Retirement Industry and Life Assurance costs: hearing; Revenue Laws Amendment Bills: adoption

Meeting report

FINANCE PORTFOLIO COMMITTEE

Revenue Laws Amendment Bill [B24 - 2004]
Second Revenue Laws Amendment Bill [B25 - 2004]
Non-Typographical Changes from Bill 22 to Bills 24 and 25
Department table of equivalent clauses
Costs of Saving for Retirement as presented at the 2004 Convention of the Actuarial Society of South Africa
PowerPoint presentation on Costs of Saving for Retirement
PowerPoint presentation by Bruce Cameron
Email correspondence and news articles about life policies (email [email protected])
PowerPoint presentation by the Life Offices Association of South Africa (LOA)
LOA comment on Personal Finance articles
PowerPoint presentation by the Institute of Retirement Funds
Institute of Retirement Funds Excel Sheet

SUMMARY
The Committee considered and adopted the Revenue Laws Amendment Bill and the Second Revenue Laws Amendment Bill.

Submissions were received on the issue of costs in the retirement fund industry. Mr R Rusconi, an actuary, had written a paper highlighting the extent of these costs and their effect on policyholders. Responses to the issue were heard from Mr B Cameron of Personal Finance, the Life Offices Association of South Africa, the Institute of Retirement Funds and the National Treasury. Charges in South Africa were higher than internationally, and concerns were expressed about the transparency to policyholders. The perverse incentive of up-front commission was also remarked on, and it was suggested that this be prohibited. The high charges were attributed to the high level of advice, complexity and flexibility associated with the products, and there was consensus that these products might not be appropriate for the South African market. It was agreed that there was an urgent need for a revision of the retirement fund policy in South Africa to avert a later unsustainable burden on the State.

MINUTES

Revenue Laws Amendment Bill [B24 - 2004] and Second Revenue Laws Amendment Bill [B25 - 2004]
The Chairperson explained that the Draft Revenue Laws Amendment Bill B22 - 2004 as previously adopted by the Committee had been split by the Joint Tagging Mechanism into two Bills, a Section 75 and a Section 77 Bill.

Mr F Tomasek (Assistant General Manager: Legislation, SARS) said that nothing had been changed in principle. Some typographical errors had been corrected. A breakdown of the split was distributed.

Discussion
Mr K Durr (ACDP) asked how the split had come about.

Mr Tomasek replied that the Joint Tagging Mechanism had requested it. The split had been very difficult. A lot of the provisions moved to the second Bill related closely to taxation of individuals and companies.

The Chairperson explained that the Committee was not responsible for tagging the Bill, and it had been approved pending tagging.

Professor K Engel (Director: Tax Policy, National Treasury) said that there was still a question on whether the split was correct, as it might have been an overly literal interpretation. The split had been done to save time.

The Chairperson read the Report of the Committee adopting the Revenue Laws Amendment Bill. The Bill was adopted.

The Chairperson read the motion of desirability of the Second Revenue Laws Amendment Bill, and it was agreed. The Chairperson read the Report of the Committee adopting the Second Revenue Laws Amendment Bill. The Bill was adopted.

Retirement Industry Hearing
The Chairperson introduced a debate and discussion on the issue of charges within the retirement fund industry.

Submission by Mr R Rusconi
Mr Rusconi said that his paper had been written out of an interest in retirement systems and he had felt that it would be useful for the industry and consultants to understand the costs as they made a significant difference. The paper had been presented at the 2004 Convention of the Actuarial Society of South Africa.

Research into South African costs was informed by the international context and international costs. The research had covered collective investments, occupational funds and individual policies, and the policy implications of these costs. A large variety of systems existed internationally, ranging from defined benefit and defined contribution funds, to public and private managed funds. South Africa was skewed to the private sector, with a very low proportion of compulsory savings and a very high proportion of voluntary saving. The common problem worldwide was the increase in the aged population. This was rapidly approaching crisis point in South Africa as well.

The research used both reduction in yield (RIY) and charge ratio as measures of lifetime costs, and several examples were included. The results of the research into occupational funds had been challenged by a shortage of data, with data often undisclosed and heterogeneous measurement methods. The major cost areas identified were asset management, administration and "other costs". There was an extremely large spread between low and high estimated lifetime charges, and a core was used. Charge ratios varied from 17% to 27%, and RIY between 1.05% and 1.65%, with sensitivity to the size of fund and significant random variation.

The research into individual life retirement annuities (RAs) used information from four providers, comprising approximately 80% of the RA industry. Estimated lifetime charges here showed charge ratios varying between 27% and 43% and RIY between 1.50% and 2.85%. There was considerable variety in levels and patterns between providers. The results on mutual fund RAs showed charge ratios varying between 22% and 33% and RIY between 1.20% and 1.95%. This was a much more competitive industry in terms of transparency and consistency. They were included as they were tax-deductible savings, but some reservations were expressed. It appeared that not all unit trusts were available under the RA banner. A comparison of costs with international costs showed that South Africa costs were fairly high, but that this might be understandable.

There was no proposal to close channels as each served a purpose. The implications of charge ceilings needed to be considered very carefully, and it was suggested that alternatives for a new class of products be assessed in the context of South African needs. Further research was required, with better data, deeper analysis and better comparisons. Charges needed to be seen in the context of policy and research was needed into lifetime savings patterns.

Submission by Mr B Cameron
Mr Cameron (Editor, Personal Finance) said that, over the last nine years, he had become increasingly concerned about costs in the retirement fund industry. Readers had raised the issue frequently. The attitude of the retirement fund industry was often arrogant and uncaring. It was appreciated that no product could be cost free, but the quantum was important, as was the question of whether costs were justified, negotiable, fully disclosed, understandable and comparable. There had been a cross feeding frenzy in the move from defined benefit to defined contribution funds. The main driving factor in increased costs was a consequence of the move from defined benefit pension funds to defined contribution pension and provident funds.

The first cost factor was purchasing the pension. Most funds now either outsourced the provision of pensions to a life assurance company or permitted members to purchase their own pensions (annuities). When a retirement annuity matured, at least two thirds had to be used to purchase a pension and even where the same life assurance company was involved, there would be a second round of costs. The second cost factor was preserving the pension. There were four options for persons resigning, retrenched or dismissed before retirement: become a deferred pensioner at no cost, transfer to the fund of the new employer at no cost, transfer to a preservation fund incurring costs or transfer to a retirement annuity incurring costs.

The third cost factor was umbrella funds. The intention of the umbrella retirement funds was to provide a cost effective retirement vehicle for the small employer. Considerable miss-selling was occurring, induced by very high commissions. Employers were being encouraged to sidestep the Pension Funds Act and there were unmanaged conflicts of interest and therefore no incentive to control costs. Most umbrella funds, retirement annuity and preservation funds also insisted that all their own services be used, thus no attempt was made to find the most cost-effective service provider.

Surrender penalties were the fourth cost factor. Life assurance policies including retirement annuities were issued for contract periods and if a retirement annuity was paid up or the premium reduced, the cost factor remained much the same, thus resulting in far lower maturity values for the policyholder. The fifth cost factor was investment choice. The consequences of the trend to give maximum choice in build up and in retirement were higher costs (and higher profits), prudential investment guidelines being ignored and financial advisers becoming quasi asset managers without the necessary skills. Consumers therefore suffered huge losses. The sixth cost factor, escalation clauses, were automatic increases in premiums on RAs to keep up with inflation. The consequences of these clauses were reduction in investment value if cancelled, that costs were irrecoverable in the last two or three years and that policies would be made paid-up or have premiums reduced with consequent penalties for policyholders. Many escalation clauses were also based on high inflation.

It was essential that costs were understood. Cost structures varied between companies and between different products. They could be disclosed as Rands and / or in percentages. They could be initial, ongoing and / or on exit. Disclosure requirements did not go far enough. Actual costs were not clearly shown, and not all costs were declared, including hidden rebates. Underlying costs were often excluded, and many products were multi-tiered. Costs were frequently not comparable, and the industry made false or misleading claims.

Possible solutions included the adoption of common standards and formats for disclosing costs by the whole financial services industry, the proper disclosure of commissions / fees to enable the investor to ensure that commission was not the basis for advice, the banning of upfront commissions on life products and a change to as-and-when-as in the unit trust industry, the banning of all non-cash incentives to financial advisers, the banning of rebates, discounts, fees and commissions between service providers and the creation of a standard formula for penalties. Low cost retirement savings options for low-income workers could be created either through the unit trust industry or a national government-sponsored fund. Draft legislation on umbrella funds should be approved as a matter of urgency.

Life Offices Association (LOA) submission
Mr F Marais commended the quantity and quality of Mr Rusconi's research, but said that the international research had basically covered mandatory systems. Serious negative perceptions were created by newspaper headlines and articles and these were causing people to panic.

Mandatory retirement systems offered economies of scale with no distribution cost and this, together with their simplicity, was the main reason for the low costs. Occupational pension funds were voluntary for the employer but compulsory for employees, and offered the employee very little individual advice or choice. Conversely, voluntary individual contributions (RAs) offered a high level of personal advice and choice, and this came at a price. The main difference between the systems of funding was the need for and cost of advice.

There was very little to choose between unit trusts and conventional RAs. Short-term life policies were often cheaper, while policies with up-front commission on recurring contributions were more expensive, but the comparison here with unit trusts was inappropriate. There were insignificant volumes of unit trust RA funds, with limited provision for distribution costs and their inclusion was a serious flaw in the actuarial paper.

The life industry, which was regulated, paid up-front commission on most recurring premiums, such as endowments, RAs, and life cover, and as-and-when commission on single premiums (with a maximum of 3%). Only as-and-when commission (with no maximum) was paid on unit trusts and linked service providers (LISPs), and these were mainly lump sum investments.

Costs, which were paid by the institution, included commission, marketing management cost, underwriting cost, administration cost and claims cost. The charges, paid by the client, included premium charges and fund charges. Different charges ensured fairness between policies with different terms and sizes, and it had been found that a premium charge was more effective over the short term, a fund charge was more effective over the long term, and fixed charges had the greatest effect on small policies. In terms of the Financial Advisory and Intermediary Services Act (FAIS) and the Policyholder Protection Rules (PPR), full disclosure of all charges was required, and all commission had to be disclosed. In terms of the new LOA Code on Policy Quotations, all charges were to be described and quantified in one section, RIY should be calculated on full actual expense charges, and required investment return (projection rate + RIY) should be printed immediately below the projected values.

It was suggested that RIY was the same as the fund charge as a percentage of assets, easy to understand and in line with the way in which charges were recouped. Charge ratio was equal to a reduction in maturity value, highly dependent on term and exaggerated the effect of reasonable RIY over the long term. It was suggested that there was a fundamental policy choice: compulsory contractual saving with limited advice and low cost or voluntary savings with personal advice at reasonable cost.

Institute of Retirement Funds (IRF) submission
Mr G Morris (Chairperson) felt that Mr Rusconi's paper had been an excellent starting point for debate on the issue. The IRF supported efforts to streamline costs and felt that the value of complexity was often questionable. Retirement provision was to be encouraged and care should be taken not to scare the consumer. Many findings were also intuitive. Key findings included the importance of size and economies of scale, and the fact that defined benefit funds were more onerous than defined contribution funds.

It was of concern that the debate focused on costs and not benefits. Other costs not yet mentioned included the cost of regulation and taxation. Longevity risks were overlooked, and the longevity cost of retirement provision was a hot debate.

Simple low cost / low frill alternatives were needed. Retirement funds could make it easier for members to preserve in the fund. Home loans were another area of costs where smaller benefits were obtained and evidence showed that banks might be overcharging. Members were also underestimating how long they would live and how to play for living on a lump sum instead of a monthly income. There was a great need to streamline the retirement fund provisioning area, and the Financial Services Board (FSB) had accepted this. There was also scope for a regulatory role for organisations like the FSB in terms of umbrella funds.

Mr J Glansbeek commented on the importance of disclosure. South African inflation rates had been much higher than international rates. Given that inflation was now under control and that rates would drop, the debate was becoming far more serious.

Mr Morris said there was now more scope to deal with costs. The impact of taxation led to a huge reduction in benefits.

National Treasury submission
Mr Dixon referred to Minister Manuel's comments taking the issues back to first principles and referring them to the prosperity and standards of living of the South African population. Wealth accumulation was a long and conscientious task of saving, hence the need for appropriate products. Mr Rusconi's report underscored the need to look at the retirement fund industry holistically and not just at pension funds.

He disagreed with the LOA on the issue of the newspaper headlines, suggesting they highlighted valid issues. The LOA had raised a defence of various causes and was focusing on adding complexity and flexibility under the RA banner. Consultants might be selling inappropriate products, and this became clear when the cross-country analysis and cross size of contributions was addressed. The general finding was that, in comparison with other countries, the charges in South Africa were higher and this sent a very clear message. The impact of the cost of charges and their impact on returns were criminal and it was essential to consider whether flexibility was appropriate. It was suspected that there were numerous instances of inappropriate selling of products, and it was a concern that the selling of inappropriate products was being incentivised.

Movement to some form of consolidation should be encouraged, in a way that did not remove the power of the Trustees. The other main issue was that of transparency. There was very strong consensus and support for mandatory disclosure in a uniform format. It was not simply sufficient to have disclosure on magnitude, the disclosure had to be understandable to the average consumer. The new Benefit Illustration Agreement (BIA) standards were a move in the right direction, but were only a first step. The underlying issue was the appropriateness of the products.

Mr Andrew said that RIY or charge ratio was particularly important where the individual member had choice. Disclosure of commission should be on an as-and-when basis regardless, in the interests of the consumer. The regulator should be mandated in the way the split of costs was easier to measure. There was a requirement that Boards of Trustees be accountable, and Boards should pay attention and be required to monitor and report on all costs.

Professor Engel said that retirement fund taxation carried the bulk of pressure on reform, but it was important to understand that this could be over-exaggerated. It was a typical tax internationally. The rate of the tax since its reduction two years ago was 18%. There may be some cost at the lower end, and the Treasury was looking into it. In the area of retirement, tax and regulations were very closely linked. People used retirement funds for tax benefits. It was essential to ensure that there was growth, as tax benefits implied Government encouragement. In terms of lock-in features, the intent with a lump sum benefit was to lock the consumer in. This was a hidden charge, and it was necessary to ensure that the tax and the charge were in sync. Tax and regulations also needed to be more in sync, and the tax had to follow the regulations.

Discussion
Mr Durr said that as far as he knew, the LOA statistics on unit trust RAs were incorrect, and asked them to clarify their numbers.

Mr Marais replied that RAs were policies built up before retirement, whereas living annuities were bought at retirement as a lump sum investment. A lot of living annuities ended up in unit trusts, but they were usually from life insurance product providers.

Mr Cameron said that the LOA was comparing unit trusts that were not contractual with RAs that were contractual by law. Unit trusts should be compared under the RA banner, as these were for the same period.

Mr Durr asked whether Mr Rusconi had done any studies of the end results of people who invested in vehicles, one of which charged up front and the other which carried performance charges, some of which were incremental. Who would win?

Mr Rusconi replied that he was unable to answer, as he did not have the figures.

Ms B Hogan (ANC) cautioned against taking parts of Mr Rusconi's research as the LOA had done, as it did not do it justice. It was unclear whether the LOA accepted Mr Rusconi's finding that South Africa appeared to be more expensive than the international industry.

Mr Marais concurred with the finding, but said that the LOA had referred to the context of RAs. The paper did not compare policies with similar types overseas, so there was not a fair comparison. It did seem that costs were higher than those offshore.

Ms Hogan said that Mr Cameron had suggested that charges be represented as a total in Rands, percentage invested and RIY, and asked whether the LOA and Treasury agreed.

Mr Dixon replied that he had been informed that there might be questions on the Rand amount, but he would support RIY or charge ratio or both. This was just one route to bring down charges and would be more helpful to sophisticated consumers. For the average consumer, it was important to ensure that the comparability of the charges was communicated.

Mr Marais felt that RIY was a more meaningful figure. Charge ratio was very dependent on the duration of the investment, and it was inappropriate to show it over a 40-year period.

Ms Hogan referred to mortgage bonds and said that the information given there was not confusing so this need not be. The figures would be clear, even if compound interest was not well understood.

Mr Marais agreed that it was not confusing but suggested that it might be exaggerating the point. Both could be used if they were used responsibly, but he would prefer RIY if only one was used.

Mr Cameron said that the LOA had been using BIA on what was obtained at maturity, and this was one of the most vexing questions for his readers.

Ms Hogan asked whether any investigation was being done on techniques to reduce costs, and whether the LOA and industry were looking at this, as well as the issue of undisclosed costs.

Mr Dixon replied that the range of charges between providers seemed to suggest a lack of competitiveness and transparency. This had been justified by the increased flexibility and complexity of products, but the serious question was whether the products were appropriate in the South African context. Increased transparency and disclosure were needed to rectify it.

Ms Hogan remarked that if a reduction in costs was being considered, policyholder protection rules were intent on lifting the ceiling on commissions, and asked what the current situation was, particularly in terms of up-front commission.

Mr Dixon replied that the LOA had touched on the distinction between the costs to the provider and consumer. If a provider chose to front-load the cost it was their decision. It was not automatic that this would also front-load to the consumer, and this was an area for discussion. All implications had to be considered.

Mr Morris suggested that the commission problem was not unique to retirement funds. Advisors would be pleased to advise on an hourly-based fee, but consumers preferred a hidden cost. One of the weaknesses of the current model was defining the difference between costs and charges. If commission was a cost, it should be shown as such. As interest rates dropped, cost issues would become more pertinent. He reiterated the need to stop looking at mortality as a whole, but looking at longevity in sectors.

Mr Marais said the debate was about the uncapping of single premium policies to level the playing fields. He supported that view and felt that the disclosure of commission would ensure fairness. It would be a terrible mistake to deregulate commission on recurring payments.

Mr Cameron felt that if upfront commissions were paid, there would still be a perverse incentive. These should be scrapped.

Mr B Mnguni (ANC) expressed concern about people who lost capital when they surrendered a policy.

Mr Marais replied that this was a big problem. The suggestion by the Treasury to divorce costs from charges would not work but would lead to huge losses. A fairly direct relationship was needed between costs and charges, and this was where the surrender charge came in.

Mr Mnguni expressed concern about the performance of asset managers and asked why they could not be penalised by the industry where they performed badly.

Mr Mnguni asked whether encouraging a person to shift between funds constituted fraud, as the person would lose money. Could this be criminalised?

Mr Mnguni remarked that the LOA had said it was unfair to compare funds, but at the end of the day, clients were losing money. Did the Treasury agree that one regulator was required?

Mr Dixon replied that the competition to bring down charges came out in the way in which new products had a spill over effect. He suggested looking at the introduction of appropriate retirement fund products, either a state provided product or one provided by the private sector along the lines of criteria set down by the Government. The Financial Services Charter had already ensured progress on banking products, but the insurance sector was slower in rising to the challenges.

Mr G Joubert (LOA) said that the LOA felt the issue was not fundamentally penetration but appropriateness. Extensive work had also been done on four basis life assurance products, and it was hoped to be able to present proposals on these either late in 2004 or early in 2005.

Mr Marais agreed on the need for products for the lower end of the market and suggested looking at a mandatory contribution basis.

The Chairperson congratulated Mr Rusconi on an excellent paper, and highlighted the concern that charges were high in South Africa, and higher for small policies, with a wide range of charges. The IRF had indicated that if charges were reduced by small amounts, the result was a big benefit for the client; therefore the charges issue was significant. There was a crisis in the retirement industry in the United Kingdom, and the main reason that South Africa was not in the same position was our higher interest rates. The situation had to be addressed, or South Africa would find that people had saved all their lives but the State would still have to provide for their retirement. Personal Finance played an important role in publicising the issue. South Africa did not have a strong consumer movement, and it should be encouraged.

Having moved by and large from a defined benefit to a defined contribution system, South Africa had adopted a Rolls Royce approach that was not reality for most people. The option put down by the LOA of a low cost basic contractual model, either guided by regulation or legislation, should be developed. The Treasury was engaged in discussions and it was suggested that these should not be in-house, but mechanisms about models should be drafted in consultations with stakeholders. The Committee would also like to engage on issues such as up-front and as-and-when commissions. Mr Rusconi had produced a methodology for uniform disclosure and this should go forward in a substantial way. It was suggested that the FSB look at the cases mentioned in Mr Cameron's documents. There was a desperate need to see urgent movement on the issue.

Mr Rusconi said that he had covered UK pension funds, UK shareholder funds and Australian pension equivalents. Personal pension products in the UK were under attack for their charges, and this was still a serious concern. He agreed with the distinction between costs and charges. He had been writing from the point of view of the saver, so had been interested in charges. South Africa had a very advanced life offices and pension fund savings culture. Shareholder funds had not been as successful in the lower end of the market, but they had been at the medium and upper end of the market. Following extensive industry lobbying, the 1% had been raised to 1.5% over the first five years. This meant a RIY of 1.00 to 1.04%. He agreed that if the life offices were transparent and competitive, their charges could be expected to look the same. Levels were actually significantly different and so were the mixes. He understood that provident funds were intended for small employers, and these were pretty comparable to unit trusts. Life offices were selling these products. They had been proven to be very competitive in the long term. He reiterated that it was a national issue that would become a burden on the State if it was not addressed.

The Committee mandated the Chairperson to write to Ms R Taljaard on their behalf and said that the Committee had been better off for her contributions and wished her well.

The meeting was adjourned.