Demystifying the fees behind investment products

Asset classes – including equities, bonds, property – are expected to struggle to deliver double digit returns in the current economic environment. As a result, it is critical for you, the investor, to understand what and how much you are paying on investment products to determine if they are reasonable.

Over the years the financial services industry has attracted a lot of criticism with regards to the types of and excessive fees that are charged. Financial products are by nature complicated without taking into account the various levels of fees that can be charged. It is therefore understandable that some investors are overwhelmed and frustrated.

Like the cell phone industry, the investment industry has evolved over the last ten years. Why would someone keep an old Nokia 100 that is slow, ineffective and more expensive than the technologically cutting edge iPhone 4? The same applies to financial products. Why would an investor stay invested in expensive, inflexible and complicated policy-based products when unit trust based products are available?

Financial products, like cell phones, have become smarter, easier to use and more importantly cheaper, than their earlier versions. Unfortunately many investors have not converted from their old financial products to the new models. Ironically, these are often the investors who complain about the poor performance and fees charged within their financial products or portfolios.

It is important to understand that the performance of a portfolio and the fees being paid are inextricably linked. The effective return you receive from your portfolio is based on the returns of the underlying unit trusts that you have selected to construct your financial product. But you need to deduct the total ongoing costs you are paying to be invested in these funds.

So, when your portfolio delivers a lower return, your fees effectively account for a larger chunk. For example, if your total ongoing fee is 2% per annum and your portfolio delivers a 30% return then this accounts for a relatively small percentage (6.7% of your total return). On the flipside, if your return is only 10% then the fees you are paying make up 20% of your total return.

You are charged two types of fees on investment products: initial fees that are deducted from your gross investment amount and paid before your money is invested; and ongoing fees that are normally deducted monthly from your invested assets. Ongoing fees are percentage-based, meaning the higher the asset value of the investment the higher the fee in Rand terms.

Fees can either be paid upfront or on an as-and-when basis. Upfront fees are paid to a company or an intermediary at the point of investment based on your future contributions. This was common practice in the older generation, policy-based products. However, one of the problems with this method is that punitive penalties are levied should you wish to amend your contributions or terminate your contract prior to the end of the contracted term.

Legislation now states that no more than 50% of advice fees may be paid upfront. Historically the upfront advice fees were non-negotiable and poorly disclosed.

Fees paid on an as-and-when basis are used by almost all unit trust based product providers, where fees are only payable when each payment is made. On a recurring investment, fees are only paid when your debit order is invested, like a ‘pay-as-you-go’ cell phone. The intermediary is also not paid upfront so there are no penalties levied if you stop or reduce your contributions or transfer your total invested amount to another product provider.

There are three parties that can earn fees when you invest in a financial product: Intermediaries, Administrators and Asset Managers.

A fee is paid to your intermediary for guiding you in selecting the most appropriate product to achieve your financial goal. You and your intermediary can negotiate an initial and ongoing fee. Initial fees can range from 0% to 3% and ongoing fees are normally negotiable from 0% to 1% per annum. Units of your unit trust are sold to pay advice fees.

A fee is also paid to the administrator or product provider for delivering a range of services to the investor. Some administrators charge an initial fee, which is calculated using a sliding scale, so the more you invest, the lower your initial fee. However, all administrators levy an ongoing administration fee.

A further fee is also paid to the asset managers of the funds selected to invest the portfolio in. Most funds do not charge initial asset management fees and those that do normally charge 0.25%. Ongoing asset management fees vary from one fund to another.

This method is in your, the product provider’s as well as the intermediary’s interest. The advice fees can be negotiated between you and your intermediary and can be changed at any stage.

Whether you are shopping around for a new cell phone or looking to invest your hard-earned money, understanding who and what you are paying for should play a big role in your ultimate decision. It should, however, not be your only consideration. You should ask yourself, what additional benefits you will receive from your product provider.