A peculiarity of the Irish market, allocation rates confuse at best; at worst they can severely hurt savers and investors.
While there was discussion to ban allocation rates – a structure that facilitates the payment of commission – almost 10 years ago, it appears that the issue is off the agenda for now in Ireland. In the UK, allocation rates were banned alongside other forms of commission in 2012 as part of a retail distribution review.
“Wherever you’ve seen a commission ban, this is what they’ve banned,” says David Quinn, managing director of fee-based advisers Investwise Financial Planning, on the subject of allocation rates. “It’s by far and away the most common charging structure and remuneration method,” he says, adding that the “vast majority” of advisers avail of it to get paid.
But how exactly do allocation rates work? What does an allocation rate of 105 per cent really mean? And what are the questions you need to ask to make sure you’re getting the best possible outcome?
In short, an allocation rate means the percentage of your contribution to a pension fund or an investment or savings product that actually goes into the fund each month.
So if the rate is 100 per cent, and you contribute €100 a month, then all of that €100 should go into the fund.
The Competition and Consumer Protection Commission (CCPC) gives the example of an allocation rate of 97 per cent, which “means that for every €100 you invest, €97 is actually used to buy units. So, in effect you pay €3 (or 3 per cent) as a charge to the firm you invest with on every €100 you invest”.
For a €1,000 investment, that would mean a charge of €30.
However, while this example is easily understandable, allocation rates are often used in different ways. Rachel McGovern, deputy chief executive of Brokers Ireland, says allocation rates need to be “clearly explained to clients”.
“Once the consumer understands them, that is what is important. They can then make an informed decision on their preferred method of payment, be that an upfront fee or otherwise,” she says.
But do investors and retirement savers always fully understand them?
The practice
“I think it’s smoke and mirrors,” says Steven Barrett of Bluewater Financial Planning.
Indeed. Just because you’re getting a 100 per cent allocation rate – which is what one would typically expect – it doesn’t always mean you’re getting the best deal.
Other fees and charges on the product might actually end up costing you more than if you had got a different product with a lower allocation rate.
Some investment products come with charging structures that allow for 105 per cent allocation – up to 5 per cent of which might go to the adviser.
Some advisers might say that their advice isn’t costing the client anything – rather it’s coming out of the insurance company’s marketing budget,” Quinn says.
“That is the key sentence that people trust and accept,” he says. “It’s most misleading” because, of course, the client will end up paying the commission via a higher management charge.
This means that even if the adviser was to offer you the 5 per cent commission (105 per cent is the maximum allocation), given the higher management fees, you’d likely start to lose money after the seventh year, says Quinn.
Barrett agrees with the comment that it’s never the insurance company that covers the adviser’s fee.
“The client is paying for it through a higher management fee,” he says.
It means that the money is coming directly out of your investment pot. An investor might be okay with that but the issue is that many people do not fully understand the structure.
“All of this is disclosed in a very murky way in the documentation,” says Quinn. It is usually phrased that the client is getting 100 per cent allocation, he adds, but on a page towards the back there will be a little box detailing adviser or intermediary remuneration.
“But a lot of people don’t read it,” says Barrett. And if they do, they see 100 per cent allocation and they expect that it is the insurance company covering the adviser’s commission – and not their higher annual management charge.
And these higher annual management charges can really bite.
“Allocation rate is a one off – annual management charges are for the life of the policy,” says Barrett. They come out of your fund every year, eating into your expected growth.
Sometimes, the adviser might split the commission, so that the client gets a 102 per cent allocation for example, and the adviser gets 3 per cent. But again, while there might be an initial uplift, this can be eaten away by higher charges.
You should also beware early exit penalties which can often apply where the allocation rate is in excess of 100 per cent. In some cases, an adviser could take 5 per cent up front and a half per cent trail every year.
“It’s not unheard of, but it’s pretty extreme,” says Quinn, adding that this could be compounded by switching to a new product provider after five years, and getting the 5 per cent upfront payment again.
While it may not be common, Quinn has seen cases of people with an approved retirement fund (ARF) of €1 million paying out €50,000 in upfront commission, or €100,000 on a €2 million fund.
“You wouldn’t pay €100,000 for a professional fee but yet people can take this commission on a big pension fund, and no one bats an eye lid,” says Quinn.
Reform?
It doesn’t have to be like this. Stockbrokers don’t pay commission on product sales, nor do online brokers, while most of the life companies also offer lower-cost products, known as the “clean pricing” option.
“There is no payment to the adviser, no encashment penalties and nothing is hidden,” says Quinn. Instead, savers typically pay upfront where advice is given.
So should allocation rates go?
Barrett suggests that everything should start from a base of being 100 per cent allocation, and if fees/commission are taken from the contribution, then the allocation comes down accordingly. So fees/commission of 3 per cent would mean that 97 per cent of someone’s contribution goes into their investment – quite clear for savers/investors.
Barrett says it is likely that allocation rates will “slowly die a natural death”, given the move away from personal/executive type pensions, towards PRSAs and master trusts.
“They don’t really do allocation rates in the same way,” he says, although he adds they can still be “very lucrative” for advisers of ARFs.
And people have become more savvy.
“I think it will be market pressure that changes it, rather than regulators,” says Quinn, adding that he sees younger professionals in particular being more sensitive to such practices, and more willing to pay upfront for advice.
Until then, it’s a case of tread carefully when buying a product where allocation rates might apply.
“I say this to everyone: ‘You can’t know who’s a good adviser who is working in your best interest, and not trying to maximise fee income out of you.’ So, the question I always say to ask, is will they do it for a fee? If they don’t, I’d be asking a lot more questions,” says Barrett.
Quinn agrees that you have to talk about the money.
“The key question is to ask the adviser: ‘What is the cost of advice here?’ Or what is the wholesale price of the product and what is the cost with advice?” he says, adding that you should also query an adviser as to whether or not there is another provider with a similar product that doesn’t pay commission.
“It cuts through any conflict,” he says.
Allocation rates in practice
Consider the charging structure on Zurich’s LifeSave investment bond. Documentation provided to financial advisers (but not investors) shows the various options that brokers can use to sell the product.
Allocation rates of 105 per cent are possible – which means that a broker can take a 5 per cent upfront commission. So, a €100,000 investment would result in a payment to the adviser of €5,000 – which is paid out of higher management charges of 1.25 per cent a year.
And early encashment charges of as much as 5 per cent also apply.
An alternative is upfront commission of 0 per cent with zero trail commission, and an allocation of 104 per cent – so an initial investment of €52,000 for a €50,000 customer investment. However, annual charges on this product are 1.1 per cent.
Another option is a 100 per cent allocation but with commission of 4 per cent, plus trail commission of 0.5 per cent a year. This option is going to hurt, as annual fees are 1.6 per cent. On top of this, there are early surrender penalties.
These, of course, are just options and Zurich is far from alone. As a spokesman for Zurich notes, “the level and type (upfront and/or ongoing) of remuneration would be agreed between the financial adviser and the customer”, while remuneration will be “clearly disclosed to the customer by the financial adviser”.
Contrast this with the “clean pricing” product from Zurich, which offers upfront allocation, and annual fees of 0.75 per cent (the lowest on offer). Clean price is an industry term, says the spokesman, “which means that the structure has an ongoing management charge only and doesn’t have any upfront allocation”.
But it does make one wonder, if such products are described as clean, does it imply that other options are “dirty”?