03.What the new laws mean
Following a Parliamentary Joint Inquiry, to which CHOICE provided evidence and a submission, in April 2010 the federal government announced a comprehensive reform package to clean up the industry. The detail is still being finalised, but what we do know is that from July 2012, financial advisers will have a legal “fiduciary duty” to place clients’ interests ahead of their own. While some professional bodies, such as the Association of Financial Advisers, have long placed a fiduciary duty on members, legally there was no explicit obligation to put their customer’s needs first.
At this stage, the reforms are expected to include:
- A ban on investment commissions: at present, the predominant form of remuneration for advisers is a behind-the-scenes payment by fund managers and other product providers whose investments the adviser recommends.
- A ban on payments to advisers for meeting or exceeding volume sales targets. These payments encourage advisers to sell more investments than the consumer needs, and to favour product providers that pay the biggest sales bonuses.
- A ban on percentage-based fees for “geared” financial products – for example, margin loans. This will reduce the likelihood of another Storm Financial disaster, where clients were encouraged to take large loans to use for investments. The leveraged nature these arrangements magnified consumer losses and increased investor liability when the investments turned sour. Some people lost their homes.
- Consumers will be required to renew their fee arrangements on an ongoing basis (after an initial period where the adviser’s payment will be guaranteed), otherwise the fees will stop.
The CHOICE verdict
These reforms are enormous steps forward for consumer protection - CHOICE has campaigned for many years for such improvements. However, we have reservations, which we hope will be addressed in the final arrangements. Of most concern are the following:
1. Asset-based fees
Percentage “asset based” fees - where the adviser’s fee is based on the value of your portfolio - are slated to continue. While some argue that percentage fees “can be useful in aligning the best interests of advisers and their clients”, we have concerns. Firstly, the adviser’s work should be much the same for a consumer with a small or big amount to invest, so why should the latter investor pay more? There’s also the temptation for advisers to recommend the sale of non-financial assets, such as property, to free up more money for financial investments and earn higher fees. But most importantly, percentage figures mask the true impact of fees – 1-2% of assets may seem harmless enough until the long-term effect is revealed.
Deen Sanders, acting CEO of the Financial Planning Association, defends asset based fees. “It’s not true to say that the same amount of work is required for big or small investment amounts,” he says. “Higher amounts can involve more work and time for an adviser, especially if complex investments and arrangements are involved, such as estate planning and family needs. And for people with smaller amounts to invest, an asset based fee can work out cheaper than fee-for-service.”
2. Trail commissions
Commission arrangements already in place before the July 2012 cut-off may continue. There's speculation that these investments will be “grandfathered” from the new rules. After July 2012, consumers should look carefully at the commissions being paid from their investments, and consider whether they should switch to lower-cost arrangements, or arrange to have the commissions (and fees) “dialled down”. In anticipation of this, when buying investments now you may wish to ask for the new lower-cost commission-free versions. FPA planners are already required to turn off the commissions on investments if consumers don’t want them, and what’s currently proposed is that from 2013 consumers will have to “opt in” each year if they want to continue paying adviser fees and commissions.
3. Risk insurance left exposed
The ban on adviser commissions may not include risk products, such as life insurance. This is despite the fact commissions of up to 120% of the first year’s premiums are paid to advisers, with trail commissions of about 10% in subsequent years. Or advisers may receive a flat commission worth as much as 30% for every year you have the policy. These are staggeringly high commissions that potentially encourage advisers to churn people into new policies in order to receive the high initial kick-back. Already we’re seeing reports of an adviser “flight to risk products” to earn commissions in anticipation of the new laws. So far the government seems to be leaning towards the industry’s argument that removing sales commissions will reduce the amount of insurance sold. “My concern is to make sure we don’t exacerbate the problem of under-insurance in Australia,” Minister Chris Bowen said in May. “There are good arguments validly made on both sides of this discussion about whether risk insurance should have its commissions banned. We also need to ensure that were we to exempt risk insurance in the ban on commissions, we didn’t allow some sort of back door mechanism to allow commissions to continue to exist for financial advice more generally, so that, if you like, large commissions might be placed on risk insurance to counteract the loss of income from the banning of commissions on more general products. So I have a genuinely open mind about this.”
The FPA also chose not to voluntarily ban life insurance commissions. “We’re concerned where we find malpractice – that’s where we act,” says Deen Sanders. “But we found no bias caused by commissions in risk insurance, and without the ability of consumers to pay by commission, we’re concerned that people won’t buy enough insurance. I think it’s possible that in the future there will be a shift away from life insurance commissions, but it will take time.”
Underinsurance is undoubtedly a real and important problem, but paying high kick-backs to advisers is not the way to solve it. It can also be argued that fat commissions make insurance more expensive so people buy less cover – which exacerbates underinsurance, rather than helping to address it.