How safe is your money? The questions you need to ask when you invest
Wealth managers throughout the financial industry are often asked: “Is my money safe with you?” The answer has to be “yes”, and not just because the advisor says so. This assurance of safety must genuinely be the case. As an investor, there are ways of ensuring that you are dealing with a reputable professional who operates according to the rules and with an ethical stance.
This article addresses two of the most commonly asked questions and how you can establish whether your money is truly safe.
Question 1: Can my advisor or someone who works at the company run off with my money?
Legislation requires advisors to make disclosures up front regarding whether professional indemnity insurance is held by the company for which the advisor works. This indemnity cover is critical since it protects you if the advisor makes a mistake with the advice that they give you. Similarly, fidelity insurance protects you if a staff member steals your money. In both cases, the cover ensures that the company has the ability to pay you in the event that something goes wrong. Given that this disclosure has to be made up front, you will immediately be able to ascertain if this insurance is in place, or not.
Another important point is that companies operating in the collective investment space, the life office or the South African banking environment are highly regulated. In this extremely controlled space, the risk of a staff member ever being able to lay their hands on your money is minimal.
Question 2: What will happen to my money if your company goes bust?
To answer this question, it’s useful to start by distinguishing between market risk and institutional risk. If markets go down, you may risk losing a percentage of your investment. But given enough time you will make it back, and more. If, however, the institution with whom you invest goes bust and, as a consequence of that you lose your money, there is little to no chance of recovering that loss. This is institutional risk.
In order to establish the extent of the institutional risk to which your money is exposed you need to know on which balance sheet your investment money sits. This tells you which institution would have to fall down in order for your money to be lost.
On whose balance sheet(s) your money sits is determined by the investment vehicles that are used in your wealth management solution. There are three broad categories of investment vehicles which use different legal structures, and it is these structures that determine which balance sheet reflects your funds.
1. Unit trust structure (investment plan, tax free savings plan)
This is a discretionary vehicle where your money is held by a nominee company on your behalf, and the money sits on your balance sheet and no-one else’s. There are strict regulations which govern the nominee companies that hold the funds. For example, the majority of board directors must be independent; the company may only hold assets, it may do nothing else with them; the company may not incur debt; it cannot transact; it can only act on instructions; and it has to be audited. So there is no risk there. In this instance, you would personally have to go bankrupt in order for the money to be lost.
2. Life wrapper (endowment policy, living annuity)
In these structures your money sits on the balance sheet of the life office you are using. Theoretically, if the life insurance company fails, then you could lose your money.
The likelihood of the life insurance company going under, or of your money being contaminated by the financial risks to which the life insurance company is exposed, increases if the company underwrites risk (insurance) products and offers guarantees on their investments. In these instances your money could be at risk if, for example, an unforeseen or unanticipated event occurs and the company has to pay up.
A slightly safer option is to use the life wrappers of pure investment companies that do not underwrite any insurance risk or investment guarantees, and whose assets match their liabilities at all times. This means that the likelihood of your investment being contaminated by risk elsewhere in the business is remote.
3. Retirement vehicles (retirement annuities, preservation pension, preservation provident)
In these structures your money sits on the retirement fund’s balance sheet and it would have to go under for you to lose your money.
However, in South Africa retirement funds are governed by the Pension Funds Act and operate in a highly regulated environment. Pension funds cannot borrow money and the money cannot be attached by creditors. The money is held in trust, and the responsible board of trustees must adhere to strict rules. There is less risk of a retirement fund going bust than there is of a life company suffering the same fate.
The final layer of institutional risk to consider is the asset management layer, or the funds into which your money is invested.
In a collective investment structure, an asset manager will never have your money in their bank account or on their balance sheet. They only issue instructions as to where the money should be invested and receive a fee for their expertise. If the management company or asset manager goes bust, then nothing will happen to your money.
Fortunately, South African financial institutions operate in a highly regulated environment and the institutional risk is reduced. It is for this reason that it is essential that you never deal with financial institutions that are not registered with the Financial Sector Conduct Authority or advisors who are not on the List of Representatives of the Financial Services Provider.
When in doubt about the level of institutional risk to which your investments might be exposed, ask yourself the following five questions:
1. Is the institution registered with and regulated by a proper authority operating in a reputable jurisdiction?
2. Is the advisor I’m dealing with properly qualified, experienced and registered?
3. Into whose bank account do I deposit my money? This will give you an indication of the balance sheet on which the funds sit.
4. How is my investment protected from the financial institution’s creditors, business risks etc.?
5. How is my investment protected from fraud etc.?
Only work with reputable companies, because as an investor you should only be exposed to market risk since that is what delivers your returns in the long run. You receive no additional value for being exposed to the institutional risk of capital loss if an investment company gets into financial trouble.
Paul Leonard is an Advisory Partner at Citadel