Journal of Law and Financial Management
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By Roger Gay and Paul Latimer
Immediate annuities (fixed term, life expectancy) are notionally the simplest of retirement income products and the simplest to price. For intending purchasers, the issuing institution’s Product Disclosure Statement (PDS) is one of the first ports of call.
An examination of a selection of immediate annuity PDSs indicates that they fall far short of the Australian Securities and Investments Commission’s requirement that a product issuer, seller, financial adviser etc. provide a retail client with “clear, concise and effective” information to make an informed choice between similar products.
For this product, a precise cost could be provided, so we ask why is the cost absent from the PDS?
Given some expertise (which most retirees won’t have), the impact of any given fee structure can be assessed, but only if a current investment reference rate is supplied. As none of the PDSs we surveyed provided such a rate (or its equivalent - the effective after-fees investment rate earned by the annuity purchase price over the term of the annuity), we query whether there is misleading or deceptive conduct under Corporations Act s 1041H, Australian Securities and Investments Commission Act s 12DA, 12DB and whether the PDSs comply with the new PDS requirements fully in force from March 2004.
In the May 2004 budget, the Federal Treasurer, Peter Costello, announced that superannuation funds with less than 50 members would no longer be permitted to provide members with complying pensions from within the fund.
The measure prohibits new Self-Managed Superannuation Funds and new Small APRA1 funds from generating fixed term annuities, life expectancy annuities and whole life annuities from fund assets. These funds can have such annuities as part of fund assets but these must be purchased from a commercial provider such as a bank, a fund manager or a life office.
For retirees wishing to purchase complying annuities to provide a regular guaranteed income, one of their first ports of call for information is the Product Disclosure Statement (PDS) of the annuity issuer.
The PDS is one of the new Corporations Act disclosures introduced by the Financial Services Reform Act 2001 (Cth) into the relationship between product issuer and retail client. Product issuers include issuers and sellers of financial products and financial advisers2 and their representatives3. Fully in force on 11 March 2004 after a two-year shading-in period, this new law requires product issuers to provide new disclosure documents - a Financial Services Guide, a Statement of Advice and a PDS - to a retail client in defined circumstances. A person purchasing a financial product of $500,000 or less is a retail client4.
The disclosure principles underlying these documents, based on the Australian Securities and Investments Commission’s (hereafter ASIC) Good Disclosure Principles, are set out in six steps which state that:
“1. Disclosure should be timely
2. Disclosure should be relevant and complete
3. Disclosure should promote product understanding
4. Disclosure should promote comparison
5. Disclosure should highlight important information
6. Disclosure should have regard to consumers’ needs.”5
The PDS is a form of mandatory disclosure, designed to limit the right of the issuer to remain silent6. The policy behind PDS disclosure - and the other disclosure requirements in the Financial Services Reform Act 2001 (Cth) - recognises that self-induced disclosure by issuers and others in the market is not always realistic or feasible, and aims to overcome the even greater economic inefficiency of no mandatory disclosure, as without it, investors for better or for worse would have to do their own research.
A PDS for a financial product is the point-of-sale document which is required when an issuer etc gives “personal advice”7 to a retail client. A PDS would usually follow advertising, discussions and meetings, and “glossy brochures”, and it sets out more formally the main features of the product, including its risks, benefits and cost8.
The aim of the PDS is to help investors compare and make informed choices about financial products9.
So that the reader can make an informed choice, the Australian Securities and Investments Commission (hereafter ASIC) has stated that it expects the information in the PDS to comply with the Corporations Act and to be “clear, concise and effective”10. In the words of ASIC’s Executive Director of Financial Services Regulation, ASIC expect the new disclosure documents to be helpful to consumers - “ASIC sees disclosure under the new law as a consumer-centric regime, focussing (sic) on the consumer’s information needs”11.
This article examines the question of whether PDS disclosure of fees and cost in annuities is “clear, concise and effective” as required by the Corporations Act. Lack of full disclosure may cross the line into “misleading or deceptive” conduct under Corporations Act s 1041H and ASIC Act s 12DA.
While fixed term annuities are one of the few products for which the impact of fees and different fee structures is precisely assessable, such determinations require considerable expertise, and assume that adequate information is available in the PDS. Fee information in the PDS is provided to potential retiree purchasers in the form of percentages. Typically, there is an upfront percentage fee (say 3.85% of total purchase price) and possibly an additional annual fee (perhaps 0.275% of the total purchase price).
However, more information is needed before the price of the product and the impact of the fees and fee structure can be determined. The impact of fees is important, but the bottom line for the investor is the after-fees cost of the product.
In order to determine the after-fees cost, prospective purchasers need to be provided with either:
The test in the Corporations Act that PDS information be “clear, concise and effective” (s 1013C(3)) is reinforced by ASIC when it advises consumers that the information in the PDS must be worded and presented “clearly, concisely and effectively”12.
Section 1013D(1) provides that a PDS must contain information which a person would reasonably require to make a decision as a retail client whether to buy a “financial product”. This includes information about any commission, or other similar payments, that will or may impact on the amount of the product’s return, information about any other significant characteristics or features of the product and general information about any significant taxation implications of financial products of that kind13.
In particular, s 1013D(1)(d) requires disclosure of such information as a person would reasonably require for the purposes of making a decision as a retail client such as the cost of the product, any amounts that will or may be payable by the holder after purchase and their timing, details of any amounts that will or may be deducted by way of fees, expenses or charges.
This disclosure is detailed in s 1013D(2), which requires that -
“For the purposes of paragraph (1)(d), an amount will or may be payable in respect of a financial product by the holder of the financial product if:
(i) a payment to be made by the holder; or
(ii) a payment to be made to the holder; or
(iii) an amount held on the holder’s behalf under the financial product; or
It includes an amount that the holder will or may have to pay, or that will or may be deducted or debited, as a fee, expense or charge in relation to a particular transaction in relation to the financial product.”
In addition, s 1013F contains a general disclosure obligation which says that information is not required to be included in a PDS “if it would not be reasonable” for a retail client to find such information. This approximates the test of disclosure of any other information that might reasonably be expected to have a materiality influence on the decision of a retail client to invest15.
ASIC is grappling with the issue of PDS disclosure and is attempting to provide issuers of financial products with a good practice model for disclosing fees in a discrete section of a PDS16.
The ASIC “Preferred Model” of 15 June 2004 provides for more transparent disclosure fees in tabular format by “Amount” and “How and When” in the case of :
“ establishment fee, contribution fee, withdrawal fee and termination fee;
“ management costs - administration cost and investment cost, and
“ additional service fee - switching fee and adviser fee.
But the fees may be disclosed in detail, and the client no wiser as to the cost.
The fee structures we examined are very opaque, and raise the question, “Why are issuers so reluctant to tell clients the overall cost of the product?” as required by Corporations Act ss 1013C, 1013D and especially by 1013D(1)(d).
The cost of an annuity, in terms of the after-fees effective investment rate earned by the purchase price over the term of the annuity, can be provided to the purchaser in a single line. This rate is something the issuer has at its fingertips; otherwise the (guaranteed) annuity could not be offered.
Loan and deposit rates offered by banks, as well as fees, are provided on a daily basis in the financial press such as the Australian Financial Review.
If ASIC is serious about retirees being informed, the effective yield which a retiree’s annuity purchase price earns for them should be disclosed in the financial press in a similar timely fashion17. This would then be something the PDS could point to to make it much more informative.
The low investment yields (less than 4%?) which issuers are offering, are not being freely disclosed, and it would take expertise and determination on the part of an investor to find out the current effective rate on the basis of fee structure and a quoted nominal rate! This is not what is intended by PDS law, as backed up with “misleading or deceptive” conduct in Corporations Act s 1041H and ASIC Act s 12DA.
To illustrate, consider a 65-year old single retiree with $300,000 wishing to purchase a 20-year immediate annuity payable monthly, from an issuing institution.
If the retiree is a homeowner with modest lifestyle assets, use of a complying annuity of this sort is a sensible strategy. Tables of the Life Expectancy published by the Australian Government Actuary reveal that average life expectancies are 16.21 years for a 65 year-old male, and 19.88 years for a 65 year-old female.
The sum of $300,000 is not an enormous amount to provide for the retiree’s future.
However, under current provisions, the retiree will be able to ‘top-up’ annuity payments with some Age Pension. Since the Age Pension is indexed in line with CPI and male total average weekly earnings, this part of the retiree’s living allowance should retain its purchasing power. Half the purchase price of the annuity will be exempt from the Assets Test applicable to Age Pensions.
For this retiree, the Assets Test would apply as follows:
Single homeowner Age Pension applicants are permitted to own $149,500 of assets without reduction in Age Pension entitlements. Thereafter the maximum fortnightly entitlement (currently $481.10 = $464.20 + $16.90 pension supplement) is reduced by $3.00 for every $1,000 of excess assets.
Suppose the retiree to have $30,000 of “lifestyle assets”; the retiree’s entitlement will be reduced by 29.5×$3 = $88.50 per fortnight under the assets test, leaving $392.60. This is not the end of the matter. Age Pension entitlements also depend on an Income Test. The actual Age Pension entitlement is the lower figure under the two assessments.
So the question becomes, “What income by way of a 20-year annuity payable monthly can be purchased from an institution with $300,000?”
The retiree only wants to know, in accordance with Corporations Act 1013D(1)(d) the cost of the product!
(The example is continued in the Appendix. There, the retiree’s ultimate Age Pension outcome is provided, under different scenarios).
The monthly payment to the annuitant depends crucially on two factors:
(i) the nominal annual percentage yield offered to the purchaser on the $300,000 investment over 20 years, and
(ii) the fees charged.
Both of these factors are needed in order to ascertain what net monthly annuity instalment will be provided to the retiree for $300,000 over the 20 year term of the annuity.
Alternatively, the issuer could provide
(iii) the effective (after fees) yield offered to the retiree on his/her purchase price over the term.
In regard to factor (i), the nominal annual percentage yield offered on the $300,000 over 20 years - this is usually assumed to vary with the general level of rates in interest rate markets, and also between institutions if there is sufficient competition in the market for the retiree annuity dollar (although arguably, the budget prohibition on small funds has reduced significantly the need for institutions to offer especially competitive rates).
Given that the ten-year bond rate is currently about 6% pa, returns on floating rate notes such as National Income Securities is about 6½ % pa and returns on various investment grade debentures are about 7% pa, it is perhaps not unreasonable to expect these institutions to be offering annuities to clients at say 5½ % pa investment yield on the annuity purchase price over its term.
Institutions we contacted were very unforthcoming about what nominal rate they were prepared to offer, but those that quoted, quoted a figure well below this. More disturbingly, no mention of a reference rate appears in any of the PDSs we examined.
Nevertheless, intending purchasers of annuities cannot hope to assess the value of their purchase, unless such an investment yield figure is provided. The annuity cost cannot be determined without it.
In default of an actual offer rate on which to work, one way to assess the impact of the different fee structures charged by different issuing institutions, is to assume a common investment offer rate of say 5% pa nominal, and apply fees predicated on this rate.
In the Appendix of this article we have provided tables for each of the institutions we investigated, which give details of the precise impact of maximum fees at a selection of different offer rates - i.e. if some nominal rate other than 5% pa is quoted.
It is possible that financial planners recommending these products to customers may rebate some of their fees, and the issuing institution may then pass on some of this benefit to annuitants. We have not taken this contingency into account in our analysis.
Unless the PDS includes both the fee structure and a reasonably accurate reference rate (or refers to such a rate), consumers would not be able to compare similar financial products so as to make an informed decision about which ones to invest in.
Corporations Act
To comply with the Corporations Act and ASIC’s intention that a prospective customer should be able to make an informed choice between similar products, a PDS must contain information set out in s 1013D.
ASIC aims to “maintain, facilitate and improve the performance of the financial system and the entities within that system” and to “promote the confident and informed participation of investors and consumers in the financial system”18.
A non-complying and therefore defective PDS misleads the market - by what it says or does not say - and can lead to many legal consequences such as those discussed below.
The Corporations Act provides for recovery of loss or damage in a civil action for breach of the PDS requirements19. A court can make an order declaring void a contract entered into by a client on the basis of a defective PDS20.
Criminal liabilities can arise for a non-complying PDS, including a strict liability offence with fines of up to $22,000 for an individual and $110,000 for a company21.
Such dollar penalties may seem irrelevant, but they can trigger ASIC’s administrative monitoring of performance of those in the market through use of its power to license and to de-license those in the market. ASIC is very active in dealing with breaches of the law through its administrative machinery by suspending, cancelling or banning any Australian Financial Services Licensee for not acting efficiently, honestly and fairly. To keep the market informed, ASIC publicises these on its website with graphic details of offenders and their licensing offences.
ASIC also using Enforceable Undertakings, borrowed from their development by the ACCC during the leadership of Professor Allan Fels23, as a means of market regulation24. This is an example of ASIC publicising breaches of the law - by accepting an “apology” and a legally enforceable promise not to re-offend, again in the light of full publicity and an entry on the public Register of Enforceable Undertakings25. Household names like Retireinvest, Tower Insurance, Citibank and National Australia Superannuation are to be found on the Register in 2003.
Misleading or deceptive conduct in financial services
The evolution of the prohibition of misleading or deceptive conduct has been lengthy since its introduction in the Trade Practices Act 1974 (Cth), a section which establishes a minimum standard of business conduct.
For example, Fraser v NRMA Holdings Limited26, a case resulting from the issue of the prospectus and related documents regarding the issue of “free shares” during the demutualisation of NRMA, confirmed the importance of avoiding misleading or deceptive conduct in the context of prospectuses and corporate communications in the financial market. In finding the conduct of NRMA to be in breach of s 52 of the Trade Practices Act 1974, the court affirmed that although s 52 does not give an independent duty of disclosure, it does target what is said, and that what is said may be misleading or deceptive. Hence information given must give a full and fair disclosure of all material facts on which one may make a properly informed decision. Failure to do this may result in the combination of what is said and what is left unsaid being misleading or deceive.
Moreover, the court in the NRMA case confirmed that a partial disclosure of a state of affairs - as in the annuities analysed - may breach s 52. What is said - and unsaid - may be misleading or deceptive. NRMA members were held to be entitled to expect that information on demutualisation involved no “half-truths” and contained a full and fair disclosure of matters to enable them to make a properly informed judgment on the proposal.
It is partly true that the FSR has quarantined s 52, which has no due diligence defences, from the area of financial services in response to the claims of business that any misstatement or error in retrospect and with the benefit of hindsight can be assessed as misleading or deceptive27. Section 52 no longer applies to financial services, but in its place are the equivalent sections in the Corporations Act and the ASIC Act.
Section 1041H of the Corporations Act provides a more ample version of misleading or deceptive conduct, not limited by the requirement of “trade or commerce” and prohibiting misleading or deceptive conduct in relation to a both “financial product” and/or a “financial service”. In contrast, misleading or deceptive conduct under ASIC Act s 12DA is limited to conduct in relation to “financial services”. Despite the differences in these, either would potentially catch imperfect disclosure in annuities as misleading or deceptive conduct.
A PDS cannot be “misleading or deceptive” if within the due diligence protections afforded by s 1041H(3)(c) and s12DA(1A) respectively. However, the due diligence defence only operates if the provider of the PDS “took reasonable steps to ensure that the disclosure document or statement would not be defective” s 1022B(7)/s 12....
Misleading or deceptive conduct in the financial sector which is wider than conduct in relation to a “financial product” or a “financial service” is still caught by s 52 of the Trade Practices Act 1974 (Cth). For example, representations promoting a company in general were wider than Corporations Act/ASIC and triggered misleading or deceptive under the TPA. Conduct was wider than “financial service” in 12BA, the forebears of s 1041E, 1041H applies if wider conduct28.
We submit that in our examples, in addition to liabilities for defective PDSs under the Corporations Act, the issuers have engaged in misleading or deceptive conduct, actionable by investor, group or in representative proceedings by ASIC29.
Products surveyed: the impact of fees in breach of Corporations Act s 1013D(1)(d)
In none of the following cases can the cost of the product be ascertained:
Product 1: AMP Fixed Term Income Plan
Fees for a 20-year annuity payable monthly:
Upfront fee: 3.96% of purchase price
Annual fee: 0.0% of purchase price
Source: AMP Fixed Term Income Plan PDS (accessed 21/05/2004)
Actual monthly income is $1883.83.
The fee charged is $77.68 per month for 20 years.
The annual effective investment rate is 4.503%
(Impact of the fees on AMP’s Fixed Term Income Plan for rates other than 5% appear in the Appendix)
Product 2: ANZ Guaranteed Income Plan
Fees for a 20-year annuity payable monthly:
Upfront fee: 1.705% of purchase price
Annual fee: 0.253% of purchase price
Source: ANZ Guaranteed Income Plan PDS (accessed 21/05/2004)
Actual monthly income is $1864.82.
fee charged is $96.69 per month for 20 years.
The annual effective investment rate is 4.380%
(Impact of the fees on ANZ’s Guaranteed Income Plan for rates other than 5% appear in the Appendix)
Product 3: AXA Guaranteed Immediate Annuities and Pension Plan
Fee for a 20-year annuity payable monthly:
Upfront fee: 3.3% of purchase price
Annual fee: 0.33% of purchase price
Source: AXA Guaranteed Immediate Annuities and Pension Plan PDS (accessed 21/05/2004)
Actual monthly income is $1817.24.
Fee charged is $144.27 per month for 20 years.
Annual effective investment rate is 4.070% after fees.
(Impact of the fees on AXA Guaranteed Immediate Annuities and Pension Plan for rates other than 5% appear in the Appendix)
Product 4: CBA Group Lifestream Guaranteed Income
Fee for a 20-year annuity payable monthly:
Upfront fee: 3.3% of purchase price
Annual fee: 0.33% of purchase price
Source: Comminsure PDS (accessed 21/05/2004)
Actual monthly income is $1814.28.
Fee charged is $147.23 per month for 20 years.
Annual effective investment rate is 4.050% after fees.
(Impact of the fees on CBA Group Lifestream Guaranteed Income for rates other than 5% appear in the Appendix)
Product 5: Citicorp Guaranteed Income Plan
Fee for a 20-year annuity payable monthly:
Upfront fee: 3.85% of purchase price
Annual fee: 0.55% of purchase price
Source: Citicorp Guaranteed Income Plan PDS (accessed 21/05/2004)
Actual monthly income is $1748.49.
Fee charged is $213.02 per month for 20 years.
Annual effective investment rate is 3.614%
(Impact of the fees for Citicorp Guaranteed Income Plan rates other than 5% appear in the Appendix)
Product 6: MLC MasterKey Annuity
Fee for a 20-year annuity payable monthly:
Upfront fee: 4.125% of purchase price
Annual fee: 0.0% of purchase price
Source: MLC MasterKey Annuity PDS (accessed 21/05/2004)
Actual monthly income is $1880.60.
Fee charged is $80.91 per month for 20 years.
Annual effective investment rate is 4.482%
(Impact of the fees for MLC MasterKey Annuity rates other than 5% appear in the Appendix)
The Purchaser’s dilemma
Suppose AMP offers a nominal investment rate of 5% pa on the annuity purchase price. The annuitant investing $300,000 in a 20-year annuity payable monthly receives $1883.83 per calendar month, paying an effective $77.68 per month in fees; the impact of the single 3.96% upfront fee. This results in an effective investment rate of 4.503% pa. Citicorp charges higher fees - 3.85% upfront and 0.55% per annum.
Suppose however, to compensate for the higher fee structure, Citicorp offered the annuitant a nominal annual investment rate of 6% pa Is this better than the AMP annuity?
And more significantly, how is a retiree pensioner able to choose between the two?
The table in the Appendix (“Product 5”) shows that although the Citicorp fees are effectively $219.19 per month for 20 years, the higher rate of 6% provides a net monthly income of $1902.68, and an effective annual investment rate of 4.624%. This is slightly higher than AMP’s after-fee offer (4.503%).
However if Citicorp only offered a nominal rate of 5.5% then the net monthly income would be $1824.93 after $216.08 of monthly fees, the effective investment rate being only 4.120%.
This example demonstrates that proper comparison of immediate annuity fixed income products is only possible when either:
or
is provided to the purchaser.
Conclusion
Different fee structures have significant impact on a retiree’s bottom line - the cost of monthly annuity payment on which they are to survive. Commercial providers of annuities usually do provide a fee structure in their PDS. But this alone is no help in assessing the cost of the annuity as required by Corporations Act s 1013D(1)(d)
Given the (assumed) reference rate of 5% used in these illustrations, it is possible to make some comparison of the impact of fees charged by different annuity issuers.
However,
Recommendation
Banks and deposit-taking institutions publish current borrowing and investment rates almost daily in the financial press. Given the potential size of the annuity market (since new retirees can no longer use SMSFs to provide annuities for themselves, and given that most retirees would like access to the security of a guaranteed income stream) ASIC should consider “encouraging” annuity providers to adopt the same course. The annuity cost could be ascertained from nominal yield and fees (1*) or effective after fees yield (2*)
The retiree’s pension outcome
If all providers offered a nominal rate of 5% pa the retiree would probably settle for AMP’s $1883.83 monthly.
CentreLink would apply the Income Test to this as follows:
Fortnightly income from the annuity is $941.92
CentreLink recognises that much of this is a return of the retiree’s own capital, calculated for Income Test purposes as follows:
Purchase Price: $300,000. Return of Capital is $300,000/20 = $15,000 per year or
$576.92
Actual fortnightly income: $941.92-$576.92 = $365
The 65 year old single homeowner retiree is permitted $120.00 per fortnight.
The reduction in maximum pension entitlement $481.10 is then 40 cents per dollar of excess income; i.e. 0.4×($365 - $120) = $98.
This compares with a reduction of $88.50 from the Assets Test.
Since the income test gives the greater reduction, and the retiree receives $383.10 per fortnight of age pension, in addition to the annuity, a total of $1325.02 per fortnight.
Note: If the retiree chose the Citicorp product offered at 5%, the net income is $1748.49 monthly or $874.25 per fortnight. Under the income test the retiree’s Age Pension reduction would be 0.4×(297.32-120) = $70.73 per fortnight.
The retiree would be assessed under the Assets Test (with a reduction of $88.50 per fortnight). The retiree would receive $392.60 per fortnight of Age Pension in addition to the annuity, a total of $1266.85 per fortnight.
There is about $60 per fortnight difference (prevailing over 20 years) in the retiree’s bottom line.
Impact of Fees from Product Disclosure statements
(Effect of nominal interest offer rates other than 5%)
Product 1
AMP: Upfront fee of up to 3.96%; ongoing fee of 0.0%30
Product 2
ANZ: Upfront fee of up to 1.705%; ongoing fee of 0.253%31
Product 3
AXA: Upfront fee of up to 3.85%; ongoing fee of 0.275%332
Product 4
CBA (Comminsure): Upfront fee of up to 3.3%; ongoing fee of 0.33%33
Product 5
Citicorp: Upfront fee of up to 3.85%; ongoing fee of 0.55%34
Product 6
MLC: Upfront fee of up to 4.125%; ongoing fee of 0.0%
[35]. Product Disclosure Statement, MLC MasterKey Annuity PDS (21/05/2004).
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