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For some RA policy holders a rising market is not all good news

It's not often that a rising market comes with negative association. After all, exposure to market growth logically leads to growth in your investment value.
However, for younger investors with policy-based retirement annuities (RAs) who are looking to transfer to a different product provider, a greater investment value also leads to a greater potential penalty. As the termination charges associated with ending these policy-based contracts may be calculated as a fixed percentage of the RA portfolio, younger investors seeking the additional value and improved disclosures a modern RA is likely to offer, may be faced with progressively higher penalties as their portfolios grow.

Policy-based RAs, underwritten by insurance companies, impose penalties when investors choose to move their investments elsewhere or to lower or cease their regular investment contributions. These penalties are levied to recover the fees that the insurer would have received had an investor continued to make all investment contributions for the entire term specified in the policy contract. As certain fees and commissions are charged for the full investment period upfront, an investor is deemed responsible for settling outstanding fees if exiting the RA before the specified term is over.

Penalties subject to legal maxima

Although these penalties are subject to certain legal maxima (30% for RAs sold before 1 January, 2009, and 15% for RAs sold after this date), the charges can be quite considerable in rand terms.

Generally, the shorter the length of time until an RA policy matures, the lower the penalty an investor will have to pay. This is because a large portion of the fees calculated at the onset of the investment would already have been recouped. As the termination penalty reduces over time while the RA policy grows, this penalty will equate to a lower percentage of an investor's portfolio the closer he gets to retirement.

However, younger investors - who may have 25 years or more before their policies mature - are often subject to the highest penalty an insurer may charge. Termination penalties are restricted to a maximum percentage and not a maximum rand amount. For a majority of young investors, penalty amounts will therefore increase as their investments grow, while the penalty percentage remains fixed (at the maximum allowed rate). It will generally be a number of years before these investors reach the tipping point where their penalties equate to lower percentage amounts.

A clear illustration

A recent practical interaction with a young investor serves as a clear illustration. Ms Investor took out her underwritten RA policy in April 2002. Upon requesting the cost to effect a transfer out of this RA in March 2011, the penalty she was quoted was just under R3500 (based on an investment value of roughly R26 000). In May 2012, a little over a year later, Ms Investor's portfolio had increased to over R33 000.Consequently, her penalty had risen to above R4700.

In response to her queries, Ms Investor's product provider noted that her termination fee is calculated as "a fixed percentage of the fund value and will therefore increase as the fund value increases". While acknowledging that the basis of this calculation was "complex", Ms Investor's product provider noted that it was "satisfied that it has acted in accordance with the provisions of the plan" and that "no further analysis of the transfer fee will be provided".

Such inflexible policy contracts and opaque disclosures are, unfortunately, characteristic of policy-based RAs. In contrast, a modern unit trust-based RA would offer the flexibility to change or cease investment premiums or to transfer to a different product provider without penalty.

Younger investors with underwritten, policy-based RA contracts should carefully evaluate the options available to them. Should such an investor wish to terminate this RA policy, it may be worth seeking independent and qualified financial advice to assess the implications of immediate action. The cost savings associated with converting to a modern, unit trust-based RA may outweigh the potential termination charge over the long term. By moving the RA relatively early into the contract term, investors may also avoid exposure to a steadily rising penalty.
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