You’ve decided which asset class and investment product suit you. It’s time for your last main investment decision.

Which product house?

The product provider could be a life assurer, a unit trust management company or a linked investment service provider (LISP). When choosing product providers, look for companies that are:

1. Focused on small, retail clients

Many companies claim that you, the retail investor, are important to them. In reality, they prefer to take your money through intermediaries like financial advisers or retirement fund trustees, rather than dealing directly with you. Signs that they are not really that interested in direct clients include:

• Very little investor education literature
• A poorly staffed call centre and irritable staff
• A website that provides very little practical information on the investment process
• No clear communication, a.k.a. simplified English policy
• An almost immediate referral to a financial adviser when you contact them

Most companies seem to still believe that dealing with direct clients is too time-intensive and expensive. A rare few know how to leverage modern technology to cost-effectively service even the smallest retail investor well.

2. Fit and proper

With unit trusts, it’s highly unlikely that your money can just disappear. The Financial Services Board approved the independent trustees who look after the money in the trust. Still, it’s always important to verify that the company you want to invest with, is fit and proper. I usually check that they at least have a licence with the Financial Services Board and read on HelloPeter what existing clients are saying about them.

3. Flexible

I choose companies that, irrespective of the investment product I choose, provide me with ‘open architecture’ to build my own underlying investment portfolio. If I, for example buy a retirement annuity, I want access to any one or a combination of unit trusts available in South Africa as the portfolio in which my portion of the retirement annuity fund will invest. Just be careful, if the product provider has an in-house investment manager, you may pay extra (in the form of an administration fee) if you prefer a third-party investment manager.

4. Transparent

Ideally, you want to be able to see a list of all the underlying assets in which your investment product invests, as well as all the expenses associated with the product. It’s very difficult to know exactly how much of your investment portfolio is paid away as expenses and administration costs if you invest in opaque old-fashioned policies. But if you choose an open architecture product, you can track the total expense ratio (TER) of your chosen underlying unit trust portfolio.

5. Affordable

With unit trust portfolios, the total expense ratio (TER) is a ratio expressing the investment management fees, audit fees, custodian fees, portfolio bank charges and taxes as a percentage of the market value of the portfolio. (These costs decrease the return on your investment.) The ratio changes every quarter and is based on the previous year’s expenses. The TER does not have to include the portfolio’s stock broking fees and these can be quite high if the investment manager trades often. Some companies, like Allan Gray, decided to include brokerage in their TER calculations to give the investor a better idea of the true costs associated with running the unit trust. This makes it more difficult to compare the cost of different unit trusts using their TERs, but generally unusually high historic TERs require further investigation.

The TER does not include all costs carried by the investor. You could also be paying a fee to a life assurer for providing the wrapper of your investment. Or an administration fee to a LISP for acting as an agent in the investment process. And if a financial adviser helped you with your application process, you could also be paying initial and ongoing adviser fees (also called ‘broker fees’). The adviser has to disclose these costs and you will have to sign on the form that those are the fees that you have negotiated.

The life insurance industry uses another ratio, the reduction in yield (RIY), to indicate the annual impact of expenses on your investment. Unfortunately, this is not comparable with the unit trust industry’s TER. It’s a good idea to always ask for a complete cost breakdown for all products that you are considering. In the case of open architecture products, also enquire whether the underlying portfolio pays a rebate to the product house from which you’re buying the product and whether that rebate is passed on to you in the form of lower costs.

That covers your five big investment decisions. You probably have plenty more questions like ‘Satrix or unit trusts?’, ‘your own share trading account or someone else’s fund?’, ‘direct or listed property?’ We’ll cover these asset class-specific questions over the next few weeks.

Which investment product?

Foreigners are often surprised at the sophistication of the South African financial industry and the wide array of products available here. Don’t worry, I won’t cover them all in this post; only the three most popular ‘wrapper’ products available to individuals.

What is a wrapper? Your investment portfolio forms the heart of your investment. In other words, your choice between interest-yielding assets, shares, property and offshore assets drives the growth and volatility of your investment. The structure around your portfolio is the wrapper. Your choice of a wrapper will determine how your investment is regulated, when you may withdraw your money, how much tax you pay on income and capital gains, and many other issues that surround your investment.

1. Unit trusts

Unit trusts allow you to pool your money with many other investors, all investing in the same portfolio as you. The portfolio can consist of only interest-bearing assets, property, shares, offshore assets or any combination of asset classes. The assets are held by trustees on your behalf. You share in the growth and income of the portfolio in the same proportion as your number of units to the total number of units in the portfolio. You can access your money within 24 hours and add money to your investment at any time.

Unfortunately, you don’t get any tax-relief for your contributions and you become liable for capital gains tax when you withdraw your money (if there was any capital growth). You will also receive a certificate every year to show how much interest, rental or dividend income the portfolio earned and you have to declare this in your tax return.

Unit trusts form part of a bigger group of investment products called ‘collective investment schemes’ and they are regulated by the Association of Collective Investments. Their prices are published daily in most newspapers and you can view all the assets in the portfolio at least quarterly.

2. Retirement annuities

Technically, buying a retirement annuity actually means you become a member of a specific retirement fund. The fund’s trustees look after your interests. Sometimes the trustees buy an old-fashioned retirement policy on behalf of all members or an individual policy for each member. Often the policies contractually bind you to contribute premiums on a regular basis until a certain retirement age and penalise you if you stop contributing earlier. The life insurers issuing the policies usually appoint asset managers who choose the underlying investment portfolio.

Nowadays there’s a more modern, flexible and transparent version of the retirement annuity which allows you to choose your own investment portfolio (often a unit trust) and also allows you to contribute only when you can – without penalties. Still, neither version allows you to withdraw your money before you reach age 55. The age is determined by retirement fund legislation.

Why would anybody choose to be locked in for so long? Retirement annuities currently provide great tax benefits for the self-employed, as the government wants to encourage you to save for old age. As a tax-payer, you may therefore receive a tax rebate on your contributions, subject to certain limits. In addition, neither you nor the retirement fund pays any tax on the income earned by the investment portfolio. It’s only when you start drawing your pension, that you could pay tax on your retirement income exceeding the annual income threshold.

Unlike unit trusts and endowment policies, regulation requires the trustees to use their discretion when they decide who your dependents are and where the money should go after your death. As a result, they may overrule your beneficiary nomination.

3. Endowment policies

Like the old-fashioned retirement annuity policies, endowment policies have become unpopular because of the high penalties life insurers charge when you end the policy or stop your regular contributions before the contractual end date. Traditional endowment policies also do not allow you to select your own underlying investment portfolio and don’t always regularly disclose all assets in the portfolio they select on your behalf. Legislation effectively forces you to remain invested for five years. If you need the money earlier, you can withdraw it, but won’t receive more than your contributions plus 6% compound interest per year.

With all these restrictions, why do some people still prefer this wrapper? Unlike unit trusts, you don’t account for your investment income and capital growth in your tax return. In other words, you are not taxed directly; the fund that pools your contributions with that of other individual policyholders will pay the tax to SARS on your behalf. Currently the rate is 30% on all interest and rental income. Even though you are not taxed directly, the net effect is that you are left with only 70% of the interest and rental income earned by the portfolio. Individuals paying more than 30% tax on their annual interest and rental income may therefore benefit from the 30% tax rate of the endowment policy. Unfortunately, the policy doesn’t allow you to use your R19 000 annual interest exemption as an individual – interest earned by the portfolio is taxed from the first R1.

An endowment policy is therefore only an option if:

• You are a high income tax payer
• You expect substantial amounts of interest or rental income from your investment portfolio

Endowment policies have also evolved over the years. It is now possible to purchase policies that allow you to choose your own underlying investment portfolio, often from a wide range of unit trusts. Because the unit trust is wrapped within the policy, it follows the tax and other rules of an endowment policy, but offers the transparency of a unit trust investment.