Issue: July/Sept 2010
RETIREMENT FUND REFORM
Towards financial democracy
The need is apparent. Colin Dutkiewicz examines some of the most glaring warts and suggests practical remedies. They might sound radical, but theyre fundamental.
SAs transition to democracy ended political and social oppression of one group by another, but has not yet shown how financial democracy can be achieved. The next step in development is to address the explosion of economic growth and the creation of jobs. Many social ills still lead from the 25% unemployment rate that is a structural legacy of apartheid.
Financial democracy will be realised when SA has an unemployment rate below 10% and where the financial benefits of employment flow directly to workers and their families i.e. that the benefits, particularly deferred compensation (pension funds), stay with their rightful owners; to be more precise, that workers who have a lower understanding of the mechanics of financial products do not lose their money to the providers of these products.
The system of wage earning, retirement saving and social security for the chronically poor and disabled must be affordable, sustainable and fair. To this end, the policy approach should focus on:
- Poor practices and unintended consequences;
- Enhancement of competition, particularly in provision of financial advice and
thereafter in the provision of innovative products that offer value to clients rather than wealth to advisers.
The diagram below represents what should be the objectives of change, specifically to move current practice from Q4 (full advice, but negative value added to the client) to Q1 (full advice with only positive value added), and from Q3 (no advice, and negative financial consequences) to either Q1 (with advice) or Q2 where defaults and self-service result in positive value added:
Financial decisions are made in one of only three ways:
- Own action is enhanced by financial literacy. This is improved by school-level basics and employer-facilitated adult financial education. Ultimately, it needs to be part of parenting (e.g. getting children to draw up a budget before receiving pocket money);
- Assisted action is enhanced by access to financial advice that is honest, independent and unbiased. This has been distorted by inappropriate regulatory commission scales, lack of transparency and misleading advice. In particular, we need improvement in competition for financial advice.
Consumers should be able to evaluate several options from which to choose the most trustworthy and well-trained adviser;
- No action is enhanced by mandatory provision (e.g. national retirement savings system) and sensible default options.
Examples of where the system has gone wrong
The formula for insurance-risk policy commission is a percentage x term x premium. This incentivises the sale of the longest term and highest premium. Neither has any relation to the amount of work e.g. there is not necessarily more work done on a policy that is for 27 years than a policy required for three years. It is in the insurance companys interest to have a 27-year policy when a three-year policy would suffice. Such a commission load increases the premium by 20%.
The adviser is then not paid for any advice beyond the second year of the policy and therefore has no incentive to continue to check that the policy remains appropriate for the client. But an adviser does have an incentive to churn old policies into new. Until recently the insurance companys contract with the adviser stated that the adviser would get all the premium-increase commission from the original sale. So if
the client changes adviser, the old adviser still gets paid. And there is no mechanism for the new adviser to get paid, unless he or she churns the policy.
Since the commission is regulated, it is easy for the adviser to claim that commission is at the regulated level. Commission deregulation would require the adviser to justify the commission. Thus the existing regulation is in the interests of the insurance company. It leads to the unintended consequence of poor advice and poor value for money.
The regulations should not allow upfront commission. This will require the adviser continually to advise the client if the adviser is to earn ongoing commission. Should the client switch advisers, he can then switch the commission to the new adviser.
Theyve been around long enough to start imploding. A low-risk investment strategy, improved longevity and recent market volatility can all lead to the first purchasers of these products, now approaching age 80, outliving their money.
It has been attractive for an adviser to sell these annuity products for because hed receive 0,5%-1% ongoing commission versus the 1,5% upfront commission of a guaranteed annuity.
Guidelines so far provided on correct drawdowns fail to view the way the annuity is managed -- to determine an initial monthly drawdown and then keep this reasonably stable, perhaps increasing with inflation or other client-specific needs. They also fail to illustrate corrective action. After say a year of poor investment performance, what is the client or a rational investor supposed to do? Decrease the drawing, change investment mandate or do nothing?
Only with the addition of these behaviours can one really communicate to clients the consequence of their actions. The tables recently issued by ASISA are at least on the basis of correct drawdowns.
The policymaker has the duty to intervene in the market when there are undesirable practices. This protects financial democracy. The FAIS Act has gone a long way to assist. The newer Conflict of Interest and Treating Customers Fairly initiatives are welcome additions.
But only by public attention will normal market competition embed these processes, for regulations alone can be circumvented. Client selection of adviser and product provider, according to their trustworthiness, is essential.
- Colin Dutkiewicz is an independent consulting actuary based in Cape Town.
Amongst other things, hes also a council member of the SA Actuarial Society, chair of the societys task force on social security and retirement reform, and serves on the Actuaries Without Borders committee.