A Moneyweb reader sent the following query:
I am a 50-year-old domestic worker who owns my own home and am debt free. I would like to start investing R500 per month (with an inflation-linked annual increase) towards a retirement annuity (RA) to supplement the government grant income I will receive when I retire. I received a quote from Sanlam (enclosed) for a Cumulus Echo Retirement Plan that I think has charges of 2.5% (it’s unclear – looks like it could be more than that too).
After reading this article on Moneyweb, I wanted advice as to which products I should rather consider investing in directly. I’m happy to look at active or passive funds, but want to know which offer the lowest costs in the market.
Mduduzi Luthuli, head of wealth management at Luthuli Capital answers:
Cost vs price vs value
The question of fees is becoming an increasingly important one in our industry, and so it should. In its effort to make the financial advisory services sector a more professionally-run industry, the Financial Services Board (FSB) has proposed the Retail Distribution Review (RDR). What is RDR? It proposes significant regulatory reform. As with any change in legislation, financial services providers (FSPs) will have to adapt to and change some of the ways in which they do business to comply with new requirements.
One of the significant reforms or key points to be addressed is how do we charge fees as an industry? Fees must be based on the value one brings to a client through their advice as opposed to just charging a fee because you’re entitled to charge it. Great financial advice is worth every penny similar to great medical or legal advice. This is the point the FSB is hoping to drive. Fees must be based on the value you bring to the client and not just because it happens to be a feature of a financial product.
We will soon be required to have very frank discussions with our clients and justify the applicable fees charged. Why does one adviser charge an upfront fee of 3% whilst others charge 0%?
I truly believe in the philosophy that in life it’s never about the price but it’s always about the value. Charge your fee, service provider, but be ready to justify it. Explain to your client what intellectual property and continued support, administrative and otherwise, went into calculating the fee you charge. The cost of your product or service is the amount you spend to produce it. The price is your financial reward for providing the product or service. The value is what your customer believes the product or service is worth to them.
Why the fees?
The RA market requires competition between service providers in order to function effectively. So what drives the fund costs and charges? More importantly, what fees can be charged on RA policies? RAs are voluntary membership funds. As such, they need to be marketed and sold to prospective customers (members). This is a significant driver of both their design and their cost. It also means that the costs of contribution collection and benefit payments are high. Most investment-linked RAs provide investment choice to members. Some require their members to take the advice of financial advisors, which raises the costs of membership. The underlying complexity of such retail products by providers is really an attempt to provide flexibility and choice to clients by attempting to segment the market into various parts for which different charges can be levied. Let’s look at the major factors of cost when designing such a product:
Early surrender penalties marketed as loyalty discounts or refunds on fees;
The extent of member investment choice (greater choice leads to higher charges);
Discounts on standard charges offered to members enrolled on the recommendation of preferred distribution channels (that is, financial advisors or groups of financial advisors);
Complex investment guarantees of various types, which are very difficult for consumers to value (greater use of complex guarantees result in higher charges);
Other policy features, such as free switches of retirement savings from one investment product to another, minimum premium amounts, and the option to make the policy paid-up, at a cost.
Flexibility and choice is great when trying to drive competition, however, the complexity of the charging structures of some RAs in South Africa is truly startling, especially when compared with other simpler (and cheaper) options on the market.
What fees can be charged? The usual suspects
If a fee or charge is levied against the fund, the fund will pass the fee or charge on to you by reducing the underlying investments of the investment account by the same amount. We all know that any fee that will be levied will be deducted from your investment amount or premiums contribution. It’s because of this principle that you wrote in, because deduction from your capital will play a significant role on your investment growth and maturity value.
Fees on most investments are charged as a percentage of the assets. This means the less you have with the company, the lower the rand amount of the fee. Similarly, if you have a larger investment amount the more as a rand amount, although, as a percentage, it is exactly the same. What is the reason for this impartiality between policyholders? Charging a fixed rand amount would prejudice those with lower balances and benefit those with large balances. This would then not be in line with Treating Customers Fairly (TCF) legislation. A natural consequence of this is that you’ll pay more (as a rand amount) over time as your investment grows. In fact, given enough time, your fees could very well become a large proportion of your contributions. However, bear in mind that this also means that your investment has grown a lot in value to the extent that your contributions are overshadowed by the growth of your investment.
I’m assuming here you have a competent wealth manager who has provided you with a good investment strategy. Therefore, it’s important that you look at the actual percentage of fees levied. There are many fee structures out there, but if your total fee is less than 3% you’re paying in line with the industry average.
Typically we tend to see three types of fees being deducted from your investment on an initial and annual basis:
- Administration fees
- Investment management fees, and
- Financial adviser fees.
Let’s briefly explore each of these fees.
Initial (upfront) fees
Initial fees are deducted before the investment allocation is made. This means that these fees are payable even before your investment has begun.
- Typically, there’s no initial administration fee payable.
- Dependent on your underlying investment choice, where your funds are invested, an initial investment management fee may be charged. The amount available for investment will be reduced by the initial fee and paid to the applicable fund manager/s before investment.
- If you and your financial adviser agree to an initial financial adviser fee, the fund administrator will deduct from each contribution, before investment, an amount equal to the initial financial adviser fee. An advisor will generally calculate his fee as a percentage of the amount of money he’s managing for you. Because of economies of scale, this percentage fee generally declines as your account size increases. The more money you have, the more power you exert in terms of negotiating with an adviser. These fees tend to vary between 0% to 3.42% (excluding VAT).
Annual (ongoing) fees
All annual fees are calculated daily, based on the market value of your investment at the end of each day.
- The administrator (where your funds are housed/ the person debiting your personal banking account) charges the fund an annual administration fee (excluding VAT). This fee can be calculated on a rolling scale based on the investment amount or as a flat annual administration fee (excluding VAT).
- The manager (where your funds are invested, dependent on your investment choice) charges annual investment management fees. These fees vary per fund; they may be fixed or performance-related.
- You and your financial adviser may agree on annual financial adviser fees. The manager pays this fee directly to the financial adviser, or to the administrator who pays the financial adviser. In the market, this tends to be capped at 1% per annum excluding VAT.
Cumulus Echo Retirement Plan
The features of RAs tend to be the same, no matter which service provider you opt to for. These features are governed by legislation so no one provider really can create a product that differs largely from what’s available in the market. With this product, Sanlam aims to give you a bonus on your investment returns as an incentive for choosing its RA and, more importantly, keeping its RA.
Active vs passive. Which is better?
With the rise of passive funds in South Africa, this has been an on-going debate with no real conclusive answer. Personally I feel both have a role to play in a portfolio. I tend to favour blended portfolios which combine active and passive funds with the hope of getting the best of both worlds. Active managers attempt to outperform the market by assembling a portfolio that is different or “superior” to the market. They attempt to achieve this through their “superior” analysis, research, forecasting and valuations. The Efficient Market Hypothesis asserts that no investor will consistently beat the market over long periods except by chance. So then what’s the point of active management? Active management aims to give you the investor greater diversification and less correlation in your portfolio which can’t be found in a passive fund. Passive funds in contrast avoid subjective forecast, take a longer-term view, and work to give you market related returns. This is based on the belief that markets are efficient and are extremely difficult to beat especially after costs. Both have a role to play in any portfolio and I really don’t believe one is superior to the other. The argument that passive funds offer more value than active funds, simply due to costs, is an insult to fund managers in my opinion and simply ignores the skill and value associated and/or required with fund management. Speak to a Wealth Manager for guidance on your asset allocation and how to blend active and passive funds.
I hope the above information helps you with the decision on which product provider to choose. One needs to understand why fees are charged before simply stating that they are too high. Ask a wealth manager to assist you with comparing multiple quotes from different providers. Not just ‘what fee is charged’ but ‘why it is charged in that manner’.
This will guide you in determining if the fee justifies the value derived from the product. Will the asset allocation/ investment choice possibly provide a return that justifies the fee? I personally like the bonus feature of the Cumulus Echo Retirement Plan, but remember that nothing is for free in this world. The value of that bonus allocation has been built into the product and is advertised as “free” and that will have an impact on the fees charged on the product.
Others may argue that a good investment strategy and low fees will offer better results than the bonus allocation. There’s an argument for both sides of the coin and neither side is incorrect. What I really like about the product is that it encourages the investor to keep their policy active and continue contributing towards their retirement.
That’s really the most important thing for me. Speak to a qualified wealth manager and they will guide you as to the merits of both arguments and how they can be applied to your unique financial situation. Is the product the best based on the fees charged? The question you should be asking is do the fees charged justify the value derived from the product?