Whether you believe that it’s a “socialist attack on the freedom of small business” or justifiable reform, the changes can’t be ignored. Robert MC Brown explains
Like most Government announcements, the Federal Government’s recent proposals, principally involving the remuneration of financial planners, include political compromises that offer either “wriggle room” for those who would like to get around the basic message, or the opportunity to build a true profession.
So what’s the basic message? Essentially, it’s that conflicts of interest which drive the industry must be removed in the interests of consumers. That will be done, from July 1, 2012, by introducing (inter alia) a statutory fiduciary obligation, banning commissions (except on risk insurance), banning percentage-based asset fees (but only on geared arrangements), and requiring clients to “opt-in” annually.
The opt-in initiative may well prove to be a much more important initiative than many people realise because it will require clients to assess and decide annually on the worth of a planner’s services, and to make that decision based on dollars, rather than an innocuous and small percentage of funds under management (more about this below).
The wriggle room is obvious. It lies in the ability of planners to continue to adopt percentage-based asset fees in lieu of commissions (“the commission you have when you’re not having a commission”), and the ability to receive commissions on risk insurance. However, given that these concessions are essentially political, and that the Government went to the trouble of making the point that it reserves the right to monitor progress and tighten the rules at a later date, it seems to this commentator that the proposed rules are unlikely to be the end game.
Therefore, the industry must either take one more step to achieve comprehensive reform and true professionalism (by removing percentagebased asset fees and commissions on risk insurance), or have that step imposed on it at a later date.
This is not a case of taking away the basic democratic right of financial planners to run their own businesses in the way they choose; rather, it’s a case of transforming an industry into a true profession – a task that imposes certain ethical obligations on the profession’s participants, including the removal (not just disclosure) of remuneration-driven conflicts of interest.
An important practical consequence of this comprehensive reform is that financial planners (whatever their form or place of employment) will be presented with the opportunity to gain increased or complete control of their professional destinies. No longer will they be controlled by the vagaries of investment markets, by the commercial necessities of dealer groups or funds managers, or by the need to sell products and accumulate “funds under advice”.
As a result, financial planners will gain the freedom to build professional practices for themselves (or for their employers) based on legitimate fee-for-service remuneration models. Many planners will be unable to make the transition due to a lack of professional qualifications and skills; others will not be able to make it due to their inability to operate a professional practice (as distinct from a product sales business); and others will be unwilling to make the transition because of their established and comfortable income streams flowing from product trails.
Those financial planners who are willing and able to make the transition will gain a level of professional satisfaction and independence that they have never experienced before, mainly because they will no longer be required to advise clients in the knowledge that a product must be sold (whether or not the client actually needs one).
Many planners expect that their book of trailing revenue, be it in the form of commissions or percentage-based asset fees (trails), will be a valuable asset on retirement. Multiples of two to four times (gross) trail revenues are often mentioned, which is considerably more than the expectation of most accountants and lawyers (who would be fortunate to achieve a multiple of one). There are a number of reasons for this substantial difference. The principal one is that, unlike regular accounting fees, there is a perception on the part of buyers that little work is required to justify and increase the income derived from a “book of trails”.
This is one of the biggest mental hurdles for many financial planners to leap in making the transition to a truly professional practice. It’s one thing to transform a book of trailing commissions into a book of (surrogate) percentagebased fees, but it’s quite another (at least in their minds) to move to where the industry needs to be if it is to be treated as a true profession.
This point is best illustrated by an example of a fictitious financial planner with a book of trails deriving an income of $500,000 per annum, represented by 100 clients, with an average funds under management (FUM) of $1 million each, from which is earned 0.5 per cent in percentage-based asset fees (previously trail commissions).
This “book” provides a comfortable income that increases (or decreases) with movements in financial markets. On average, each client is paying the planner $5000 per annum (at least). In many cases, little professional and administrative work is required to collect the percentage-based asset fees, and most of the clients would be relatively unaware that the payments are being made automatically out of their funds.
In a true professional environment, the fee of $5000 per annum would need to be justified annually to each client by way of an accounting of actual professional services rendered, backed up with regular invoices or a formally agreed retainer arrangement, in much the same way as any other professional services provider is required to do.
While the professional fee of $5000 need not be directly calculated by reference to time, it is understandable that when clients are confronted (as they will be after the introduction of the annual “opt-in”) with a decision about whether the financial planner is worth that much, they will think about time spent and the value of services rendered. This means that where a planner has spent 15 to 20 hours per annum of value-added consulting time with a client, transforming a percentage-based asset fee of $5000 per annum into, say, a quarterly retainer fee of $1250 (unrelated to FUM), there should be no significant problems.
It is only where little or no time is spent, or a planner has inadequate professional expertise, that clients should quite reasonably baulk at paying for a planner’s services. Put simply, where the remuneration to the planner cannot be justified, it should not be paid in any form (and never should have been paid).
For some (older) planners, particularly those with high financial expectations on retirement, this analysis and transformation of their book of trails to an annually justified retainer, flat fee or hourly rate will prove to be an impenetrable barrier to transition; but, for others (who understand that the current situation is inherently unstable), initiating a program of transforming percentage-based trails into genuine fees for service will prove to be a liberating process, undertaken in the interests of longer-term viability, independence, sustainability and professional recognition.
The change may have a detrimental impact in the short term on businesses that are based on product sales. In the longer term, however, the viability and value of financial planning practices will be justified and sustainable because they will be viewed as legitimate professional firms in which the participants are earning a fair day’s pay for a fair day’s work.
Some dealer groups and institutions that own, partly own, or have significant financial arrangements with distribution networks may find the transition very challenging. This is because their cultures, expectations and structures are designed around the sale and distribution of products, rather than the provision of advisory services. Inherent in these structures is a strong control mechanism that exercises considerable power and influence over the decisions and recommendations of financial planners.
In the restructured environment, this power and influence will be considerably reduced or removed. Therefore, it is understandable that a fundamental change of this nature will be resisted, although it is likely that some product manufacturers will view the change as an opportunity to achieve some direct access and influence over financial planners who might otherwise be inaccessible.
It is beyond the scope of this article to analyse the multitude of financial and employment arrangements that exist in the industry. Suffice to say that in any restructuring of the nature proposed herein, there will be winners and losers. The losers will be those organisations and individuals that do not accept the seriously detrimental consequences of maintaining the status quo or who seek to exploit the wriggle room to which I referred above. The winners will be those who understand the depth of the problem, and realise that it must be solved once and for all, without resorting to “workarounds”.
More than anything else, reform and transition of financial planning into a profession requires visionary leadership. Without it, the industry is consigned to a future of unworkable workarounds and an increasingly complex and costly compliance regime.
A satisfactory outcome will never be reached until the industry’s leaders openly and unreservedly recognise the unacceptable consequences of remuneration-based conflicts of interest and then enthusiastically commit to remove the problem once and for all.
The consequences of taking this position will not be as difficult as many people might fear and anticipate. This is because financial planners will become respected as true professionals; their practices will gain legitimacy, sustainability and longevity; and institutions and dealer groups will enjoy an improved image and reputation.
Most of all, the public interest will be served unambiguously. This is the unique distinguishing feature of a true profession.
Robert MC Brown is a chartered accountant with more than 30 years’ experience in accounting, superannuation and financial planning. in 2007, he was authored the landmark industry paper ‘Reinventing Financial Planning’