By Professor Dimity Kingsford Smith and Virosh Poologasundram.

SYDNEY: 16 February 2014 - In Australia every employed person is required to be a ‘financial citizen’: that is they must enter the financial markets through superannuation, and they are encouraged to be financially self-sufficient. The Australian government now foregoes an annual amount of tax revenue in support of superannuation, equal to the old-age pension. This tax support is most generous for high income earners and those in continuous employment. It is the tax supported superannuation savings of financial citizens which comprise the bulk of funds for which Australians need financial advice. Self-managed superannuation funds and superannuation fund choice, mean that most Australians will need financial advice some time in their life cycle.

All the research shows that many financial citizens lack financial knowledge: they do not understand fees and commissions, and cannot calculate percentages. Many, overwhelmed, simply trust their financial adviser. For these reasons, all Australians deserve advice to be independent, professional and to put clients first.

The Labor government introduced the Future of Financial Advice (FOFA) reforms to improve the independence and professionalism of advice to financial consumers. The FOFA legislation was recommended by the Ripoll Committee which investigated the conduct of advisers at Storm Financial and managed investment schemes. The Coalition in its Streamlining of FOFA Bill 2014 seeks to roll-back some of the most effective aspects of FOFA. Most notably it intends to remove the prohibition on conflicted remuneration (commissions; bonuses for sales volumes; ‘soft commissions’ such as travel costs for training and the like) for general advice, which is far and away the kind of advice most frequently offered to Australians. The Streamlining proposals would also remove the ‘best interests’ duty on advisors, that requires advisers to exercise their personal judgment outside a checklist. It also removes the ‘opt in’ requirement which encourages clients to review the advisor’s performance every two years or the advisory agreement will end. 

Conflicted Remuneration

The FOFA reforms ban advisors from accepting benefits (monetary or not) that influence the advice they give a client. The Streamlining proposals limit the ban to ‘personal advice’ when most Australians receive general advice. Personal advice is based on a review of a client’s circumstances; general advice does not match the product to the client and provides information only about the product and its general appropriateness.

The FOFA reforms did not ban bank sales staff from conflicted remuneration when selling ‘basic banking products’. Insurers too were able to earn commission on general insurance products (such as car or home contents) and life risk insurance sales outside superannuation. This was permitted because basic banking products and general and life risk insurances are familiar to most people. The FOFA ban did not allow conflicted remuneration on life insurance attached to super. The Streamlining proposals will allow commissions and bonuses to return to life insurance inside super. The only way to avoid this is for members to acquire life risk insurance when their balances are in a MySuper default fund. 

The likely results of these changes are unhelpful and unfair.

First they are unhelpful since advisors will have an incentive to offer general advice (paid by commission from the bank or insurer) and not more detailed personal advice for which the client pays directly a management fee or hourly rate fee. Second, it is not always clear whether advice is general or personal. An electronic flyer sent to 200 clients may be worded as general advice in legal terms while appearing as directed to the recipient’s personal circumstances. Third, as we discuss below, the Streamlining proposals also promote scaled advice. Here the scope of personal advice can be narrowly focused. But if that has the effect of denying commissions then advisors may not bother to scale the advice, they may simply sell a product with general advice and earn the commission. 

The proposals are unfair because they polarise the quality of advice between the smaller and wealthier part of the population (less than 25%) that obtains personal advice, and the vast majority of Australians who will now pay commissions to receive general advice. While an upfront personal advice fee may seem a hurdle, the combination of initial and trailing commissions (paid annually therafter) certainly does not mean that commissions are aways cheaper. The UK tried a polarisation remuneration policy for a decade: they abandoned it over the last five years. The proposals are also unfair because they ignore the concentrated and related structure of the Australian financial sector. About 70% of financial advisors are owned by or related to the four big banks and AMP. Research by the Australian Securities and Investments Commission (ASIC) shows that over half of investment recommendations are concentrated in a small band of less than 10 products. The Ripoll Committee identified conflicted remuneration as the leading cause of poor financial advice. The Streamlining proposals reverse much of that Committee’s valuable work.  

Best Interests Obligations

The FOFA ‘best interests’ duty, which applies only to personal advice, requires the advisor to tick-off a list of investigations and then “take any other step…in the best interests of the client” that would be reasonable in the client’s situation. In short, the duty requires the advisor to exercise professional judgment, especially if the client’s circumstances are unusual. This is why personal advice is sought and paid for. The Streamlining proposals remove this so-called ‘catch-all’ provision, which reduces the ‘best interests’ duty to a check-list. The only remaining standard is that the recommendation given to the client be ‘appropriate’. There is a big gap between requiring an advisor to act in a client’s ‘best interests’ and that the advice be merely ‘appropriate’. 

This reversal is compounded by another aspect of the Streamlining proposals. The proposals will allow ‘scaled’ advice. Scaled advice is limited personal advice: it may consider only one or two aspects of a client’s entire financial circumstances. The idea of scaling is to permit a small scale service for those not wanting to pay for a comprehensive financial strategy. The FOFA reforms allowed scaled advice, mostly through the policy work of ASIC. ASIC’s scaling requirements made an advisor’s agreement to give scaled advice subject to all the requirements of any personal advice, including that the scaled advice be in the client’s ‘best interests’. 

The Streamlining proposals will reduce the investigations and obligations of the advisor providing scaled advice. There is no overarching protection which explicitly protects the client from advisors who deliberately recommend scaling when comprehensive advice is actually required. For example, a client who seeks advice about a small inheritance may be given scaled advice to invest in a managed investment scheme (earning fees for the advisor) when a wider review would reveal that the client would be better off by paying down their credit card or home mortgage. As we have already showed, there is also no protection against giving general advice when scaled personal advice is ‘appropriate’.

Ongoing Fee Arrangement

A central element of FOFA was the ‘opt-in’ requirement. Where a client had an ‘ongoing fee arrangement’ such as a managed account, an advisor was required to give their client a notice to ‘opt in’ every two years – that is, to sign up again - to continue the arrangement. This gave clients a reason to review their financial advisory arrangements not simply to continue paying fees. The Streamlining proposals abolish this requirement. They also remove the requirement that advisors send clients a fee disclosure statement each year if their arrangement was entered into prior to 1 July 2013. If the agreement was entered after that date, the fee disclosure statement will still be required. The government believes the ‘opt-in’ requirement is too costly. Instead the advisor or client must expressly opt out in order to end the arrangement.

Conclusion

If the Streamling proposals go ahead, most Australians will receive general financial advice that is commission and volume bonus driven. They will also pay conflicted remuneration on life insurance attached to their superannuation. Given Ripoll’s findings that conflicted remuneration causes poor advice, rolling back the prohibition in areas with greatest application to ordinary financial citizens seems indefensible. The proposals go against the ethical rules of the leading financial advisors professional body, which abolished commissions for its members from 2007 onwards. The UK - which does not compel retirement savings - has abolished conflicted remuneration and has no proposals to reinstate it.

An important criticism of this regulation is that it is merely ‘box-ticking’ compliance. The so-called ‘catch-all’ element of the ‘best interests’ duty required advisory judgment. If the proposals become law then the ‘best interests’ duty will be reduced to box-ticking procedure that the final advice is ‘appropriate’. This standard does more than take us back pre-Ripoll. Before Ripoll there was a requirement for a ‘reasonable basis for advice’ whereby advice had to be suitable or at least not negligent. This was abolished when the higher standard of ‘best intersts’ was introduced. Tick-a-box ‘appropriateness’ weakens the position of the financial consumer even more that a ‘suitable/not negligent’ standard.

The abolition of ‘opt in’ is the most anticipated change. Opting-in gives financial consumers a ‘nudge’ to monitor their advisor’s work. There were however obstacles to implementation: what would happen to the investments under management if the client did not reply, neither opting in, nor out? What if the advisor was compelled to sell at the top or bottom of the market to end the mandate in the absence of instructions? These and other questions were never really resolved, and they provided a loaded gun for ending ‘opt-in’. The fact that the fee disclosure statement will still be delivered every year may affect an otherwise acquiescent approach adopted by many clients. 

It is true that most economic regulation must find a balance between productivity and protection. There is no productivity gain in allowing citizens’ savings and foregone tax revenue to be lost through no advice or partial advice in a sector where related party and concentrated product recommendations are more common than not. The Streamlining proposals over-reach: they threaten to destroy the most important protection of the FOFA reforms being the abolition of conflicted remuneration in relation to general advice. They also undermine quality of advice standards. The U.S. has had a requirement of suitability or reasonable basis of advice since the 1930’s. The weak proposal that advice be simply ‘appropriate’ is not worthy of a country which compels its citizens to invest and which should therefore be more vigilant in their financial protection.

The views in this article are the views of Professor Kingsford Smith in her personal professional capacity, but not in her capacity as independent Chair of the Conduct Review Commission of the Financial Planning Association nor in her role as a member of the New Zealand Financial Markets Authority Code Committee.