Cost in the mists of time
A common but poorly understood category of investments has had some harsh scrutiny recently. A wealthy businessman took his financial adviser, the Hong Kong-based Clearwater International, to court over the high commission he paid on on a class of products called investment linked assurance schemes (ILAS).
Jeremy Hobbins, a director of trading firm Li & Fung, was shocked when he found out how much Clearwater had been paid by insurer Royal Skandia on the ILAS products it had sold him. He complained to the court that he paid almost US$1 million in fees over eight years.
According to court documents, Hobbins traded actively through Clearwater in transactions involving tens of millions of US dollars.
Hobbins claimed that, while Clearwater had disclosed it would be earning commission, it failed to specify exactly how much this would be, according to court documents.
The Clearwater case was closely watched by Hong Kong's independent financial advisers, given that their industry depends quite heavily on the sale of ILAS plans to individual investors.
These complex and high-fee instruments are viewed with some ambivalence by the financial advisory community. While the plans can pay advisers a lot of commission income, they are a source of client complaint.
Hobbins was the rare client who actually sued his adviser - in December 2011 - over the scheme. He alleged that by recommending the ILAS plans, Clearwater was not acting in his best interests, but 'acting solely so Clearwater could profit from commission and fees paid by Skandia and other insurers', according to the court documents.
A director of Clearwater International - who asked not to be named - says: 'Clearwater made it clear that it would be earning commission, and there was no evidence that the money it received was higher than was normally paid.'
In January, Justice Anselmo Reyes of the Court of First Instance, found against Hobbins, but added: 'The practice of insurers paying commission to insurance brokers may or may not be unsound. It ought possibly to be strictly regulated or even prohibited.'
The Hobbins case made public the many criticisms that are often made about ILAS products.
First things first: what is an ILAS?
An ILAS is an investment-linked plan sold by insurance companies. It includes an insurance component but commonly takes the form of a savings or pension plan.
The schemes are common. One adviser estimates that about 75 per cent of investment products sold to individual investors in Hong Kong come under the ILAS umbrella.
The money paid into an ILAS typically is invested in a range of funds picked by the investor.
The products are offered by the major insurers, such as Friends Provident, Generali International, Aviva, Zurich International Life and Royal Skandia, as well as banks, including HSBC and Citibank. It is sold through financial advisers and insurance brokers.
Like many insurance products, clients typically sign up for long periods - as long as 30 years - and commit to regular premium payments. Early withdrawal, or a failure to make a premium payment, can involve steep penalties.
The product is not always labelled as an ILAS. It is sometimes referred to by other names, such as unit-linked life insurance, an offshore pension, or just a pension.
An example of an ILAS is Generali's Vision plan, another is HSBC's WealthInvest Insurance Plan.
The product has its supporters.
'These plans definitely have a place. I have a couple of them as retirement plans myself,' says Robert Flux, a Hong Kong-based director of Simmonds (International) Financial Associates. Flux says the plans can be good for investors who want to frequently move their money to different funds without incurring the fund houses' full upfront charges. And, so long as the plans are held to maturity and investors do not miss too many payments, their can offer decent value: 'In the long run they can be quite economical,' Flux says.
But while an ILAS enables consumers to access a range of investment funds and helps to instil the discipline of regular saving, it has disadvantages, such as the high levels of commission that come with the product.
It is not unusual for a client to see his first full year of contributions to an ILAS paid out to cover commission costs - money that goes to the person who recommended the plan.
Money Post reviewed an 'introducer agreement' document produced by Generali International that breaks down the fees the insurance giant pays financial advisers for selling its Vision product, which is a savings plan.
The document explains that an agent (introducer) will receive the equivalent of 3 per cent of the first year's premium for each year of the policy's term.
So, for a 25-year plan into which a consumer pays HK$10,000 a month, Generali would pay the adviser selling the plan an upfront commission of HK$90,000.
There are many complexities to this. For example, advisers may receive an extra fee in the form of an 'override commission', which essentially is an extra incentive insurance firms pay to those who sell ILAS. This can increase the commission from the sale of an ILAS product by about 40 per cent.
Chantal Tighe, manager of marketing for Generali International, says of the Vision plan that 'any commissions paid are in line with market practice'.
Indeed, financial advisers say the commission paid on Vision is standard for the industry.
Tighe adds: 'Commission is a recognised and lawful means of remunerating an intermediary and generally preferred by clients to upfront fees.'
But it is fair to say that insurance firms often structure these products with a large upfront commission. The main issue in the Hobbins case was whether an adviser needed to disclose the commission he earned on a transaction, so the client could see if there was a conflict of interest.
Financial advisers say many insurance firms ask them to tell clients they earn commission on an ILAS sale. The insurance companies also tell advisers to disclose their commission income, if a client asks.
Privately, advisers are sceptical such guidelines are fully followed.
So commission income on ILAS plans can be high, which raises the possibility that a financial adviser is selling a product to earn a fee, not because it is right for the client.
How are ILAS plans able to pay such high commissions? Well, they can carry high fees.
A managed savings account offered by Skandia International gives a sense of the size of the fee charged on a typical ILAS. Skandia says, 'Every time you pay a contribution, we deduct a single bid/offer spread charge. This can be up to 7 per cent of the amount invested.'
The firm adds that it also charges a 1 per cent management fee, and the fund managers will charge another fee, 'usually between 1 per cent and 2.5 per cent a year', and there are other charges.
'Unlike the case of companies who employ their own agents, Royal Skandia products are distributed through independent advisers. Clients choose their adviser, and the adviser identifies and ensures the client's needs are matched with the right products. This includes fee structures and any further investments,' says a Royal Skandia spokesman.
Why do clients agree to such high commissions? Unlike the clear language seen on the Skandia product above, ILAS products tend to be complex and jargon filled. Even financial advisers can have a hard time interpreting the language of an ILAS document, especially the fee breakdown. This raises the possibility that clients agree to fees they simply do not understand.
Tony Noto, a Shanghai-based financial adviser, attempts to break down the fees of the Vision plan offered by Generali International. (See Table)
The Vision plan has many variables (premium holidays, death benefits, bid-offer spreads, bonus offsetting, surrender values, discontinuation fees, administrative charges), making it hard to understand what an investor will pay in fees in a given year.
This is despite the fact that ILAS products are commonly marketed to novice investors.
Tighe of Generali says Vision's marketing and offer documents are approved by the Securities and Futures Commission (SFC).
'Each customer is issued with an illustration ... which shows years one to five and every five thereafter and is completely transparent. All clients in Hong Kong would need to sign their illustration before proceeding. There are plenty of warnings on the opening page and the surrender values are shown for the first five years together with the total premium paid,' she adds.
The SFC does indeed review the marketing and offer documents used for ILAS products, which is what insurance firms mean when they say they are offering an 'SFC-authorised' product. However, SFC's authorisation does not imply official recommendation or endorsement of the ILAS.
The SFC does not regulate those who sell ILAS products. The Insurance Authority performs the function with a number of self-regulated industry bodies.
People who invest in ILAS plans my find themselves disappointed by the returns, as the high fees often seen on the instruments will deplete returns. ILAS products offer little in disclosure documents about the expected yield of the plans.
The product can also be inflexible. Investors might commit to paying high premium payments for a 30-year period, only to find later in life they can no longer afford such payments. This triggers steep withdrawal penalties.
Financial advisers say that many investors often do not hold the plan to maturity, partly because they are unhappy with the returns of plans and do not like to see so much money locked up for so long.
'There is possible abuse with people encouraging clients to put more money into ILAS products than perhaps they should, knowing full well that they won't be able to maintain the level of savings through the whole contract,' says Flux of Simmonds.
Peter Hatz, a director of One Axcess, an online trading platform, estimates that only 7 per cent of ILAS products are held to maturity.
Furthermore, the fact that an adviser gets paid his commission in one, large, upfront payment means the adviser has little incentive to stay with the client after the sale.
'Earning an upfront commission and selling someone a product with a 25-year term, then earning no further income for the next 25 years, means there is no incentive to maintain the relationship,' says Hatz. 'The structure is fundamentally flawed.'