Friday, September 04, 2009

Who will be in Majorca?

This week I received two warnings. The first from Chubb Security Services, advising me not to flash at vehicles with no headlights. It might be a gang who will turn around and kill me. The other (if I can recall) from homeland security, advising me not to open Michael Jackson e-mail as it may be a computer virus.

These e-mails are well intended, sent by concerned friends. The odds of occurrence? Relatively low.

Today, I am issuing a warning. One that I hope you will forward to your friends, as this may probably be the longest running scam in South Africa. It is called Term Policies.

Also known as a savings policy, education plan, spaarplan, committed investment plan, personal investment plan, endowment, uitkeerpolis and a host of other company specific names to disguise it as a great investment that will enable you to lie on the beaches of Majorca for the rest of your life.

Consider our client Paula.* When Paula was 30 years old, her then financial adviser sold her a policy. She contributed R13,70 every month since May 1980. 29 Years later, on 1 May 2009 the policy is worth R19 512. The average return were a mere 8.18% per year, which I am willing to bet is probably only a percentage point or two above inflation. The hundred year average return of the South African All Share Index by contrast, is 16%. Without Paula's adviser, her investment could have been worth R103 513.75.

In April 1993, Mrs. Maseko gave birth to a healthy boy. The Maseko's named their son Godfrey. Mr. and Mrs. Maseko were smart enough to go to college but they lacked the funds. The Maseko's vowed therefore, that a lack of money will not deprive Godfrey of higher education. That same year, they bought into a R70 per month Education Plan.

In January 2008, when we met the Maseko's, Godfrey turned 15. He is a very bright and interested in law because he's dad is the office assistant and messenger for a prominent law firm in Johannesburg.

The Maseko's have increased their savings each year with 10%. In January '08, they contributed R271.56 per month. Since life companies in South Africa do not issue regular statements, the Maseko's had no idea how their investment was holding up. They approached us.

Over the period of 14 years and 9 months, the Maseko's contributed R26 721.57 to find a investment worth R64 177. The yield of the education plan averaged at 12.8% per year, almost 3,2% below the average.

If Mr. Maseko invested this money in the South African market, the value would have been around R86 641.40. That is 35% more than their actual investment value.

Then there was the case of Mr. Jacobs, who diligent invested R60 per month from March 1986. Every year, he increased he's premium with 10%. In January 2008, the policy were worth R177 786. At the rate of the JSE All Share, it should have been R272 564.66. A difference of 53,31%

It is important to note, that the great recession cannot be blamed for the difference in investment value since the market decline only started in April 2008 - four months prior to these figures. I am further willing to bet that was it not for those spectacular growth years prior to the imploding, the investments would have performed even worse.

In the above cases investors - at least - investors received positive returns. Old generation policies are renown for the fact that they only break even after several years. The Financial Services Board
did change the structure for policies, but until every one of these old policies mature, citizens will either have to accept below average returns, of pay possible penalties. It could take decades for the system for clean itself.

The only one who is lying on the beaches in Majorca, are those who sold and continue to sell these policies to clients who truly believe that the adviser is acting in their interest.

We need your help to inform those who bought these products to seek help and to warn friends only to deal with financial advisers who accept fees as-and-when the premium is paid. In other words, financial advisers who do not charge for premiums only due in the future. The reason why the term policies fail to perform are:
  1. Poor asset allocation. The financial adviser's inability to structure the investment in such a way that above average returns is actually possible. Most policies I have studied are structured too conservative - they will not even beat the fixed interest rate from day one.
  2. Poor asset management. Once you have cleared the hurdle of asset allocation, you have a 90% chance of being in a portfolio that will fail to generate a return in excess of the benchmark. In a study done by the University of Pretoria they concluded that a mere 10% of all asset managers in South Africa manage to beat the benchmark. In 90% of the cases, your investment is better off without the help of a so-called asset manager.
  3. High management fees. Typically just under 2 % per year.
  4. Your growth is taxed at 29%. The majority of those who commit themselves to term policies, do not even have an average tax rate of 29%. So why pay more tax than required?
  5. You pay the financial adviser upfront fees - that is why you are all of a sudden advised to invest in one of these products.
  6. You cannot decrease your investment or cease payments without paying penalties.
  7. You are locked in for the entire term of the investment.
Consider then, the benefits of a Unit Trust (or collective investment
  1. The investment returns will match the portfolio. Just by being in a unit trust does not mean that you will achieve better results. If you choose one of those 90% poor performance funds, your will underperform the benchmark. You will receive a quarterly statement however, and hopefully it will not take you too long to figure out that you are loosing money. If your financial adviser is worth he's salt, you will outperform the average of the JSE All Share Index over the long term.
  2. Lower management fees. Research have shown that fees have a major impact on the compounded return of a investment.
  3. You can increase, decrease, start or stop your investment without paying any penalties
  4. You are allowed to make full or part withdrawals and receive the funds within 3 working day's.
  5. You only pay tax at your rate should you be a good citizen and declare the profit in your tax return.
  6. You can switch your investment from one asset manager to another if you conclude that the investment fails to perform as expected.

The most important difference between term policies and unit trusts is that you have control over the destiny of your investment.

You can address problems without the dreaded penalties and those poor call centre service usually associated with them.

Best of all is, you will be the one in Majorca!

*All names changed