| Article
2:
Protect
your Pension: When ‘commission’ becomes a dirty word
In the wake of recent revelations concerning the pension fund
industry in South Africa, questions have arisen about the role of
the pension fund administrator and who should earn the benefits
from pension fund investments. This week I take a look at practices
surrounding commission.
How commission schemes work
In the pension funds industry, commission is either tightly regulated
through statute, or it can be unregulated, the latter being more
in the category of a ‘kick back’. Typically, commission
paid by insurance companies is regulated while commission paid by
other providers is mostly unregulated and may be categorized as
‘kick back’.
Many will have heard the statement that insurance is sold, not
bought. True, if one thinks of insurance in respect of the unthinkable
such as life or disability cover for an individual. Not true though
as far as any group scheme or investments are concerned.
Retirement funds and the benefits they provide, including group
life and disability benefits, have become a business norm these
days rather than an exception and hence don’t have to be sold
but are bought rather.
Looking at the regulated commission regime which always refers
to the maximum commission that may be paid, commission on an insurance
product sold to an individual is usually quite high, since this
type of business requires the labour of selling. Commission is based
on the premiums paid. First year commission is normally like a bullet
payment and makes up the largest portion of the total commission
that will be paid in respect of a sale. It is typically calculated
as 3.25% of the annual premium multiplied by the premium payment
term, with a maximum of 27 years. So if you buy a policy with a
monthly premium of N$ 1 000 and the policy runs over 27 years, the
first year commission is likely to be around N$ 10 500 (i.e. 88%).
In the second year another payment will be made equal to one-third
of the first year commission.
The effort of selling
Commission may be questionable where it is applied to a pure investment
product. As I understand it this is what was revealed by a prominent
investigation into the financial matters of a parastatal a few years
ago. This institution had to invest its capital and was only required
to find a suitable investment vehicle, no question about the investor
having to be talked into investing. Maybe the investor had to be
talked into investing in a particular product but I don’t
think this is what is meant by the statement that insurance has
to be sold?
Commission with regard to group schemes is paid on a more modest
scale, also based on premiums paid. It is also to be noted that
this commission normally only applies to risk schemes, i.e. group
life or disability reassurance schemes but not to fund investments.
Currently the following scale applies, unchanged since18 July
2001:
- 7.5% on the annual premium up to N$ 126 500 (premium, not commission);
- 5% on the annual premium above the previous level and up to
N$ 218 000 (premium, not commission);
- 3% on the annual premium exceeding the previous levels and up
to N$ 471 000 (premium, not commission);
- 2% on the annual premium exceeding the previous levels and up
to N$ 1 380 000 (premium, not commission);
- 1% on any annual premium exceeding the previous levels.
Therefore, on an annual premium of N$ 1 380 000 the maximum annual
commission that may be paid is N$ 39 833 or 2.89%.
Given the above disclosure of maximum commission, the individual
or the pension fund trustee should be aware that nowadays commission
is generally negotiable at lower levels (down to 0%) as well and
most product providers are quite flexible to accommodate any lower
rate of commission.
As far as unregulated payment of commission/kick backs or other
creative incentive and remuneration schemes are concerned, ‘the
sky is the limit’ and we do not profess to have the knowledge
of all traps that are out there and that one has to be wary of,
but a few situations spring to mind.
Undue influence
Consider a hypothetical situation in which an inferior investment
product offers a higher commission than a superior product which
offers a lower commission. The intermediary is placed in a potential
quandary. The interest of the seller dictates that the intermediary
should earn a lower amount for the similar amount of work entailed
in selling the superior product as opposed to the inferior product.
Unrealistically high commission
Commission earnings and other incentives (such as gifts) will count
as a cost against the gross return on the investment, directly or
indirectly, since ‘there is no such thing as a free lunch’.
If the investor is financially skilled, he or she will be able to
discern the difference, however an unskilled investor will not easily
be able to discern the cost.
Kickbacks
In a sphere which is reliant on commission or similar incentive
payments to intermediaries, it may be difficult to discern the difference
between a true intermediary or an individual who happens to be in
a position to influence the decision, although this is not a normal
part of his or her business. In this regard, the commission may
be regarded as a kickback, particularly if the person influencing
the decision is not a trained financial intermediary.
Treatment of commission for purposes of accounting
In some cases, commission is treated as ‘windfall’ income,
over and above normal administrative income. If commission is known
and treated as income derived from the normal course of business,
then the level of commission can be used to mitigate administrative
income to provide a more equitable return to the investor.
What you can do to prevent abuse
The problem with commission and other incentive payments is for
one, if it is applied to products that are bought not sold and also
where it is not regulated and open to misuse. Non-disclosure of
such remuneration is also a common problem. As with the case of
bulking, the individual making the investment is entitled to a fair
return that takes into account necessary costs (mostly related to
expertise and skills), but not excessive costs. The recommendations
are the same as those that prevent abuse through bulking…
The parties to the fund: Who has been contracted
to provide services to the fund and how are they remunerated?
The contract: what are the expenses that have been
agreed upon and contractually stipulated? Does the contract clearly
stipulate that the service provider shall not be entitled to any
income arising from its appointment other than what is stipulated
in the agreement?
The returns: what are the actual returns earned
by the fund and what are the returns that the fund reports and distributes
to individual members of the fund? Is there any discrepancy, and
if so what is the reason for any discrepancy?
The reporting: is the reporting regular and comprehensive,
are regular meetings held to discuss the management and status of
the fund?
Independent supervision: Is the fund audited by
independent auditors? The ultimate expert in the pension fund industry
is the actuary. Is the fund subject to regular actuarial reviews,
and more importantly, is the actuary independent of the administrator
of the fund?
Board of trustees: Is the board of trustees capable
and experienced enough to manage the affairs of the fund without
outside interference and is it managed in an unautocratic manner
free of fear of victimisation?.
In this regard, each fund has a duly appointed fund administrator
who must be able to provide the answers given fair notice.
Commission has the benefit of making funds more attractive to intermediaries
and their clients. It is also a reward for a job well done. With
a querying, regular reporting and transparent management in the
interest of members, no individual need fear an undue loss of return
due to improper practices surrounding commission.
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