Ce­cila Melville

In a pre­vi­ous ar­ti­cle, I ad­dressed some of the key dif­fer­ences be­tween de­ferred an­nu­ities of­fered by in­sur­ance com­pa­nies and re­tire­ment prod­ucts sold by mu­tu­al fund providers.

One of the main con­cerns was the fact that de­ferred an­nu­ities sold by in­sur­ance com­pa­nies tend to have hid­den fees as well as high­er fees and costs than oth­er pen­sion prod­ucts. This ar­ti­cle elab­o­rates on the var­i­ous types of fees and charges ap­plied by in­sur­ance com­pa­nies and gives some in­sight in­to their im­pact on the client’s con­tri­bu­tions. What is ob­vi­ous is that pol­i­cy­hold­ers have borne and con­tin­ue to bear the bur­den of high and ris­ing fees.

The bur­den of fees may be best il­lus­trat­ed us­ing the cost struc­ture of a lead­ing in­sur­ance com­pa­ny.

A de­ferred an­nu­ity typ­i­cal­ly in­curs a range of fees, some of which are di­rect­ly im­posed on the pol­i­cy­hold­ers. These in­clude an al­lo­ca­tion charge, a pol­i­cy fee, bid/of­fer fee and a guar­an­teed fee.

The al­lo­ca­tion charge com­pris­es the up­front costs which are de­duct­ed in the first pol­i­cy year as well as the charge for any con­tri­bu­tion made in ad­di­tion to the planned month­ly pre­mi­ums. Some poli­cies, which of­fer a guar­an­teed rate of re­turn, have a $15 month­ly guar­an­teed fee. This fee is de­duct­ed from the change in the val­ue of the client’s ac­cu­mu­lat­ed bal­ance.

The pol­i­cy fee is an ad­min­is­tra­tive fee while the bid/of­fer fee is a charge for in­vest­ing the un­der­ly­ing fund. In ad­di­tion to these di­rect costs, in­vestors in these prod­ucts al­so in­cur ex­pens­es as­so­ci­at­ed with the man­age­ment of the un­der­ly­ing fund, where the de­ferred an­nu­ity is a unit-linked fund. The costs of the fund com­prise man­age­ment charges, in­vest­ment ex­pense, in­come tax­es and a tax re­serve pro­vi­sion.

The ta­ble be­low sum­maris­es the var­i­ous fees which are di­rect­ly in­curred by the pol­i­cy­hold­er:

Ta­ble 1:

An analy­sis of the above fee sched­ule is un­der­tak­en to il­lus­trate how these fees af­fect clients’ in­vest­ment over time. All clients are neg­a­tive­ly im­pact­ed by the var­i­ous charges, but the re­gres­sive na­ture of the fee struc­ture leads to a dis­pro­por­tion­ate im­pact on those who pay small­er pre­mi­ums, pre­sum­ably low-in­come earn­ers.

In the first pol­i­cy year, the com­pa­ny im­pos­es an al­lo­ca­tion charge, which varies from 55 per cent to 100 per cent. The high­est charge is im­posed on the low­est pre­mi­um brack­et (i.e. per­sons pay­ing less than $200 month­ly). As a re­sult, the pre­mi­um that is al­lo­cat­ed in the first pol­i­cy year can vary from 0 per cent to 45 per cent of con­tri­bu­tions.

The “al­lo­cat­ed pre­mi­um”, which is net of up­front charges, is fur­ther re­duced by the de­duc­tion of oth­er fees and charges. This net pre­mi­um rep­re­sents the avail­able funds to be in­vest­ed in the un­der­ly­ing fund. The im­po­si­tion of an al­lo­ca­tion charge of 5 per cent on lump sum pay­ments al­so re­duces net pre­mi­ums. Giv­en the sig­nif­i­cant fees and charges, per­sons pay­ing small pre­mi­ums may end up with a deficit in their net bal­ance in the ear­ly years of the pol­i­cy. How­ev­er the high­er the pre­mi­um brack­et, the low­er the im­pact of flat fees.

Ta­ble 2 il­lus­trates the im­pact of fees on a 10-year pol­i­cy for a per­son who pays a $200 month­ly pre­mi­um and who in­creas­es her con­tri­bu­tion by 100 per cent in the sixth year. The pol­i­cy fee rose four-fold from $10 in 1990 to $40 at the end of 2023. An as­sump­tion is made that the pol­i­cy fee in­creas­es from $10 per month af­ter the first year to $40 there­after. For ex­am­ple, a $40 pol­i­cy fee rep­re­sents a 10 per cent charge on a month­ly pre­mi­um of $400, while a per­son who pays a $1000 month­ly pre­mi­um in­curs a 4 per cent charge. Over the 10-year pe­ri­od, fees and charges ab­sorb around 25 per cent of the to­tal (gross) pre­mi­um paid. This means that out of every $100 paid in pre­mi­um on­ly $75 is as­signed to the client bal­ance to be in­vest­ed.

The im­pact of the fees in year 1 and year 6 is no­table. In the first year, a 90 per cent al­lo­ca­tion charge on the $200 month­ly pre­mi­um re­duces the al­lo­cat­ed month­ly pre­mi­um to $20. Thus, the an­nu­al pre­mi­um is $240, one-tenth of the to­tal con­tri­bu­tions.

Sec­ond­ly, when the pol­i­cy­hold­er in­creas­es the pre­mi­um by 100 per cent in year 6, on­ly 45 per cent of the ad­di­tion­al con­tri­bu­tion is ap­plied to the ac­count. The ad­di­tion­al charge in year 6 caus­es the share of fees to rise to ap­prox­i­mate­ly 40 per cent of gross pre­mi­um.

Ta­ble 2:

A 10-year pol­i­cy with a $200 month­ly pre­mi­um and a 50 per cent in­crease in pre­mi­um in year 6

In Ta­ble 3, it is as­sumed that the pol­i­cy­hold­er ini­tial­ly pays $300 in month­ly pre­mi­ums and sub­se­quent­ly in­creas­es the con­tri­bu­tion to $1,000 in year 6. In year 1, fees ac­count for 84 per cent of to­tal gross pre­mi­ums. The pol­i­cy­hold­er al­so in­curs a 55 per cent charge on the in­cre­men­tal $700 based on her de­ci­sion to in­crease the con­tri­bu­tion to $1,000. In this sce­nario, fees ac­count­ed for 18 per cent of gross pre­mi­ums over the 10-year pe­ri­od. On av­er­age $82 out of every $100 paid in pre­mi­um is in­vest­ed on be­half of the client.

Fur­ther, a five per cent charge is ap­plied to any un­planned pay­ment of pre­mi­ums. For ex­am­ple, a change in pay­ment fre­quen­cy of the pre­mi­ums from month­ly to an­nu­al­ly will in­cur this five per cent penal­ty. Al­though not shown, a change in pay­ment fre­quen­cy caus­es the share of to­tal fees and charges to rise to al­most 20 per cent even though the amount paid is equiv­a­lent to the pro­ject­ed an­nu­al pre­mi­ums. Al­so the five per cent penal­ty is im­posed on any ad­di­tion­al con­tri­bu­tion which ex­ceeds planned pre­mi­ums. While the share of fees is low­er for per­sons pay­ing high­er pre­mi­ums, it is still sub­stan­tial.

Ta­ble 3:

Sum­ma­ry

Di­rect fees and oth­er costs as­so­ci­at­ed with de­ferred an­nu­ities sold by in­sur­ance com­pa­nies have a ma­te­r­i­al im­pact on the growth of their clients’ ac­cu­mu­lat­ed bal­ance and ul­ti­mate­ly on their pen­sion ben­e­fits.

On the oth­er hand, per­sons who pur­chase de­ferred an­nu­ities man­aged by mu­tu­al fund providers ben­e­fit from the al­lo­ca­tion and in­vest­ment of 100 per cent of their con­tri­bu­tions to their ac­count. They al­so en­joy greater flex­i­bil­i­ty in that they can vary con­tri­bu­tions at no ad­di­tion­al cost. It should be not­ed that both in­sur­ance com­pa­nies and mu­tu­al fund providers deduct ex­pens­es for in­vest­ment, bro­ker­age and oth­er ad­min­is­tra­tive ser­vices pro­vid­ed in the man­age­ment of the un­der­ly­ing fund. The mag­ni­tude of these costs as well as the per­for­mance of the un­der­ly­ing fund will de­ter­mine the growth of the client’s in­vest­ment.

Cus­tomers must be aware of and care­ful­ly as­sess the fees as­so­ci­at­ed with var­i­ous pen­sion prod­ucts, es­pe­cial­ly their im­pact on low-in­come house­holds. The analy­sis demon­strates that these fees are sub­stan­tial. Ad­di­tion­al­ly, it is clear from the analy­sis of the fees im­posed by this in­sur­ance com­pa­ny that there are con­sid­er­able in­equities in the fee struc­ture. The im­pact of these fees on low-in­come house­holds es­pe­cial­ly de­serves at­ten­tion, as these erode a greater per­cent­age of the pre­mi­ums cred­it­ed to their ac­counts.

While con­sumer ad­vo­cates have point­ed to the dele­te­ri­ous ef­fect of high bank­ing fees on con­sumers’ wel­fare and have lob­bied for a cap to be placed on such fees, lit­tle at­ten­tion has been paid to the im­pact of fee in­creas­es on in­vestors in pen­sion prod­ucts.

The ab­sence of caps on fees means that there is a greater prob­a­bil­i­ty that fees would be in­creased in the fu­ture, which would neg­a­tive­ly im­pact the client’s ac­cu­mu­lat­ed bal­ance.

Reg­u­la­tors must be more proac­tive in safe­guard­ing the in­ter­est of con­sumers of fi­nan­cial ser­vices, es­pe­cial­ly in an en­vi­ron­ment in which fi­nan­cial lit­er­a­cy is ex­treme­ly low.

Al­though the dis­cus­sion does not ad­dress the in­di­rect costs as­so­ci­at­ed with the man­age­ment of the un­der­ly­ing funds, there is the need for greater trans­paren­cy in the ac­count­ing and re­port­ing of these funds. More­over, it is im­por­tant for cus­tomers to have the nec­es­sary in­for­ma­tion to al­low them to shop around as the range of pen­sion prod­ucts has in­creased.