Negatively charged
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The irony is that most companies have continued to understate their charges to this day on most contracts because few of them use total expense ratios.
One major insurance company uses TER for its wrap account. When it discovered that others were not using TER, it asked the FSA if it could follow suit but was refused permission. The other companies have been allowed to continue understating their charges!
Illustrations have other inadequacies. For example, only growth rates are used, typically 4 to 8 per cent a year for life products and 5 to 9 per cent for pension products. This is misleading because it means that plans can only grow in value not fall. But most investments rise and fall in value.
Has nobody at the FSA heard of Monte Carlo simulation? This mathematical technique allows a range of possible outcomes, some positive and some negative, using probability.
The other fundamental flaw in the quotation system is that past performance statistics are not allowed to be used. This is unfair on companies that have shown superior investment performance over many years.
It means companies that continue to understate their charges continue to provide illustrations which show a better rate of return net of charges than companies that do use TER. Every company has to use uniform growth rates, so a company with poor performance and understated charges can still produce illustrations which project better returns than a company which uses TER and has far superior investment returns. How absurd is that?
When analysing existing clients' investments and pensions arranged through previous advisers and comparing the projections against our recommended alternative provider, we have come across cases where the projections for the old plans give impossibly high returns equating to negative annual charges.
We had a case recently when a well known company had to make manual projections on a client's existing plan. Performance was poor. It was an antiquated plan. Future growth prospects were poor in comparison with the modern, low-charging wrap account we were recommending with zero initial charges on external funds, reduced annual charges, whole of market funds availability, etc. The previous plan's projections showed significant outperformance. We calculated its charges equated to an annual charge of -0.3 per cent a year, that's right a negative charge.
Insurance companies' policies of understating charges have continued unabated and been approved by the FSA.
Tony Byrne is financial planning director at Wealth and Tax Management
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