Too much trumpeting

Approximately two weeks ago we covered the launch of a new Old Mutual product designed to fill a gap in the market for retirement products for domestic workers. The product, known as the Domestic Workers Plan was lauded as an affordable and cost effective solution for domestic workers wanting to save for their retirement.

Today we revisit the product and discuss the conflicting concepts of affordability and cost effectiveness (or value for money). While a product might be affordable by way of a manageable monthly contribution, this affordability does not guarantee value. This truth seems to have escaped the numerous market commentators who have welcomed Old Mutual's entrance to this under-serviced segment of the market.

The question is how you can encourage the poorest of the poor to buy an insurance product with (at the entry level) a Reduction in Yield (RIY) of more than 5%? And why are insurance companies still introducing products with such high costs after all the negative publicity they have endured over the last five years?

The profit motivation

The life insurance industry has been in the spotlight in recent years for failing consumers in a number of areas, most notably the transparency of costs and high early termination charges. Consumer activists supported by independent actuarial analysis from the likes of Rob Rusconi led to a much publicised revolt against local insurance giants. A new public awareness combined with the FAIS Act ensured that a number of positive steps were taken in improving the situation.

In January 2007, Karin Mackenzie published an article titled "A comparison of unit trust and underwritten retirement annuity funds." What this article revealed about the respective costs associated with each alternative is alarming, particularly in the choice of product to service one of the poorest sectors of the South African employment environment.

Underwritten retirement annuities consumed between 27% and 43% of the gross value of savings over term, with smoothed bonus funds swallowing up between 40% and 53%. Unit trusts, on the other hand, had charge ratios of between 22% and 33%.

An innovative product or the only alternative

How does the Domestic Workers Plan compare? Well, the first observation is that the product is an umbrella retirement annuity fund. And before delving deeper into the cost implications, we should consider two other factors. One is that domestic workers get no tax benefit from investing in a retirement product, and the other is the possible impact of this policy on future means testing...

The Reduction in Yield (RIY) on a retirement annuity is the "percentage deducted annually from the members full fund value in respect of costs." The Reduction in Yield (RIY) on the Domestic Workers Plan ranges from 5% for the entry level option over ten years, to 2.12% on the more expensive policy over longer periods.

The entire administration fee is deducted from the portion of funds intended for savings. Thus in the entry plan approximately R42.17 of the R50 per month contribution will make its way to the savings pool. The fees deducted include a R7 per month administration fee and a 1.6% per annum management fee, levied monthly.

Assuming a 10-year term, annual payment increases of 6% and a 12% annual return, a domestic worker on the entry level plan should receive in the region of R11 500. This follows gross contributions of R7 908 and fees in the region of R1 665. On this basis, the total charge ratio is probably close to the low end charged on unit trusts.

The argument of whether a solution could have been better implemented in the RA Unit Trust space may be a moot point. It is likely the government retirement fund reform process will scupper products like the Domestic Workers Plan and require the assets under management to be transferred to the government pension plan at some future date.

Tell it like it is

In the interim it seems strange that some of the strongest campaigners for consumer rights have dedicated inches of column space to Old Mutual's Domestic Workers Plan in recent weeks. They welcome the product as a solution to domestic workers' retirement problems and suggest these workers can finally empower themselves and plan for their own retirement.

Yes the product is affordable after all it requires a monthly contribution of only R85. But the value proposition is not as certain. How much of a 'pension' will the domestic worker secure with the R11 500 paid out at the end of this annuity term?

Editor's thoughts:
Much has been written about the cost effectiveness of conventional retirement annuities compared to unit trust products. Investors prefer the greater transparency and flexibility offered by unit trusts solutions. Should Old Mutual rather have investigated implementing a solution in the unit trusts space? Send your comments to gareth@fanew.co.za