Financial advisers like using terms such as "white-label payments", "cross-subsidisation", "vertical integration" and "volume payments". You probably won't know what they're talking about unless you're an adviser yourself. It's even harder to know whether the financial products they recommend are good for you, or just good for them. And that's where the Future of Financial Advice (FoFA) reforms are meant to step in.
Deciphering the jargon
The cryptic terminology basically describes how advisers get paid. In the case of volume payments, advisers are encouraged to sell as many financial products to as many people as possible, regardless of whether the product is suitable for the client.
They get a cut from the originator of the product or investment scheme (usually an insurance company, bank or fund manager) based on the total volume of sales.
It's not unlike how salespeople receive commissions to sell cars, except what's on offer can have a permanent impact on your financial well-being.
The payment models
There are three main types of payment schemes for advisers: commissions, asset-based fees and fee for service.
This is the most common type, and usually attracts the highest fees.
- An adviser will get a commission from product providers such as managed funds when they sell their products.
- This is usually an initial (entry) fee of up to 5% of your initial and subsequent investments, and a trail commission of about 0.5% of the balance of your portfolio each year.
- Commissions are much higher on life insurance, income protection and disability insurance.
A second form of payment, similar to trail commissions and agreed between investors and advisers, is a percentage 'asset-based' fee. It's charged as a proportion of your investments or portfolio.
We recommend consumers avoid this type of payment scheme, since fees increase as the value of the account increases, whether or not the adviser has done anything to earn the extra money.
Fee for service
This is a basic fee-for-advice, based on a set or hourly fee.
- This type attracts the fewest conflicts of interest.
- There are an increasing number of fee-based advisers and groups who have adopted this approach, including the Financial Planning Association, AMP and MLC.
- However, even with fee-based advice, there are traps to watch for.
- Some advisers may like to appear independent by charging fees, while continuing to rake in product commissions as well.
Commissions proved toxic for unwitting consumers in corporate collapses such as Westpoint Corporation.
In the quest for commissions, some advisers persuaded consumers to lend money to property developers without warning that the investments were highly speculative. The developers were, in effect, gambling with their money.
Others talked clients into complex and high-risk structured investments that offered no way out when the global downturn began to spread in late 2007.
Worst of all, some investors were advised to take out margin loans, sell shares or investment properties and even borrow against their homes. As markets were pushed downward and the margin calls came in, many lost their homes along with the initial investments.
Relationship advisers are co-dependent with the companies who make the products they sell.
- Our 2010 investigation revealed that Australia's six largest financial planning groups had consistently directed customers to their own superannuation products.
- The breakdown showed deep-rooted conflicts of interest, since advisers were clearly inclined to recommend products that stood to increase their commissions.
- In all, advisers recommended products from their direct or indirect employer a whopping 73% of the time.
- These were unlikely to be best products for their clients.
- Worse, these fee schemes are often ongoing (a phenomenon known as trailing fees) and unaccountable.
In 2009 alone, around $1.3 billion in superannuation commissions flowed from consumers to advisers. That's despite the advisers providing no service to the consumer.
Case in point
CHOICE members Denise and her husband were talked into having a fresh look at their finances by an adviser. They were charged $1250 up front. "We were advised to borrow $200,000 against our house to invest elsewhere, to switch our super funds, and to take out extra life insurance to cover new debt," Denise says. "They ran through it as if it was a win-win situation and expected us to sign on the spot."
The couple didn't sign as they felt uncomfortable with the recommendations. The adviser would have taken a large cut of their money, including:
- not only the $1250 upfront fee, but a further $6600 from the loan for "initial advice"
- $3800 in initial insurance commissions
- $2700 per year in insurance trail commissions
- $2200 annually in superannuation investment commissions.
All up, the strategy's fees were almost $12,000 up-front and $2700 annually. Denise's super fees would have doubled if she'd switched, as recommended, from her industry fund, REST Super.
"All I wanted was advice on how to minimise our tax, pay off the mortgage and boost our super. We also wanted some advice on a property investment, but were advised to invest in a managed fund with lots of adviser commissions.
"Our bank felt it was risky and that the expected returns were a bit inflated, so we didn't follow through. I wish we hadn't been pushed into the appointment, as that $1250 could've been spent on my mortgage."
FoFA – the long-awaited reforms
Thankfully, the way advisers make their money is undergoing significant change with the implementation of the Future of Financial Advice (FoFA) reforms. The reforms:
- require financial advisers to ask clients to 'opt-in' every two years if they wish to continue to receive ongoing advice
- place a ban on commissions on risk insurance inside superannuation
- put a broad ban on volume-based payments.
The reforms also imposed a ban on trailing and up-front commissions and similar payments as of July 2013, but allowed existing commission arrangements to remain.
It means you may still be paying commissions if you established a relationship with a financial adviser before July 2013.
What it means for you
The net effect of FoFA should be that you'll no longer receive recommendations based on the adviser's commercial relationship with the bank or insurance company. You should also be able to see and understand the advice you're paying for.
These are huge changes that go a long way to improving transparency and fairness in the financial advice industry, but the industry is not letting go of its long-entrenched funding models without a fight.
The reforms only go so far. For instance, the ban on adviser commissions does not include risk products, such as life insurance outside of superannuation. 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.
They've been left out of FoFA because the advice industry convinced the government that removing sales commissions would reduce the amount of insurance sold, leaving consumers vulnerable.
The financial services industry fought hard to get rid of important consumer protections in the FoFA reform package – to the point where the reforms would no longer achieve the intended effect of removing bias and conflict of interest.
The anti-reformists have gone right to the heart of why the reforms came about in the first place. Among other things, the industry pushed to have the legislation amended to allow advisers to continue recommending financial products from which they draw ongoing commissions.
Many advisers don't let vested interests influence their advice. But there are many who do. The victims of financial advice scandals such as Storm Financial can attest to that.
Money for nothing
And in an attempt to hold on to passive income streams – those hidden ongoing fees you pay whether or not you've asked for or received any services – the industry pushed hard to scuttle the opt-in clause.
The advice lobby also attempted to persuade MPs to do away with the requirement to provide customers with an annual statement explaining what they've been paying for.
These provisions were included in FoFA for good reason – because such information has been woefully lacking for decades, and the lack of transparency has cost Australian consumers dearly.
Reforms cost consumers?
The advice industry argued that the cost of implementing the reforms without its recommended changes would be passed onto consumers and that, as a result, fewer people would be able to afford advice. The counter-argument is that conflicted advice and hidden fees are the greater long-term threat to consumers.
Advisers also have a habit of selling advice to consumers that's inappropriate to their circumstances, which is why FoFA requires that advisers act in the "best interests" of their clients. The advice industry also tried to water down this key FoFA clause.
What CHOICE called for
In a submission to the federal government aimed at preventing the reforms from being amended in favour of the advice industry, we called on lawmakers to:
- keep the best interests obligation intact
- keep the opt-in requirement intact
- ensure that consolidated annual fee statements go to existing clients, not just new ones
- ensure that the ban on commissions is not watered down.
We're not the only ones who have found evidence of a broken system. An ASIC investigation in 2012 found that only 58% of retirement advice was of an acceptable standard. In many cases, the bad advice was attributed to the influence of commissions and the failure of an adviser to act in the client's best interest.
The financial adviser reforms were rescued from a self-serving overhaul at the hands of the advice industry in November 2014, when four cross-bench senators decided not to back the government's efforts to water down the rules.
Knocking back the agenda of the powerful financial advice industry was a sweet victory for consumers; now it's a question of keeping advisers honest.
FoFA back on track – what you need to know
The nuances of the FoFA reforms can be complicated, but the basics are refreshingly straightforward. Here we focus on what are arguably the three most important elements of the reforms from the standpoint of the average consumer.
Annual statement of fees – Advisers are required to send you an annual breakdown of how much you've been charged and what you've been charged for. This eye-opening bit of communication may come as a revelation to many consumers, especially those who weren't aware they were receiving and paying for 'advice' in the first place through their superannuation accounts. (But be advised that the annual statement rule has some shortcomings. If you have a pre-FoFA financial product in your account, for instance, trailing commissions may not be disclosed.)
Opt in – Advisers have to contact you every two years and give you an opportunity to opt in to ongoing advice – an essential communication for clients who no longer need the advice allegedly being supplied or are unaware that they've been receiving and paying for it. Opponents of FoFA in its original form attempted to do away with this provision.
Best interests, all the time – The proposed FoFA changes would have watered down the 'best interests duty', the obligation that an adviser act in the client's best interests – not their own or their employer's – 100% of the time. Under the proposed changes, the adviser would have had leeway to determine when the best interest duty should be applied. Now an adviser must act in the client's best interests at every stage during the advice process.
The ADF test
The Australian Defence Force has made some big moves toward taking conflict of interest out of the client/adviser relationship and protecting its members from conflicted remuneration (when a financial adviser makes a recommendation based on the commission or bonus they stand to receive rather than on what's best for the client).
Financial advisers who take part in the ADF's Financial Advice Referral Program have submitted written declarations that they "will at no times be under the direct or indirect influence of a financial product manufacturer".
In addition, these advisers promise to charge ADF personnel on a strict fee-for-service basis. It means the adviser and client agree on a specific fee for a specific task, much like a one-off tax preparation job.
For advisers taking part in the ADF program, hidden remuneration streams are off limits:
- No one-off or ongoing commissions.
- No asset-based fees (in which advisers charge clients a percentage of their assets regardless of the extent or quality of work they've done). As Industry Super (the representative body for industry super funds) pointed out last year, "there is no requirement for a financial adviser to provide ongoing advice, but they can continue to deduct ongoing percentage based fees from a client's super nest egg".
- No bonuses (in which advisers get paid extra for recommending certain financial products or service providers over others).
And in case there's any confusion, the ADF's referral program rules out any other form of remuneration "that could reasonably give rise to a conflict between the adviser's interests and the interests of the adviser's clients".
We think it adds up to a pretty good checklist for making sure any financial advice you receive is focused squarely on your best interests, not the adviser's. Tell your prospective or current adviser they need to uphold the ADF standard.
What's so bad about commissions?
Simple – the prospect of a juicy commission unduly influences financial advice. Recent proof comes courtesy of an Australian Securities and Investments Commission investigation in late 2014, which found that about a third of the life insurance advice on offer falls somewhere between poor and terrible, mainly because commissions steer advisers toward life insurance products that are often woefully unsuitable for the client.
Twenty-five years of campaigning
A review of CHOICE research and investigations over the past two decades vindicates our public statements that the industry needed urgent reform to protect consumers.
"Many financial advisers are simply agents for fund managers and investment companies; although they claim to offer impartial and independent advice, their main priority is to sell as many investments as possible, so the client's needs are often pushed into the background."
- (In) vested interests, CHOICE, March 1990.
"The further we delve into the industry, the less attractive it appears. All of these arrangements are structurally corrupt."
- Australian Consumers' Association chief executive, Louise Sylvan, in the Australian Financial Review.
We launched our first 'shadow shop' of the advice industry, with disturbing results. Less than 10% of the 58 financial plans examined were classified as good, based on the scores of our expert panel. 65% ranged from acceptable down to bordering on poor, while a quarter were sub-standard.
- Take my advice? CHOICE, April 1995.
Our shadow shop found found many planners falling short of the industry's own best-practice standards. "The best comprehensive plans were generated when a client had a significant amount of money available for immediate investment," we wrote. "It's unacceptable that the quality of advice is determined by the amount of money you have to invest … If you're getting cheap advice, it's probably poor advice."
- Who do you trust with your life savings?, CHOICE, October 1998.
Another large-scale shadow shop, this time a joint project with ASIC. "The quality of advice given by some financial planners in our survey is frighteningly poor. The'advice' given often seemed like thinly disguised product selling. Far too many planners behaved more like salespeople for fund managers than impartial financial guides. Plans graded poor or very poor (27% of the total) were grossly inadequate."
- Too many poor plans, CHOICE, January/February 2003.
"Financial planners want to call themselves professionals, but they don't want to commit to the fundamental underpinnings of a profession – the fiduciary duty to the client. This would require the elevation of the client's interest over and above the industry's and require the removal of all conflicts of interest. Structural conflicts in the industry undermine consumer confidence, destroy trust and suggest the industry is without integrity. My message to you is this: unless the industry reforms itself, change will be imposed."
- Jenni Mack, CHOICE Chairperson, in a speech to financial advisers.
"There's no valid justification for trail commissions and fund managers should abolish them as a payment method to planners. Trails paid by fund managers create a conflict of interest for financial planners."
- Unhappy trails, CHOICE Money & Rights, October/November 2005.
"Conflicts can mean that advisers are effectively salespeople of product providers. Conflicts can encourage advisers to sell products instead of providing strategic advice. Conflicts may provide incentives to recommend products that are inappropriate. They can encourage advisers to churn clients through products. Worse yet, they can encourage clients to borrow inappropriately to invest. Upfront and trail commissions, asset based fees, soft dollar commissions and volume bonuses all exhibit one or more of these conflicts. This is not a marginal problem. Around 85 per cent of adviser revenue is generated through these payments."
- CHOICE evidence to Parliamentary Joint Inquiry, September 2009.
"Consumers will be the winners as a result of the federal government's decisive action to end commission-based remuneration for financial planners. CHOICE has argued over many years that commissions create an unacceptable conflict of interest for financial planners which can lead to dangerous or poor quality financial products being sold to consumers. The government's plans incorporate many of the recommendations we made to the parliamentary joint committee on financial services. We are particularly pleased that asset-based fees will not be levied on geared products. But we remain concerned that the industry is attempting to transition from commissions to asset-based fees. Our preference is for fixed fees which could be either a fixed lump sum or hourly rate charged by the adviser to the client."
- CHOICE Media statement.
In a submission on the proposed changes to the Future of Financial Advice (FoFA) reforms, CHOICE called for a comprehensive regulatory impact statement to assess the impacts on consumers. "The proposed changes follow an aggressive campaign from banks and the financial advice industry, so it's critical that any changes take into account the significant likely impacts on consumers. The balance needs to be in favour of protecting consumers and their retirement income, rather than protecting the income of financial advisers."
- CHOICE CEO Alan Kirkland.