Beware the fox in the henhouse

By GARETH MORGAN - Part 3

The Government has consistently branded banks as a rapacious, profiteering cartel. Hence the rationale for Kiwibank. Can something similar be said about life insurance companies?

Unfortunately the evidence says yes. From a consumer's perspective this sector is evil. Of more intrigue perhaps is why and what can be done about it. But first consider the facts, and be patient, the list is long.

Many of us might recall those dogs called endowment policies. These products bundled life insurance with retirement savings so that on maturity the holder could receive a lump sum or annuity until death.

The companies employed an army of agents to flog this stuff with the agents' fees being deducted from contributions in the initial years.

Net result for the holder was that the surrender value of the policy would plummet substantially but on the promise that as retirement approached all the value would materialise.

Fascinatingly though, the companies went to inordinate lengths to ensure you couldn't possibly evaluate what annual return they were making on your contributions.

The popular means of obfuscation was to award bonus points which, according to the marketing department's theory, reflected the value of your return already made, but measured in dollars at policy maturity.

An obscure concept if ever there was one, it guaranteed you couldn't possibly confirm whether their fund's management arm was making or losing money. That, of course, was the whole idea.

Many will also recall just how poor these companies were at investing when in the 1980s the concentration of their investments in the CBD property market was revealed.

So severe was the loss of their customers' savings they had to ring-fence and even close many of the superannuation schemes they'd conned people to invest in. A generation's savings were eliminated.

The empire moved on and didn't allow that setback to tell it much.

In the deregulated market, changes were required so it could capture its share of Granny's money from the banks. This has been achieved by moving more assertively into funds management.

To do this it has had to train its army of insurance salesmen to understand a little about savings products and equip them with the banter to be able to flog these alongside trimmed-down insurance products such as term life. In truth, peddling insurance has as much to do with retirement-saving as peddling cans of boot polish does. Nevertheless, the industry has a large historical investment in its field agent army and the more product it can shove down those channels, the better their profits.

Never mind whether the savings products are any good, a small number of big firms proved an effective cartel in insurance, at least up until the 1980s property crash. So achieving the same in savings products has been worth trying.

From this pedigree come today's lobbyists for this industry, still barking at the Government to legislate for compulsory contributions and to lock up people's savings in their care. Their purpose? To collect fees year in, year out without accountability.

The affliction of the insurance companies, their rubbish products and the expansion into direct fund management has not been just a New Zealand phenomenon; our suffering reflects the evolution of the empire in the US, UK and Australia.

Recently, though, the balance has shifted. Regulatory authorities in all three markets have belatedly recognised that consumers have been ravaged.

As New York Attorney-General Eliot Spitzer remarked in exasperation: "Under every rock we turn over in this industry we discover more vermin."

Some data from the funds management business demonstrates the damage being wrought. US figures comparing returns from high-fee to low-fee unit trust offerings demonstrates that in these products you don't get what you pay for. Rather, the less you pay for the better the performance of the fund.

There is a 30 per cent difference of annual return between the most expensive and cheapest funds. And the data in the table above, comparing expensive to less expensive unit trusts, doesn't measure the largest source of the bleeding - the inordinate tax load that active fund managers incur by virtue of the lazy design of their products.

Our own study of New Zealand savings products and providers revealed that for a range of real returns actually earned by the products, the investor would end up, at best, receiving about a third of it and often simply losing wealth in real terms.

The second table shows the extent of the gouging investors suffer as a result of fees and poorly designed products.

If the return earned by the product in the market is 10 per cent, investors can expect to reap under half of that (about a third if the comparison was done in real terms).

If the return earned drops to 5 per cent, investors end up with a return of about a third of that (less than the inflation rate of 2 per cent).

Marketing organisations, with various backhanders to so-called independent advisers, have inordinate power in this market.

A proliferation of designer funds designed to pull money in on the back of the latest fad, and not concerned about any sustained performance, is in evidence with the fact that in 1970 the US had 355 mutual funds and only 40 per cent (147) survived the following 30 years. Only 2 per cent (seven) beat the index significantly.

Conclusion: fund managers systematically fail to beat the market and fail to add any value for investors. In fact, our survey shows the three-layer system of fund managers, financial services companies and commission salesmen make investors poorer.

The conflicts of interest are shameful. Even worse, financial services companies parade them in public. In New Zealand one major Australian-based fund has declared it will be expanding its retail financial planning firm. So here we have a firm pretending that it can offer Mum and Dad independent financial planning expertise while it bundles them into the products of its owner.

Yet, when you look at the fees charged by its so-called financial planning adviser franchise throughout the country, you quickly see what's happening. These fees range between 2.5 per cent and 3.5 per cent a year, and a fair portion of the products investors are fitted out with are the products of its parent, and are as tax inefficient (negligent) as they can be.

In Australia the Securities Commission has threatened more regulatory crackdowns on the rewards financial product providers give financial planners. Here, the Commerce Commission is at last asking the question, while our Securities Commission appears to be comatose.

It is clear this industry is incapable of cleaning itself up.

The global regulatory noose is tightening as regulators start a major clean-up job. Let's hope it chokes the bleeding before the patient expires.

Ironically, just as this industry is being exposed globally as infected by a cancer of self-interest and consumer exploitation, the New Zealand Government is doing the opposite.

Through a couple of working parties it is soliciting advice on how it can force-feed more of the public's hard-won income down the rapacious throats of the funds management industry.

It is unfortunate that Labour comes to the table with a view that households are saving insufficiently and fund managers are needed to help. The fox is very pleased to be put in charge of the hen house. Could we have an advocate for the hens please?

Lest we forget, there is a plethora of ancillary businesses that feed from the rort that funds management has become.

Among these parties are the consultants who on the one hand provide advice to well-intentioned but amateur trustees about their investment policy, and on the other, run their own competing funds.

On the optimistic side, there are murmurings of discontent within the financial advisory industry that the fund managers, by their sheer size, have undue influence and are compromising the ability of the advisory business to gain independence, and work in the investors' interest.

Recently a company was in the press for the strong-arm tactics it's been using to get advisers to sign up agreements. At the core of the problem, however, is that the advisory business is so weak it cannot tell the providers to go jump. Only by the Government prohibiting fund providers dominating the business of investor advice, and instead compelling product sellers to call themselves product sellers rather than use commission salesmen as Trojan horses, can there be any end to this market failure.

Part 1 | Part 2 | Part 3