The impact of fees on your retirement

In this financial planning column, Dave Crawford, CFP® and founder of retirement educator Planning Retirement, answers a reader’s questions about retirement planning.

Question

I currently use the services of a financial advisor, whom I’m sure has the best of intentions, but I am not sure if my current investments are really my best option. I would appreciate the input of an independent, knowledgeable person.

I turn 26 in November and would like to retire at 60, but to err on the side of caution, I have assumed that I would only retire at 65. This gives me about 40 years to save.

I had a retirement annuity on top of my pension fund to which I contributed R275 per month. I also contributed a once-off lump sum of R15 000 for tax purposes. In July 2015, my financial advisor transferred the RA to Sanlam’s Cumulus Echo Fund – an initial lump sum of R18 231 and the initial recurring payment of R275.

Since then, I have started a new job (January 2016) and transferred my pension fund to Sanlam’s RA fund (a lump sum of around R122 000). At my new job, I only have a 10% provident fund and I decided to increase my RA contribution to R1 500 per month with a planned 10% escalation.

The Cumulus Echo Fund invests 50% in Coronation’s Balanced Plus Fund and the other 50% in the Satrix Dynamic Balanced Fund. Both are excellent Regulation 28 funds where annual returns were roughly 16% since inception. My concern is the fees charged by the Sanlam Fund. They charge 4% on recurring payments and 2.4% on lump sum payments. There are also charges for Coronation (0.97%) and Satrix (0.2%) and I am not sure if this is already included as well as my financial advisor’s 0.5%, which I assume also has to be deduced.

Despite the high fees, the fund is attractive due to the significant Echo Bonus percentage added, but there is a considerable difference between the percentage bonus related to the initial recurring and lump sum payments compared to the additional recurring and lump sum payments.

My dilemma is the fact that I will lose a significant part of the bonus since the initial payments were relatively low. I did some calculations and it seems that it may be better to invest directly with Satrix and Coronation.

I would like to know:

Are my assumptions correct with regard to the fees? If I assume growth of 16%, would I effectively only receive 10.9% (16 – 4 – 0.5 – 0.6% (average for Satrix and Coronation))? Is the financial advisor’s fee included? Although I won’t complain, I doubt whether a 16% return is sustainable. What is a realistic return expectation? Do you have any other suggestions?

Answer

Are the assumptions on the fees correct?

Yes, except for:

• The on-going commission rate which is 0.5% but to which VAT must be added resulting in a 0.57% pa charge.
• The annual management fee which appears to be 2.40% per annum on the capital value. The 4% management charge is on the on-going contributions.

With on-going charges of:

Investment management charges are included in the above.

Annual Management fee 4.00 % plus VAT =  4.56 % on premiums as paid.

That’s a little different to the calculations that you have done. But even at 3.891% costs this is expensive (0.56% plus 0.585% plus 2.736% that is still quite a bite). The 4% cost, apparently on recurring premiums reduces the actual investment amounts. I thought it worth pointing out rather than trying to redo the entire set of calculations.

Yield assumptions

On a gross 16% yield this is still a reduction in yield of 24.32% on 16% yields. With the deepest of respect I cannot believe that one should assume returns of more than 13% pa, which is still a 6% real return. On 13% the reduction in yield is 29.93%, which is massive. Bear in mind that Regulation 28 compliant investment portfolios are limited to a maximum of 75% in shares, which may limit potential investment growth.

The difficulty here is that you may have assumed that charges from the houses, if you deal direct, will be lower. Coronation Balanced Plus has a retail TER of 1.68% but no administration charge is taken into account. Your figure for Satrix looks about right but it’s difficult to know if an administration fee is taken into account.

If we assume that the costs to you are as follows, if you go directly:

• TER weighted                                              1.18%
• Administration 0.40%
• Total                                                               1.58%

Total Expense Ratio is the investment management fee charged as a percentage of capital every year.

Then on a 13% gross yield your reduction in yield will be 1.58% ÷ 13% or 12.15%. That is way better than 29.93%. So if both products’ gross investment yields are the same the one with lower costs will give the investor the best return.

I did a rough example using R1 500 per month rising by 10% pa for 40 years at 13% pa gross investment return.

With no costs the investor got 100% of any investment growth;

With 1.58% pa costs the investor got 71.54% of the investment growth; and,

With 3.891% pa costs the investor got 45.39% of the investment growth.

We must bear in mind that it is almost impossible to earn a level return over a period as long as 40 years. But comparisons need to be done and so we use these level rates. It is interesting that Rob Rusconi’s study of costs in 2004 found similar figures. (He is the actuary who made all the fuss about the damaging effects of costs).

I have checked the calculations in a few places and believe them to be correct.

The conclusion that can thus be drawn is that any two investments with the same returns will reward whoever uses the lower cost vehicle over the person who pays higher costs.

One last thought. As you are 25 years old you may want to consider increasing your exposure to shares. It sounds more risky, because this entire aspect has been hyped up but when you have time to invest for longer periods, as you have, you need to consider doing this. In practice this means considering investing in a portfolio with a higher percentage of shares. You have the time and long-term exposure to shares reduces the volatility. I have included a graph kindly supplied by Old Mutual to show how patience with share investments pays.

The virtue of patience

Source: Old Mutual Investment Group; Macrosolutions

I didn’t spend too much time on the sophisticated bonus system included in that policy structure because I found it very complicated indeed. There are calculators available but they don’t escape the main contention that costs are important.

Tiaan Fourie, product actuary at Sanlam Personal Finance responds:

The Cumulus Echo retirement annuity (RA) includes an Echo Bonus, which is a unique approach to the loyalty bonus concept. It aims to encourage clients to start saving for retirement and then help them stick to their retirement goals. The Echo Bonus is added to the fund value at retirement as well as at earlier termination. The longer clients save or remain invested, the bigger the Echo Bonus.

It is essential for the client to understand the effect and working of the Echo Bonus, noting that this information did not form part of the feedback in the Moneyweb article. In fact, we urge clients to note the article’s closing paragraph as it positions the shortcoming of the article and its conclusions i.e. ‘I didn’t spend too much time on the sophisticated bonus system included in that policy structure because I found it very complicated indeed.’

The article also incorrectly mentions

–        that VAT must be added to the charges of the Cumulus Echo RA product. The Cumulus Echo RA is a policy and not a linked investment, therefore no VAT is applicable on any of its charges.

–        that there is 0.5% per annum advice fee being paid to the financial advisor. The advice fee for this specific policy is zero.

The client’s concerns relate to the different charges being levied within his Cumulus Echo RA. Any Cumulus Echo quotation includes a reduction in yield (RIY) figure that shows the extent to which the return earned on the assets until the planned retirement date will be reduced by the charges on the plan. The RIY includes the effect of all charges, i.e. administration, commission and asset management. The RIY calculation also includes the effect of the Echo Bonus which reduces the impact of the plan charges and, therefore, the RIY. It is therefore essential that the charges are not viewed in isolation, but in conjunction with the Echo Bonus.

–        The RIY for this particular plan, initially paying R275 per month (which is a conversion of his existing plan,) is 2.19% – assuming a gross investment return of 10% per annum. When the monthly contribution was increased to R1 500, the RIY reduced to 2.1%.

–        The RIY includes the mentioned administration charge of 4% per annum which is effectively reduced over the term of the plan, due to the fact that the longer the client remains invested, the bigger the Echo Bonus becomes.

Retirement planning can indeed get very complex, as there are many decisions clients need to take (including how much to save, selecting a solution that is tax- and cost-efficient and picking investments that are appropriate for the client’s investment horizon and risk profile). Registered financial advisers can help clients to make informed decisions about their retirement savings.

Dave Crawford responds: 

Although there was no intention to do so the article appears to conflate VAT within a life assurance policy with VAT on an external product. I apologise for this unreservedly.

It is however incidental to the broader message that costs have an impact on investment outcomes.

I would appreciate a simple explanation of how the Echo Bonus works, how it is funded and what guarantees apply, as I had difficulty understanding it clearly.

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