The first two things I look for in a financial adviser

Most financial products are purchased through a financial adviser. Your adviser receives a fee for providing you with the advice they give you. Usually the provider of the product you are purchasing pays the adviser commission. For example, if you purchase a Liberty insurance product through an adviser, Liberty will pay the adviser commission.

What this means for you is that you should ensure that you get your money’s worth from your adviser. Like any profession, there are good and bad financial advisers. It is up to you to make sure that you get the best possible advice.

While the best adviser for you is often a personal choice, the first two factors I would consider are:

  •          Qualifications

In South Africa there are increasing requirements for advisers to pass a certain level of exams in order to be allowed to give advice. Previously there were none. There have been a fair amount of advisers who have left the industry because of the exam requirements.

The minimum requirements have been set to ensure that those giving you advice are qualified to do so. However, advisers are able to study beyond the minimum requirements. The most qualified advisers are Certified Financial Planners (they have the letters CFP after their names). This is a fairly tough qualification to gain.

It is important to note that unless the adviser has a fee-based practice, they don’t get paid any extra commission if they are more qualified, so it does not cost you any more to get advice from a more qualified adviser.

While qualifications alone are not the only criteria to judge an adviser, I believe that they are the clearest indicator that your adviser is capable of giving you good advice. An adviser who is qualified is able to demonstrate a certain level of knowledge, ability and work ethic.

  •          Tied agents and independent advisers

Advisers fall into a myriad of different categories, but the two extremes are independent advisers and tied agents. Independent advisers are allowed to sell you a financial product from any provider they chose, while tied agents are only allowed to sell you products from the provider they are tied to. For example, a Discovery tied agent can only sell you a Discovery product.

In reality there are a wide variety of advisers who fall into categories between the above two extremes. But the point I would like to make only requires us to consider tied agents versus independent advisers.

Tied agents argue that because they have access to assistance from the company they are tied to it makes them more qualified. Also, because they only sell one provider’s product, they argue that their product knowledge is better than an independent adviser who sells a wider variety of products.

However, the problem is that no provider provides the best products for every possible customer. If the best product for you is provided by Competitor A, while Competitor B can only can provide you an average product, visiting even the best tied agent for Competitor B will result in you not getting the best product you could get.

A large part of the advice process is helping you to choose the best provider. This is assistance that a tied agent cannot give. Tied agents usually do sell for companies that have decent products, so it is not the end of the world, but it is definitely something to remember when purchasing cover.

While I place considerable value on the above two points, an adviser must be able to give you advice that you feel comfortable with and understand. It is up to you to make sure that you don’t settle for anything less but the best advice from your adviser.

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Beware of bad investments – my experience last month with a questionable investment proposal

A month ago a friend and I went to a presentation by a company called Flipping 4 Profit. The company buys properties, renovates them and then sells them quickly in order to realise a quick profit. While I have nothing against this form of investment, there were several issues with the presentation that left me feeling very uncomfortable. Some of the issues, and why they bothered me, were:

  • The presentation video they showed us spent a lot of time showing emotive images of expensive cars and big houses while asking “isn’t this the kind of lifestyle you would like to have?”, at the same time as being quite vague on the details of the scheme. Investment decisions need to be made unemotionally. By selling the scheme on a lifestyle rather than the actual scheme they neatly sidestepped having to provide the necessary information needed to make an informed decision. The highlight for me was when the presenter got her cellphone out and showed us a picture of expensive cars, which she claimed were hers as a result of investing in the scheme.
  • If someone is going to give investment advice, they are required to be FAIS registered. This helps ensure that they are qualified to give you the right advice. I am almost completely certain that the presenters were not FAIS registered and thus not qualified to give investment advice.
  • The presentation spent a lot of time showing the returns they had made on a few specific properties. I asked for an indication as to how the scheme had performed as a whole, because your actual investment return is from all the properties purchased, not just the best ones. Not only did the presenter not have this information on hand, she guaranteed me that if I invested today I would have my money back plus at least 50% within six months. Higher expected returns come together with higher risk. You cannot promise astronomical risk-free returns.
  • A large part of the presentation dealt with how you could make money by referring other people to the scheme. This concerned me, firstly, because it gave the impression that anyone could go out and sell this investment without being FAIS registered, which is not true. Secondly, the scheme needs to generate enough returns from their investment in property to deliver returns to members as well as pay commissions those who refer members. I’m not saying that the scheme is a pyramid scheme, but there are a lot of worrying signs that the investment structure is not sustainable in the long term
  • Finally, the presentation they showed us had a few spelling errors in it. While I am a bit of a grammar Nazi, incorrect spelling on a business presentation speaks volumes about the quality of the proposal and the professionalism of the presenters.

I left the presentation and told my friend to not invest in the scheme, for my reasons above. My friend isn’t familiar with investing, so he actually left the presentation thinking that it looked like a worthwhile investment before I spoke to him.

When it comes to investing your hard earned money, you need to be wary of any proposal that sounds too good to be true. There are a lot of high quality, well managed options for you to invest in. Good investments don’t over-promise on their expected returns, while so many of the investment schemes that have imploded in the past have been on the back of impossible promises made to investors.

 

Things to think about when purchasing insurance: Premium Patterns

When purchasing insurance, you are faced with a myriad of choices with regards to your policy. One choice you have to make when purchasing long term insurance (i.e. insurance that pays if you die, cannot work, or are diagnosed with a critical illness) is your premium pattern. The premium pattern that you choose determines how your premiums change every year. Premium pattern choice is a significant decision for your insurance cover, but it often does not get the full attention it deserves.

For the most part, there are three main types of premium pattern. These are:

  • Level premium patterns: Every year your premium remains the same for as long as your cover remains the same.
  • Compulsory increases: Every year your premium increases by a compulsory percentage (this is usually 5%) for as long as your cover remains the same.
  • Age Rated: Every year your premium is adjusted to allow for the fact that you are a year older. The change in premium is in proportion to how much more likely you are to claim at this older age. As such, age rated premiums don’t have as predictable a development as the other two premium patterns.

Consider this simple example. You want a quote for life cover and need to choose your premium pattern. Your options are:

  • A level premium pattern, which costs R400 per month initially. Your monthly premium will remain at R400 for as long as your cover remains the same.
  • A compulsory increase premium pattern of 5%, which costs R300 per month initially. When the policy commences your premium is now R300, but every year it will increase by 5%
  • Finally, an age rated premium pattern. When the policy commences the premium is now R270. Every year premium increases in proportion to how much more likely you are to have a claim now that you are one year older.

So, from the above examples you may have noted that level premium patterns are usually more expensive when the policy commences, but you will see bigger increases to your premium on the other premium patterns. We can compare the different premium patterns on a typical policy below.

premium pattern graph

Premium patterns are ultimately a decision around how you want to structure your payments for your insurance cover. Basically, the more you pay now, the less you pay later.

When deciding on premium patterns, policyholders often choose compulsory increase or age rated premiums in order to enjoy cheaper cover when the policy commences. However, as seen above, compulsory increase and age rated premium patterns can quickly become unaffordable as the policy runs its course. For age rated premiums this problem is compounded as you get older because your likelihood of having a claim increases exponentially. This means that your premium increases get steeper the older you get.

Choosing age rated premiums in order to save money when a policy commences can lead to unaffordable premiums when you are older and are most likely to need the cover.

Let’s look at one final example using the actual premiums of a recognised South African insurance company to illustrate this point. Consider a 50 year old man, earning R50 000 per month. His financial advisor calculates that he needs R2 000 000 critical illness cover. The financial advisor also recommends that he selects the option for his cover (note: not premium) to increase by 5% every year in order for his benefits to keep pace with inflation.

As you would expect, the cover on the age rated premium pattern is cheapest initially. But what about in the future? In the table below, we compare the different premium patterns in the first and fifteenth year. We can see both the monthly rand amount of the premium, and the premium as a percentage of his earnings before tax:

premium pattern table

So, while the age rated premium is initially 3.3% of his earnings, after 15 years his age rated premium would be an eye watering 8.4% of his earnings before he pays tax. The level premium patterns starts off more expensive, but the premium after 15 years is a lot more manageable.

One final point to note when considering the above. Fifteen years might seem like a long time, but in life insurance it is not uncommon for you to have a policy for double that amount of time. If the above table does not make you feel a little uneasy about age rated premiums, you should note that the longer the above policy runs the bigger the gap between age rated and level premiums becomes.

So in summary, you should always consider all your premium pattern options when choosing a premium pattern. A projection of your premiums over the lifetime of your policy is shown on every long term insurance quote. Don’t be swayed just by the initial premium. Ask your advisor to draw a quote for you on each premium pattern, and use the premium projections to choose the best premium pattern for you.

Special thanks to my friend Tyrone Morris for suggesting this as a blog post.

A simple example of the power of compound interest

There is an urban myth that Albert Einstein, when asked what the most powerful invention by man was, simply replied with “compound interest”. While there is little proof that Einstein actually said that, I believe it isn’t unlikely that the man who helped invent the atomic bomb would recognise compound interest as an incredibly powerful concept.

What makes compound interest so amazing are the seemingly impossible amounts that money can grow to if left for a long enough time. While it is difficult to conceptualise how huge amounts can accumulate to under compound interest, I came across an example the other day that really helps put it into perspective.

Imagine a worm one centimetre long – so not that much bigger than a grain of rice. Every day, this worm grows ten percent longer. So on day one it is one centimetre long. On day two it is 1.1 centimetres long, on day three 1.21 centimetres long etc.

How long will the worm be after one year?

Now, you would have gathered that the answer to this question is going to be a big number. So, how big do you think it will grow? A kilometre? Ten kilometres? Or something audacious like the distance from Durban to Johannesburg?

A one centimetre long worm that grows ten percent longer every day, will stretch from the sun, to Pluto, back to the sun and end on Venus after a year of growing at that rate.

Absolutely mind-boggling, I know. Even after checking this myself it still feels impossible. But far from being just an interesting anecdote, this example does illustrate a very important aspect of compound interest that you can use to your advantage:

Invest early, and invest for a long time.

Compound interest means that your money grows exponentially. In our example above, after eleven months our worm only stretches 12% of the way from the sun to Pluto. The last month of the worm’s growth makes up 94% of its total growth after a year.

What does that mean for you now? It means that it is never too early to start saving. Are you thinking of only starting to save in two years’ time once you have a better cashflow situation? Don’t wait too long – every year you wait now has a massive impact once you want to realise your investment!Image

To rent or to buy your home – what do the numbers say?

Recently a friend spoke to a financial adviser when the topic of renting or buying property came up. The adviser’s opinion was that if you can afford to buy a place, it is always a better option than renting, regardless of the scenario you find yourself in. My friend, having recently just bought a place, disagreed and he felt that there definitely were occasions when the smarter financial decision is to rent. So we decided to put some numbers to it.

1. The model

We put together a simple model that compared the cashflows under two scenarios: one where you buy and the other where you rent the property you live in. First, we projected all the cashflows that you would incur if you were to buy a property. This includes:

  • The expenses you incur upfront (transfer lawyer fees, bond lawyer fees, transfer duties etc.)
  • The deposit you would be required to pay upfront
  • The ongoing mortgage repayments you would need to make on a monthly basis.
  • The ongoing costs you would be required to pay as an owner (rates, levies, water & lights and ad hoc expenses)

We then compare these cashflows to the scenario where you rent the equivalent property. We have assumed that the renter pays an all in rental amount that includes all the ongoing expenses (rates, levies, water & lights etc.) We also then assume that in any month where the total amount the renter pays is less than what the property owner pays (see the four bullets above), the renter invests that difference in equities. Thus, we have assumed that the renter and the owner pay the exact same amounts every month. The renter’s investment into equities is the balancing item that makes the monthly payments from the owner and the renter the same.

Under the owner scenario, we then model the value of the property, less the outstanding amount of the loan, less the commission the owner would have to pay to an agent on sale. i.e. we are modeling what the property owner would receive if they were to sell their property and pay the outstanding balance on their mortgage.

Under the renter scenario, we then model the accumulated value of the equity investment.

Thus we are able to compare the value of the two investments over time: the value of the property (in the case where you buy your property) and the value of the equity portfolio (which is made up of the savings when you rent instead of buying).

2. The assumptions

Now, the big influencer of the results of any model are the assumptions that go into it. We have made a number of assumptions in order to compare the two scenarios. The important ones are:

  • Property value is R1.6 million
  • Prime rate is 8.5% and the buyer qualifies for a loan at prime less 1%
  • The buyer puts down a deposit of 10% of the property
  • The term of the loan is 20 years. The monthly mortgage repayments are then R11 600.
  • The fees and taxes on purchasing the house are R100 000
  • The monthly costs for the property total R 4 300 (Rates, levies, water and lights, ad hoc expenses)
  • The all in rent for the equivalent property is R10 000 per month
  • The monthly expenses and rent rates grow at 6% pa
  • The value of the property grows at 9% pa
  • The equity investment that the renter holds grows at 14% pa

The two big assumptions that might strike you immediately are:

  • The rent assumption versus the mortgage repayment amount. Generally, the cost of renting a property is less than the mortgage repayments. I checked with the property leasing experts and this was the amount that they felt was reasonable
  • The growth rate of property versus equity. Historically, over the long term in South African equity returns have exceeded property returns. It is not unreasonable to assume that an equity portfolio will grow at a faster rate than your property (on average!)

3. The results

The results of the above were interesting, but not that unexpected. Below we have plotted the value of the property less the outstanding mortgage, against the accumulated value of the equity portfolio that the renter would hold. The equity portfolio starts off at a higher value, but somewhere between year 4 and 5 the value of the property overtakes the value of the equity portfolio. So, if the above assumptions were to hold true, the purchaser of a property is better off than the renter from year 5.

Graph 1: 10% Bond

Graph 1: 10% Bond

However, things got a little interesting when we changed the assumption around the amount of the deposit. We then assumed that the purchaser puts down a 50% deposit instead of a 10% deposit in the above scenario. Have a look now at the projected value of the property value and the equity portfolio.

Graph 2: 50% Bond

Graph 2: 50% Bond

In this scenario, if the above assumptions were to hold true, the renter is always in a better position than the property purchaser. This model even allows for the fact that rental costs will eventually exceed mortgage repayments and the renter will need to realise some of their investment portfolio in order incur the same monthly costs as the property owner.

Why is the renter better off now? It would seem counter-intuitive, since conventional wisdom would tell you that it is better to put down a bigger deposit on your property. While it is still a good idea to put down a larger deposit on a property purchase, a smaller deposit does increase the gearing of your returns. Purchasing a property is an investment in property over other assets (in this case, equities). The renter does not choose to invest in property. In the second example, the purchaser puts down a deposit of 50% (R800 000). The renter instead chooses to invest that R800 000 upfront in equities, which in this model, are expected to outperform property growth by 5%.

In the first scenario, equities are still expected to outperform property, but the property purchaser has geared their property returns. The bank has purchased 90% the property for the owner. The property is expected to grow at 9% pa, but the financing charge on the mortgage is only 7.5% pa. So in the first example the property purchaser is better off because they have geared their property returns more than in the second example.

4. Conclusions

Now, please don’t take the above as me advising you to always rent a property over buying it, or to put down the smallest possible deposit on a purchase, that is definitely not the purpose of this post!

On the flip side, yes you could argue against a large number of the assumptions that I have made in the above model. However, what I have set out to do is show that, for a reasonable set of assumptions (and the above assumptions are reasonable), it is possible that renting is a better financial decision than buying.

We live in a world of infinite possibilities, so absolute advice is usually risky. Don’t assume that it is always better to buy than rent. When deciding on whether to buy or rent, look at the circumstances that you find yourself in, and make the correct decision for your situation.

5. Final points

One of the big implicit assumptions in the above model is that the renter is disciplined enough to invest the extra cash they have by renting rather than buying. Not a lot of people are able to do this, especially in South Africa with our terrible savings culture.

There are factors that influence your decision to rent or buy that are not modeled above or do not have a financial impact. I will unpack these in my next post.

And finally, for what it’s worth, I purchased the property I live in, in spite of the above.

Thanks to Warwick Wiseman, Jared Cumming, Mark Leslie and Kim Woods for their help in this post.

Are you guilty of irrational behaviour when the petrol price goes up?

So petrol goes up 32c per litre tomorrow (7 August). When I was a child I never understood why my parents seemed obsessed with the price of petrol. Now, as an adult, my eyes water every time I see the cost of filling my tank up.

Motorist behaviour around the time that petrol prices increase has always interested me. In particular, I have never quite understood why people insist on going out of their way to fill up their tank the day before petrol goes up. It might seem obvious as to why they do this, but consider this angle.

A while back I was at a friend’s house the night before the petrol price was due to go up by around 30c. They remembered that the price was due to go up the next day, so they promptly got in their car and drove off to the nearest petrol station to fill up. It was an inconvenience, but my friend was happy that they had got one over the petrol station.

This is not an uncommon event, but here’s why I don’t understand it:

  • Firstly, if you assume that you only buy 40 litres of petrol (remember, your tank isn’t empty), you’re only saving R12 (40c x 30). 
  • Secondly, and more importantly, if my friend was at home at 9pm at night and I offered them R12 to drive to the petrol station and back, they probably wouldn’t do it because R12 is not worth the hassle.

And that’s where the irrationality comes in. We should be indifferent between saving R12 by buying petrol, or being given R12 for going through the hassle involved in filling up. But for some reason, a lot of us are not. A large number of people will happily go through the inconvenience of filling up now, but they wouldn’t go through the same hassle if you paid them the same amount of money.

This post was just intended to be a light-hearted, topical piece around consumer irrationality. But, this subject is more important than you might think. Through designing insurance products, I have learnt that policyholders and financial advisers often make irrational decisions around their risk cover. I won’t try to explain why this is so, but I will remind you that when making financial decisions, it is important to to take emotion out of your decision making process as far as possible, as well as constantly making sure you are able to justify your decisions to yourself.

And if you are going to rush off to the petrol station tonight, at least make it worth it and get an ice cream at the same time.

The impact of telematics on your car insurance premiums: A pricing actuary’s thoughts

In the last year or so, telematics has become the new buzzword in car insurance. Most of the noise I have heard is that the introduction of telematics into the car insurance industry will result in lower insurance premiums for those who drive responsibly, and higher premiums for those who drive recklessly. I have my doubts that this is a perfect solution for determining insurance premiums though. Let me explain.

1. What is telematics?

If you opt for the telematics insurance option, a telematics device will be installed in your car. This device then monitors your driving behaviour and reports this back to your insurer. The device can monitor your acceleration,  braking, cornering, speed and numerous other aspects of your driving. The more responsibly you drive, the lower the likelihood that you will have a claim on your car insurance and the lower the premium the insurer needs to charge you. If you drive recklessly, the opposite applies. The thinking is that telematics will mean that the insurer no longer needs to charge you a premium that represents the average level of driver competency, but rather the premium that reflects your specific competency as a driver.

2. What are the potential shortfalls  of telematics?

I have three main concerns about how telematics will be used in the car insurance industry. These are:

  • The aspects that telematics monitor are not a perfect indicator of your claims likelihood

While the theory behind telematics sounds great, I’m not convinced that your telematics score is the perfect indicator of your liklihood of having a claim. My grandmother would probably be classed as a low risk by telematics. She doesn’t speed, doesn’t corner aggressively and she doesn’t accelerate quickly. However, being in the same car as her is a terrifying experience, because she is just a terrible driver. On the flip side, I know a number of excellent drivers who do drive recklessly according to any telematics evaluation, but I would sooner get in the car with them than my grandmother.

A particular example is speed. Say one telematics device records one driver regularly travelling at 130 km/h, and another travelling at 100 km/h. At face value, the former is higher risk because he is definitely speeding. However, I would argue that someone travelling at 130 km/h on a four lane freeway with a speed limit of 120 km/h is a lot lower risk than someone travelling at 100 km/h in a residential area with a speed limit of 60 km/h.

  • The difficulty of turning all the data provided by telematics into a factor to load premiums by

The data provided by telematics is by no means simple. Whoever decides on the formula that decides how telematics data impacts on your premiums will need to decide how to weight the myriad of different aspects that the telematics device reports to the insurer.

More importantly, whoever does this will likely not have enough historic data on which to decide which factors the telematics device reports on have the biggest impact on your claim likelihood, since the telematics device has only recently become affordable and used widely. In order to do this properly, copious amounts of data is required. This makes an already difficult task quite subjective, requiring the person who determines how premiums are impacted by telematics data to use gut feel and how they think the telematics data should be interpreted, instead of objective historic data.

  • There are other factors that already used that determine your risk profile

I don’t price car insurance, but I would imagine the main factors that influence your car insurance premiums (from an accident perspective, not theft) are car model, your monthly mileage, your age and your gender.  If telematics is to be used correctly, it needs to factor in these aspects before impacting your premium.

Confused? Let’s consider a simple example. Young people tend to pay more for car insurance, partly because they are more reckless drivers. Before telematics data is used to influence the premiums for a young life, they already pay  a higher premium because young people in general are more reckless. Telematics only adds value to the extent that it measures how reckless you are compared to the average person similar to you, not the average person in general.

If telematics does not take this into account and just adjusts premiums compared to the average driver overall, then the groups who are generally more risky will get double damned, and those who already drive better in general will be given too big a premium reduction. Again, the only way to correctly allow for telematics is to have very large amounts of telematics data for all types of drivers, together with their claims history, which is not available yet.

3. Conclusion

From the above you’ll  gather that I don’t believe that telematics is the answer to providing every policyholder with an accurate premium for the way that they specifically drive. However, I am all for telematics being introduced in car insurance. In South Africa in particular with our horrific accident rate, any development that reimburses drivers for driving less aggressively (even if it’s only on the telematics score) can only be a good thing.