Retirement Investments: High Costs Structures create Low Returns

Retirees find that “nest eggs” in the form of Retirement Annuities were a worthless investment.

Those Retirement Annuities that I subscribed to 40 years ago as an Articled Clerk were supposed to be the “nest egg” that would supplement my work pension. I was gaily promised huge returns. These policies would make the difference between a comfortable and totally carefree retirement.

After 20 years of Debit Orders being processed, I fully expected a sizable investment to have built up. Instead what I found was abysmal returns & an inadequate capital sum. The one policy was growing at 5% at the time in an era where interest rates & inflation were three times that figures.

I was so incensed that I demanded an explanation for this state of affairs. After much pressure I was fobbed off that this was the average and that in bad years I could still expect 5%.

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What balderdash! What I realised was that the fee structure would make only one person rich and that was person was not me. For an exorbitant fee which was paid upfront based on a 40 year policy, this person who I met once and would never ever meet again had scored handsomely for a one hour chat.

 

I was caught between the proverbial devil and the deep blue sea. If I cancelled the policy at that point, I would be subject to ruinous cancellation fees or faced the prospect of an underperforming investment for another 20 years.

At 40 years of age, probably most financially illiterate individuals are still under the misapprehension that their retirement nest egg was growing spectacularly whereas it was growing at a pedestrian pace.

Reducing the cost of investment

My eyes were opened when I read an article on the cost of retirement vehicles in the USA. Firstly they used a novel approach called ETFs [Exchange Traded Funds] but secondly that the fee structure was much lower due to their competitive market.

Whenever I questioned Brokers about the pros and cons of Active versus Passive Fund Management, I was always provided with data to support their contention that Active Management was always more advantageous than Passive Management. As an outsider it was extremely difficult to judge whether the Broker was merely being highly selective in their choice of data or whether it really was preferable and advantageous to follow their advice.

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Many studies both locally and overseas have supported the contention that it is extremely difficult to choose the top managers of the future and more importantly, how many Active Managers fail to beat the Index over the long term. It is not sufficient to beat the investable equity index after costs, one needs to choose a top quartile manager.

Finally I found these statistics which were compiled by Satrix in support of my contention about Active versus Passive Investment.

Satrix compared the SA universe of active equity manager’s performance against the SWIX – the best proxy of the investable equity universe – minus 0.57% being the average passive fund fee.

As the table below illustrates, even over a 10 year period only slightly more than a quarter of the managers were able to beat the SWIX minus 0.57%.

 

Years % of Active Managers outperforming the SWIX [net of 0.57% fee] as at March 2014 % of Active Managers failing to beat the SWIX [net of 0.57% fee] as at March 2014
1 28% 72%
3 24% 76%
5 19% 81%
7 22% 78%
10 27% 73%

Why did Satrix use the SWIX Index and not for example the ALSI – The All Share Index – for this comparison? The answer is simply that the SWIX Index reduces the weights of the ALSI for foreign shareholders thereby creating the best representation of the Companies that local shareholders are invested in. Hence this is the best proxy for the local investable universe for SA equity investors.

Even over extended periods of up to 10 years, in excess of 70% of Active Managers fail to beat the SWIX minus 0.57%. One of the major reasons for this state of affairs is chiefly the high costs structure of these Funds.

Welsummer Hen

As has been seen in the American example, even this low fee will decline as the investment process becomes more efficient and the competitive pressure increase.

 

 

 

What about Retirement Annuities?

In my view, the old fashioned RAs were a rip-off. The sole cause of this state of affairs was exorbitant commissions. But has the RA Industry made amends and introduced suitable cost investment vehicles?

Yes they have. The newly introduced index tracking RAs now have substantially lower fees but again the devil is on the detail. Commissions are hidden at every level of the transaction and unless one is wary – the old caveat emptor dictum applies equally in these cases – one is burdened with that old bête noire high commission albeit in a new disguise.

A comparison of Index Tracking Retirement Annuities will expose this practice:

Fees 10X Absa eftSA ITransact Sygnia
Fund or Investment Management Cost [1] From .4% to 1.02% 0.28% to 0.31% 0.39% 0.35% 0.45%
Asset allocation fee None None None 0.28% None
Additional fees [2] None None None Yes None
Platform fees None 0.228% 0.57% 0.79% to .4% [3] None
Fund fees None R34 0.57% None None
Total From .4% to 1.02% 0.508 to 0.538% + R34 1.53% 1.28% to 1.19% 0.45%
Advisor fees Optional Optional Optional Optional Optional
Debit Order Fees None None None R 3.99 None

Source: The Saturday Star- 24th May 2014

Legend:

All charges include VAT

[1] Includes brokerage within the product

[2] Brokerage fees for buying and switching ETFs

[3] Platform fees depends upon the amount invested

Even the most expensive of these options is significantly cheaper than the traditional life assurance and Unit Trust RAs which cost between 3.4% & 3.9% per annum.

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American comparisons in this debate

As most SA information is tainted or compromised as the parties have vested interests in the outcome, I would rather cast my net wider to the USA where extensive research in this matter has been performed over decades.

Figures compiled by AthenaInvest from the USA highlights the following:

Fund Returns for Period 1997 to 2012
S&P 500 Index 6.1% pa
Real active funds 8.9%
Best ideas 13.9%

Despite Warren Ingram using these figures in support of his contention that Active Fund Managers can provide superior returns, I am not convinced for numerous reasons:

  • Most of the differential between 6.1% and 8.9% will be consumed by the additional 1.5% to 2% additional commission. Together with a fee amounting to 20% of profits, the difference will be significantly if not entirely eroded.
  • This comparison is not a true reflection as the S&P figures were based on a full basket of shares & not the top 40 shares
  • Many brokers classify themselves as Active Managers in order to charge the higher fees but in reality they are index-huggers.
  • Finally Active Managers are not able to match the 13.9% of the Best Ideas categories because they are forced to dilute their holdings by acquiring other shares which do not necessarily meet those returns.

 

Termination charges on investment policies

Another bane of RAs was also the exorbitant Termination Charges which dissuaded me form switching products some 20 years ago.

What is the current situation?

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Retirement annuities in particular were historically sold with high upfront commissions paid to theinsurance brokers who sold them. Broker commission is calculated as a percentage of the contributions paid by the client over the lifetime of the policy. Prior to 2009, commission could be paid all in one lump sum to the intermediary at the policy’s inception.

When the client then wanted to terminate their Retirement Annuity or move the investment to another Insurer, the insurer would claw back broker commission and costs by charging the client a hefty penalty. As of 2009, Brokers can now receive only half the commission upfront, while the rest must be paid on an ‘as-and-when’ basis, as clients pay premiums each month.

Although this has helped, the penalty problem persists and is made worse by the dubious practice of ‘double dipping’. This occurs where product suppliers apply early termination charges twice, say for instance when a client reduces their monthly contributions (strike one) and then later decides to cancel the investment altogether (strike two).

While both instances can still legally trigger a termination charge, Leanne Jackson of the FSB said that a recent FSB directive prohibits the cumulative effect of these charges from placing the client in a worse-off position than they would have been had the more extreme event (policy cancellation) happened first. She said that this was happening in cases where insurers were applying the maximum penalty twice.

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Leanne Jackson has stated that the maximum penalties long-term insurers would be allowed to impose when their clients move or terminate savings policies, such as retirement annuities (RAs), would be reviewed and further reduced, if not cancelled altogether.

Jackson, who heads up Treating Customers Fairly (TCF) at the FSB, pointed out that these charges had already been reduced significantly and were capped at 15% of a client’s invested value.

The shift away from commission-based fees on investment and savings products in favour of fees for advice will eliminate or significantly reduce early termination charges on these products, the Financial Services Board (FSB) has claimed.

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Sage advice in conclusion

I strongly content that active managers’ returns do not consistently beat those of the market and it is difficult for investors to predict the managers who will out-perform the market.

I argue that paying lower costs is a predictable way in which to improve your returns and that it enables one to secure a higher return in retirement.

For every one percent in fees that one saves, one can add 30% to one’s income on retirement over a working life of 40 years.

If you still wishes to invest with an Actively Managed Fund, restrict one’s investment to 20% of one’s portfolio.

In my case, this sage advice is too late as the Investments have now matured.


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