Three costs that a financial product seller must sign off on

Though I knew the extent of angst against banks as serial mis-sellers of financial products, I was a little surprised at the huge reach-out from readers after the column last week where I wrote about systematic cheating by banks (http://bit.ly/iffYbq) to collect fees and commissions on retail financial products. Apart from sharing stories of being lied to and cheated by banks, readers wrote in to get inputs on what sort of checklist should they ask the seller to sign off on. Of course, implicit in the request is the knowledge that regulatory action will be too little and too late. A specific request goes like this: “Could you make a simple checklist which we can use? We could simply print it out and have the relationship managers sign it when approached.” Says another reader on Twitter: “…practical suggestion—a simple carbon copy worksheet, where employees explain the workings of a scheme. Each retains a copy it can be signed by both. If there is a dispute, each can go back and refer.”

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Great ideas. Look out for stories on the Mint Money pages over the next few weeks for templates of such checklists for each retail financial product that most of us use—funds, term insurance, unit-linked insurance plans (Ulips), health cover, household insurance, credit cards, to name a few. In this space I’ll attempt a slightly larger picture description of a financial product, what it does, where costs are embedded and how to evaluate benefits. Costs first.

Remember that costs don’t really matter in a fixed-return product, such as a fixed deposit (FD) or a bond. A 10% FD will give 10% on the principal. The banks price the deposit after taking care of their costs and profits. Bonds and traditional plans (endowment, money back) sold by insurance companies, too, work on the same logic—you get a defined amount back either periodically or in one bullet shot some 10-15 years later. You need to just worry about the rate of interest, what you are getting back and what the inflation rates are currently at. But you need to think about costs in a market-linked product or one in which the returns are linked to an underlying asset such as stocks, bonds, real estate, gold or commodities. In its simplest form, a market-linked investment product carries three kinds of costs.

One, the cost to enter the product, also called a front load. If you invest Rs100 and Rs2 from that is cut out so that Rs98 is invested, the Rs2 is called a load. A load is part of the price of the product, or is embedded in the price—it is an invisible charge because it is not usually disclosed. Mutual funds have zero loads and are an extremely investor-friendly product. Ulips have seen the front load fall from Rs40 on Rs100 to about Rs5-10 now in the first year. Question to ask when buying a market-linked investment product: How much of my money will be invested? Write down the amount you are investing and get the seller to write down the number that goes into the product. The difference is your cost.

Two, an on-going cost, or the annual fees that you need to pay to have experts manage your money. To take care of the running costs and profits of investment managers each year some fees are deducted from your money. This is shown as a percentage that will be charged, usually at the end of the year. If Rs1 lakh grows to Rs1.25 lakh and the charge is 2%, Rs2,500 will be deducted and rest carries on in the product. Mutual funds have cleaner rules and there is a regulatory cap of 2.5% each year for the entire life of the product. Insurance products that carry investment embedded in them are more difficult to deal with. The cost structure slides down over the life of the product and in a 15-year product. For the first five years the cost is capped at 4% per annum, but must be a maximum of 2.25% per year over a 15-year policy. Question to ask: What is the annual cost of this product as a percentage? Get the seller to write this down. If buying an insurance product, ask for the cost structure for each year. Anything lower than 2% is good in the current stage of the market.

Three, an exit cost, or the cost to sell the product. To take care of expenses of selling the investment you made or to act as a deterrent to frequent churning of money, funds levy exit charges. This is a percentage of your corpus and usually falls off to zero after about one or two years. Investment-bearing insurance products are more complicated and come with a lock-in of five years. Ask this question: what does it cost to redeem this product after one, two, three years and so on over the life of the product? Now get the seller to sign off on it. Put a date, location and time and keep this paper with you.

(Next week: How to evaluate returns.)

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, and can be reached at expenseaccount@livemint.com