Before signing up for a retirement annuity make sure you understand what type of policy you are signing up for and the financial consequences should you not be able to maintain your premiums.
When Neil could no longer afford to keep up with his retirement annuity (RA) contributions he was shocked to discover that by cancelling his monthly premium the value of his policy would be reduced from R342 000 to R284 000 – a reduction of R58 000. Neil further discovered that if he wished to transfer his RA to another product provider he would pay further penalties and his retirement nest egg would fall by a total of R90 000.
Werner, a small business owner, was equally shocked to discover that his staff would stand to lose 12% of their retirement contributions when he sold his business. “As a small business I could not offer my employees a pension fund but I was worried about their retirement options so two years ago I insisted they take out a retirement annuity,” says Werner. His business has now been bought out by a larger company and so his staff will be transferring to the new company’s pension fund. Unable to afford to contribute to both a retirement annuity and the pension fund, many staff members will have to make their retirement annuities paid up and will pay early termination fees equal to 12% of their fund value.
Both these cases highlight the importance of understanding what kind of investment you have signed up for and what the implications are if you can no longer continue with contributions.
Not all RAs are the same
There are two different types of retirement annuities – one is a policy issued by an insurance company, which can carry an early termination fee, and the other is an investment-linked retirement annuity where termination fees are not levied and the underlying investment is usually a unit trust fund.
With a policy retirement annuity the policy holder effectively signs a contract to contribute to the retirement fund until a certain age – usually 55 years old. If they break that contract the insurer has the right to deduct certain upfront costs they would have recuperated over the term of that contract. This is a similar concept to a cellphone contract where the individual pays off the handset over the period of the contract.
Under an investment-linked retirement annuity there is no such contract and if the client decides to stop contributions there is no financial loss.
Why do policy RAs exist?
One could ask why, in the current economic environment where people could lose their jobs or face financial constraints, policy retirement annuities are even sold when investment-linked polices are far more flexible. The simple answer is that it is a mechanism to pay for the advice you receive.
Most retirement and investment products are bought through advisers. There are very few people who will take their retirement provision into their own hands and actively seek out their own investments. Advisers therefore remain a very important link in retirement savings and they need to be remunerated for their advice.
With an investment-linked retirement annuity an adviser only receives commission when the premium is deducted each month. An adviser who sells a retirement annuity for R500 would at most make R15 per month commission. The adviser could also charge an annual fee on the value of the investment of 1%, however, it would take a long time to build up sufficient asset value to pay for the initial advice provided – after one year the adviser would have earned a total of R240. With such a low rate of return many advisers are, understandably, reluctant to sell these products.
A policy retirement annuity currently allows the advisor to receive an upfront commission based on the value of the premiums the client has contracted to pay. For example on a R1 000 retirement annuity for 35 years the adviser would receive, for example, an upfront commission of R3800 which would cover their fees for the initial advice given. They would then receive R25 per month on the contract to cover ongoing advice.
The commission that is paid upfront is effectively borrowed from the client’s future investment with interest charged, therefore should the client stop contributions, some of these costs need to be recouped.
It is important to note that this upfront cost is not limited to the advice fee and also includes the administration costs of the product provider which means the initial costs could be substantially higher.
For individuals who do not wish to take out a policy-backed RA, they could either pay the adviser an advice fee or invest directly in a unit trust RA with no advice.
The current status of policy RAs
Policy-backed retirement annuities have come under heavy criticism by National Treasury and over the last eight years reforms have been introduced to limit the termination fees and increase disclosure. The advice fee is only a portion of the total costs and it is the lack of transparency around these costs that have raised concerns.
What to do if you can no longer afford your premiums
If you have already purchased a policy-backed RA and face financial constraints there are several options open to you. The following examples are based on Sanlam’s retirement annuity products but can apply to other funds so it is worth finding out what rules apply:
Stop your escalation: Nearly all clients have an annual escalation on their retirement annuity in order that their contributions keep up with their salary increases. Most retirement annuity products allow you to cancel the annual increase without any penalties.
Take a holiday: Many product providers include a premium holiday of up to 12 months over the lifetime of the policy where no penalties or charges will be subtracted. Be aware that some funds may lengthen your retirement date if you take a premium holiday.
Re-instate your premium: If you make your policy paid up but then re-instate it at a later stage, a portion of the early termination fee could be refunded.
In 2006 changes were introduced limiting the maximum early termination fee that could be charged to 30% of the fund value. This was further reduced to 15% in 2009 when commission structures were also changed so that the adviser could only receive half of the commission upfront. The remainder of the commission is paid “as and when” the client makes their monthly contribution. If the policy is cancelled within five years the adviser has to repay a portion of the upfront fee.
All documentation provided to the client stipulates the percentage one would pay in early termination fees – for example if you cancelled your premiums after two years you would pay 12% of your policy value in fees, after five years that falls to 7.5% and after ten years no early termination fee applies on a retirement annuity with a 20-year term.
The future of policy RAs
National Treasury has made it clear that it is uncomfortable with early termination fees and these products may become a thing of the past. The question for the industry, advisers and for clients is: “how do you pay for advice?”
Understand the implications of moving to a new fund
Clients who have had a poor experience with their financial adviser, may be tempted to cash in their policy retirement annuity and move to an investment-linked product where they pay a new adviser a more transparent annual fee of 0.5% – 1%. Remember, however, that this means from the first year the adviser receives a fee on assets you have accumulated over several years and for which you have already paid someone else for advice.
A client will need to either pay the adviser upfront or create a separate loan account with the product provider which is paid off over time from the fund. This is in essence the same structure as we currently have except that it is far more transparent and the client will have to sign a separate agreement and fully understand their liability in terms of what they owe the adviser.
Challenging the status quo
Unfortunately Neil entered his retirement annuity contract in 2008. This means the maximum early termination fee of 30% could be applied and the adviser received the full commission upfront; therefore a portion of the early termination fee is the adviser fee plus interest. With the advent of the Financial Services Board’s Treating Customers Fairly programme many of these products could face challenges as they are clearly not fair to the customer and the product provider would have to justify how the client received R58 000 worth of services.