Five mis-selling scandals waiting to happen

It should come as no surprise that many people hold the financial services industry in low regard.

Looking back at the past three decades, it becomes hard to deny that other people's money simply presents too great a temptation to those who lack scruples, and who are therefore attracted to the heady thrills of money games like moths to a flame.

Businesses from the lone offshore adviser to the multi-national banking giant have been found guilty of selling customers products they shouldn't have: from endowment mortgages and payment protection insurance to dodgy off-plan hotel schemes in Venezuela.

Yet with more people set to gain free access to their life savings as they approach retirement, investors risk becoming more vulnerable, both to unscrupulous salespeople and to their own greed or ignorance.

FREE TO FAIL

Here, we look at some possible investment scandals of the future. We're not accusing anyone of breaking the law, but instead focusing on some areas that could be either sold overzealously or bought misguidedly.

In the wake of the 11 September 2001 attack, when the Bush government pushed through its controversial Patriot Act, some argued that it would be impossible to increase security without decreasing personal freedoms.

This may be so. Unfortunately, the reverse is arguably also true. You can't increase people's freedom without also leaving them less secure - more vulnerable to dishonest salespeople, or indeed to their own shortcomings.

That's why, as George Osborne's much-lauded pension freedoms take effect, cautious pundits warn that scams, pitfalls and mis-selling scandals await around every corner.

Pension transfers

The traps that await over-55s who decide to take advantage of the newfound pension freedoms are the big unknown here.

Read more: Is pension freedom working?

'Pension liberation' used to be considered a threat, whereby fraudulent advisers would convince savers to transfer their pensions to supposedly more lucrative investments, which were generally unregulated, often extremely illiquid and sometimes non-existent.

Read more: Could you fall for a pension 'liberation scam?

Typically, victims would also find their transfer was subject to heavy tax penalties.

But now that anyone over 55 can do whatever they want with their pension savings, it's open season.

Unscrupulous advisers - often based offshore - could easily convince the less financially savvy to transfer their pension pots into some dodgy scheme, netting the adviser a hefty commission while exposing investors to phenomenal risk and illiquidity. Or of course, they could be out and out frauds.

'The big risk is people being encouraged to transfer into small pensions, either Qrops [qualified recognised overseas pension schemes] or SSAS [small self-administered schemes] with extremely unstable investments in them; these may be high-risk and illiquid, or even fraudulent,' says independent pensions expert Alan Higham.

'A lot of it is being sold by the old-fashioned commission-based advisers, based offshore. There is no such stringent regulation overseas,' Higham adds.

Annuity resales

One of the most confusing recent proposals has been for a secondary annuities market.

The argument goes that annuity rates have been progressively falling over the past couple of decades, but because annuities were the only option for most retirees before pension freedoms, many people are now 'trapped' in poor-value annuity plans that cannot at present be undone once purchased.

Read more: The harsh reality of annuity resales

In theory, a secondary annuities market would allow people to sell these annuities: the buyer would receive future income instalments, while the seller would receive a taxable cash lump sum, which could be used, for instance, to pay into a flexi-access drawdown policy or buy a new flexible annuity.

But the proposals are confusing, and the consensus is that you would be extremely unlikely to get anything like the whole value of the annuity back.

There would be costs and fees involved, and your life expectancy might meanwhile have changed (the payments would continue until your death, regardless of whom they went to).

In practice, says Martin Tilley, director of technical services at pension specialist Dentons, the problem will more likely be in managing consumer expectations than in the prevention of mis-selling.

'[Annuity resale] is likely to be quite heavily regulated, so what we will have to contend with there is naivety,' he maintains.

Read more: Will annuities get a second life?

Interest-only mortgages

Of all the products listed here, interest-only mortgages could be the surest and most prevalent mis-selling scandal.

Lenders have historically been quite generous in their handing out of residential mortgages, whereby the borrower need only pay the loan interest each month, repaying the capital when the term of the mortgage comes to a close.

These days, residential interest-only mortgages will only be sold to those who can prove they have a repayment vehicle in place. But lenders have not always been so strict.

In recent years authorities have issued warnings about how many people could lose their property as a result of having no way to repay the capital on their loan when it comes due.

Martin Wheatley, former chief of City watchdog the Financial Conduct Authority (FCA), has referred to the interest-only space as a 'time bomb', for example.

Interest-only mortgages on buy-to-let properties are much more common because the landlord can sell the property and use the proceeds to pay off the debt.

But if the borrower is living in the house, they could be in a much tighter bind. They could sell the home and clear the mortgage, but they still need to live somewhere.

Last month Money Observer reported warnings from Citizens Advice that almost a million people could have their homes repossessed when their interest-only mortgages come due and they find themselves unable to repay the loan.

The FCA has forecast three waves of repossessions based on the history of interest-only lending: the first in 2017-18, the second in 2027-28 and the third in 2032.

But Ray Boulger, senior technical manager at mortgage adviser John Charcol, believes the alarm surrounding interest-only mortgages is overstated, and that many people will have more options available to them than simply losing their homes.

Buy to let

With hordes of investors approaching retirement under the new pension freedoms regime and thinking about generating an income after they stop working, the residential rental market could be a popular option for many.

After all, it's much easier to get a buy-to-let (BTL) mortgage, which isn't regulated by the FCA, than it is to get a residential mortgage.

For example, whereas your eligibility for a residential mortgage is based on your earnings, eligibility for a BTL mortgage is based on the lender's estimate of what the rental income would likely be.

Read more: Commercial property beats BTL for retirement income

But the rental market goes up and down - and if savvy developers build thousands of flats to sell to investor landlords, supply could outweigh demand and rents could fall. And mortgage payments will still be due, even if there are no tenants paying rent.

There is a host of other costs - lettings agents and upkeep for example - that will also eat into your income and make it more unpredictable. That income will be further dented by planned government cuts to mortgage tax relief on buy-to-let properties.

If a lot of retirees are taking their money out of their pensions, paying tax on the way, and buying BTL properties on which they overestimate the net income and underestimate potential market fluctuations, we could end up with a lot of ageing landlords struggling to meet costs, maintain their properties and live off what's left.

P2P lending

Heralded as a new alternative to savings, peer-to-peer (P2P) lending has grown in popularity recently. But even though P2P lending is regulated by the FCA, it is still largely unexplored territory and has only really existed in a low interest rate environment.

Moreover, with so many new P2P platforms launching in the past year alone, the question arises as to whether there is a market to support them all - and what they'll do to capture business.

Tilley says: 'The returns they quote look attractive next to cash rates, but the higher these returns are, the higher the potential risk to capital, because to offer these returns to their investors the P2P platforms must be getting more than the offered interest rate.

'But that raises the question: if the borrowers are happy to pay this high rate of interest, is that because they couldn't get cheaper rates through conventional banking?'

In most cases, investors have to trust the lender's methods of vetting borrowers, but it's such a competitive market that platforms could be tempted to look further and further afield at progressively riskier groups of borrowers to find the 'critical mass' of borrowers they need to keep the company afloat.

Some of these risks also apply to P2P's cousin, equity-based crowdfunding, but investors will typically be able to look at more robust documentation about the companies before putting their money in.

So what's to be taken from this? Every investment carries risk, but it helps to invest in things you understand, avoid fads and be wary of trusting your life savings to the hands of a friendly stranger. And above all, diversify across a range of assets.

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