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Investment Strategy
Monday, May 1, 1989
Caught short

Certain investment schemes introduced into the market pose inherent risks for clients. These schemes use an investment plan which is funded by a short-term loan.
Says J Jooste, GM Old Mutual, ‘They pose a serious hazard to the client and therefore I consider it to be undesirable. “It is in the interests of the whole industry that representatives should be honest and open in their dealings with clients,” he says.
With the scheme, money is borrowed at fluctuating short term interest rates (for example linked to the prime rate).
Then the money is invested in an investment plan in the hope of generating profit. These schemes are effective only when the average short term interest rate payable on the loan is lower that the returns on the investment plan over the term of the policy.
There is no guarantee that this will definitely happen. In fact, the risk of sustaining a loss as a result of a rise in short term interest rates is very high. And this is exactly what’s happening to short term interest rates today!
Short term interest rates are very volatile. The prime rate, for example, was 12,5% at the beginning of last year - today it is 18%. As recently as 1984 the rate escalated to 25%. Even a temporary rise in interest rates may have catastrophic results because a vast amount of additional interest will have to be paid from the client’s pocket.
Institutions like churches, schools, sports clubs and even municipalities should not opt for speculative investments for profit-seeking purposes. They have a vast responsibility towards members, councils, and so on. It is their duty to cover expenses with income from legitimate sources such as contributions and taxes - not to take chances.
These schemes don’t offer tax benefits like, for example, the loan account redemption plan, which allows for a more effective utilisation of existing funds in a company with the view to obtaining a tax benefit. They also operate with funds that are non-existent funds that have to be borrowed without any tax benefit whatsoever. Indeed, there is a tax disadvantage, as in many cases the investment income in terms of the policy is taxable in the hands of the assurer.
Old Mutual believes that it is not in the interests of the client to effect such a hazardous scheme. We are not prepared to get involved with these schemes, except if the client states in writing that he understands and accepts the hazards or risks involved.
If a scheme of this nature fails, Old Mutual will lose face. Our image will be harmed seriously if, for example, we are held “responsible” because the individual, or even worse, a congregation or town for instance, sustained a financial loss.


If the loan interest rate remains unchanged at 14% over the term, the income from the investment plan will be sufficient to cover the interest on the loan. At a 15% per annum rate of return in the future, after 5 years the policy returns will suffice to repay the loan and to provide the client with a profit of R472 000.
Usually it is generalised by saying that the client, despite a fluctuating interest rate, should always be able to make a profit over the long term, as it can be expected that the assurer, on average, will fare better than an investment at the short term interest rate.
Looking at our investment history in isolation, this is certainly not an unfair statement to make, but one should beware of the pitfalls. Short term interest rates may be very volatile. Prime interest rates reached a level of 25% in the last few years. Should this happen in our example, the client would have to pay R900 000 per year from his own pocket. Thus the fixed interest rates may have catastrophic implications for the client’s cash flow. Even moderate increases in the interest rate may be fatal if the loan is large in proportion to the remainder of the client’s assets.
Should interest rates become unfavourable, it would not be possible to cancel the scheme early without negative results. The surrender value varies in line with the current level of interest rates on the date of surrender: the higher the interest rates, the lower the surrender value. Thus the client may sustain a capital loss if he cancels the investment plan when interest rates are high.
The investment plan is a long term contract which should be terminated only in exceptional circumstances.

Copyright © Insurance Times and Investments® Vol:2.5 1st May, 1989
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