Lisp costs and commissions/fees.)
We asked for the cost structures on two investment amounts - R2 million and R5 million - assuming an average return of 10 percent a year and a pension drawdown of eight percent (including VAT). On R2 million, your monthly pension would be R13 333.33, and, on R5 million, your monthly pension would be R33 333.33.
The costs are deducted separately; they are not deducted from your monthly pension. Companies such as Citadel are excluded from the survey because their costs are not comparable. See the results in the table headed "How costs can eat into your capital".
Switching between Lisps
Lisps are administration platforms. Some-times their service provision is tardy, or they increase their fees, or do not offer you the range of underlying investment choices you require.
If you are unhappy with a Lisp's services, the answer is to switch to another one.
Historically, the individual Lisps have either refused to allow you to switch or have made it as difficult as possible to do so, particularly when your investments are made under a legal wrapper, such as an RA or a preservation fund.
Before you give a Lisp one cent of your money, you need to confirm in writing that you will be able to change to another Lisp in the future at a reasonable cost. You must also obtain, in writing, what these disinvestment costs will be. The reason you change Lisps, however, should not be the performance of the underlying investments. It is highly unlikely this has anything to do with the Lisp.
You must also be wary of being advised to change a Lisp without any real cause. There was a lot of switching of pensioners between Lisps at one stage when the practice of luxury foreign trips was more prevalent than it is today, and qualifying for the trips was based solely on the amount of business a financial adviser brought to a Lisp.
You also need to be able to switch out of an Illa altogether and purchase a guaranteed annuity from a life assurance company.
Financial services company Alexander Forbes recently published research that shows that, in the current low-interest environment, until you reach your seventies, it is probably best to invest your retirement savings in an Illa rather than in a life assurance guaranteed annuity product. Once you reach your seventies, the life assurance company will give you a much higher guaranteed annuity than it would have given you if you had taken out a guaranteed annuity at 60, because the life company expects you to die sooner rather than later.
Investing in the guaranteed annuity later in your retirement could place you in far less vulnerable position than would be the case if you invested in an Illa. The reason is that, with a guaranteed annuity, you transfer to the life company the risk of being paid an annuity until the end of your life.
One by-product of this is that if you suffer from mental degeneration in your old age, no one will be able to take advantage of the situation to your financial detriment - as is possible with an Illa.
Versatility of the Lisp offering
You need the versatility of being able to draw down from different parts of your investment.
Initially, Lisps insisted that you draw down your monthly pension in equal proportion from all your underlying investments - and some still do. This is not in your best interests.
You need to be able to segment your underlying investments so that you are not caught out by market crashes. Many good financial advisers now recommend that you should compartmentalise an Illa. So you could have:
- A segment or portfolio purely in equities from which you are seeking long-term capital growth;
- A buffer portfolio consisting of high-dividend equities and interest-earning investments; and
- An interest-earning portfolio with sufficient assets to provide you with an income for at least two years. Your pension would be derived only from this portfolio, which would be kept in the money by the other two portfolios.
A segmented structure enables your investments to withstand market volatility, but you need to invest through a Lisp that gives you this versatility.
10. Being your own worst enemy
The facilities offered by a Lisp or an Illa will not solve your financial problems if you retire with a shortfall in retirement capital.
Initially, much of the mis-selling of Illas revolved around pensioners being shown glossy brochures of how stock markets always, on average, provide better returns than other asset classes. So, the argument went, because of the better performance of the equity asset class, an Illa will eventually provide you with a far better pension than a guaranteed annuity, because a guaranteed annuity is linked to interest-earning investments. But the key phrase is "on average". Actual annual performance is very different from average performance over a number of years. Markets rise and fall, sometimes very dramatically.
The table, "The effects of a market crash", illustrates what can happen to your living annuity if there is a market slump, as happened in 2000.
Remember, the biggest financial risks you face in retirement are:
- You simply do not have enough money on which to retire;
- Living "too long" and running out of money;
- You draw down too much from a living annuity, particularly in the early years;
- You make the wrong investment choices; and
- You obtain investment advice from someone who is not skilled enough to provide it.
In all these cases it is not the fault of the Lisp, or the underlying investment choices or the Illa that things have gone wrong. There is nothing wrong with the concept of a Lisp or an Illa. However, they must be correctly used and not abused.
What is a living annuity?
An investment-linked living annuity (Illa) is a flexible, pension-generating tool that allows you to:
- Decide on the level of pension you wish to draw down every year. In terms of tax legislation, you must draw down at least five percent but no more than 20 percent of the annual value of your capital as a pension. This range is under review by the South African Revenue Service. Some life assurance companies are now limiting the maximum drawdown in the initial years of the pension to 12 percent to ensure that your pension lasts throughout your retirement.
- Select from, and switch between, a wide range of underlying investments, allowing for extensive use of equity investments.
- Bequeath the residue of your funds on death.
The main differences between traditional life assurance guaranteed annuities and Illas are:
Guaranteed annuities
- Offer longevity insurance
- Income levels assume you stay healthy
- Can leave dependants with no inheritance
- Can lock you into low interest rates, depending on your starting date
- Often produce bond-like returns
Investment-linked annuities
- Do not offer longevity insurance
- Income levels can be adjusted for ill heath
- Can leave dependants with an inheritance
- Allow adjustments for different interest rate regimes
- Give access to better-performing asset classes
Source: Lispa
Moves to put Lisp industry on a sound footing
The linked-investment service product (Lisp) industry is looking to raise its game to ensure that when you invest in an investment-linked living annuity (Illa) you will receive a sustainable income until you die.
The Lisp industry initially took the view that it provided merely an administrative service and did not need to take responsibility if Illas failed to deliver.
However, poor market returns at the turn of the century, and low inflation and interest rates left many Illa pensioners facing destitution, bringing about a volte face by the industry.
Much of the change of heart can be attributed to increasing concern that, as a result of the Illas' failure to deliver adequate returns, the government would force the Lisp industry to provide pensioners with an income.
Last year, the South African Revenue Service (SARS) told the Lisp industry it must ensure that Illas are sustainable until the annuitant's death or else SARS might have to reconsider the tax concessions on Illas.
The Life Offices' Association, which represents the life assurance industry, has already drawn up its own code of conduct for the responsible selling of Illas.
Some industry players have made recommendations to SARS and the National Treasury that the maximum drawdown amount should be reduced from 20 percent to 12 percent of the annual value of your capital, and that the minimum amount that may be invested in an Illa should be R500 000.
Riaan van Dyk, the newly elected chairman of the Linked Investment Service Providers Association (Lispa), says Lispa wants to toughen its self-regulation of the industry but it also wants the government to improve the regulatory environment. For example, Lispa:
- Plans to introduce a code of conduct for the governance of Illas that could be included in future regulations. It is currently proposed that the code of conduct will:
* Include age-related drawdown limits to prevent annuitants drawing down too much in the early years of the annuity; and
* Make it mandatory for every annuitant to be sent an annual "sustainability of income" report that will provide an update on the status of their Illa, as well as information that will assist them to make investment and drawdown decisions for the following year.
- Wants the Financial Advisory and Intermediary Services (FAIS) Act to be strengthened to cover the sale of Illas. Van Dyk says unless Illas are managed by skilled financial advisers, you could face destitution.
- Wants Illas to be defined in the Long Term Insurance Act. This would include:
* The drawdown range being written into the Act; and
* Having prudential investment regulations for Illas similar to those that apply to other retirement products, such as employer-sponsored retirement funds, to limit high-risk investments.
A number of Lisps are already voluntarily imposing the recommended minimum investment amount and drawdown limit. They will agree to pensioners drawing down higher percentages only in exceptional circumstances - for example, when a pensioner is critically ill or is emigrating and wants to transfer retirement savings to his or her new country of residence.
A limited number of Lisps are also applying prudential investment restrictions on underlying investments, limiting the amount that can be invested offshore or in equities, among other things (see "How the Lisps shape up").
Van Dyk says prudential investment regulations, similar to those imposed on the retirement fund industry, should be enforced to ensure lower-risk investment decisions. He says this means that better control is required to ensure:
- A high standard of advice from financial advisers. This can be achieved by the Financial Services Board (FSB) strengthening the fit and proper requirements under the FAIS Act so that financial advisers who sell Illas are better qualified.
- Better disclosure by Lisps to investors of all the implications of investing an Illa. This would be achieved by self-regulation of the Lisps by Lispa. Better disclosure would entail health warnings on Illas, including warnings:
* Against making inappropriate investments that may result in a lower income over time;
* That you should limit your exposure to equities and international investments;
* That you should obtain proper advice; and
* That you should limit the amount you draw down as an income to percentages that will ensure your pension remains sustainable.
Van Dyk says Lispa does not want tighter regulation on Illas, but "wants to ensure that the right guidelines exist for proper advice and disclosure of information".
He says Lispa members accept their responsibility for ensuring that Illas are sold responsibly, but an appropriate regulatory framework is also required to ensure that this happens.
Lispa has offered to start monitoring Illas and to report to a Lispa market conduct committee and to regulatory bodies, such as the FSB. Van Dyk says this will enable the FSB to take action when it feels incorrect advice is being given.
Illas are sound and useful products for investors, Van Dyk says. The Lisp industry must, however, ensure that Illas are appropriately sold and that pensioners are given proper advice and make the correct decisions.
This article was first published in Personal Finance magazine, 2nd Quarter 2007. See what's in our latest issue