As a result of the global financial crisis (GFC) and the collapse of numerous investment schemes, many financial advisers have been exposed to a perfect storm: extraordinary circumstances combining with a drastic impact on advisers and their clients.
The following advice situation involves the confluence of three sets of circumstances producing substantial capital losses for the client and a potentially enormous impact on the adviser’s business.
Three dynamics were in play.
Rollover of Defined Benefit Fund
The first was that the client was a member of the Commonwealth Superannuation Scheme (CSS), a defined benefit scheme and approaching retirement. Upon his retirement he would be eligible to receive a CSS Benefit. He sought advice concerning his financial affairs in retirement.
The CSS Age Retirement Benefit application form set out six options, three of which were applicable to the client:
– Option 1 paid a CPI-indexed pension with an additional non-indexed pension purchased with the client’s member and productivity components;
– Option 2 paid a CPI-indexed pension with an additional non-indexed pension purchased with the client’s member component and refunded a productivity component as a lump sum;
– Option 3 also paid a CPI-indexed pension plus a lump sum of the client’s member and productivity components.
The advantage of the CSS fund (in particular Option 1) was that once he elected to claim pensions those amounts were guaranteed and payable for his lifetime.
The Advice
The adviser prepared a Statement of Advice (SoA) recommending investment of a lump sum the client would receive when he claimed his CSS benefit using Option 3. When the adviser presented the SoA to the client he gave the client a prepared CSS Benefit application form, choosing Option 3 for him to sign.
The SoA did not discuss the client’s other CSS benefit options and the adviser did not provide him with advice about them. The client and his wife were relocating from their principal place of residence and had no need for a lump sum.
Investment using ‘time-segmentation approach’
The second dynamic was that the adviser’s practice had developed an investment strategy known in the financial services industry, (Forbes online issue 8 May 2012), as the ‘time-segmentation approach’. Such strategies quarantine the client’s investment funds into notional categories.
– The first category or ‘bucket’ would contain those funds the client anticipated needing in the short-term, say one to two years, and would be in cash investments;
– The second bucket would contain funds the client anticipated requiring in the mid-term (around five years) and would be in cash and fixed interest investments as well as growth investments, mainly managed funds or equities; and
– The third bucket would contain funds only required in the long term. Those funds would be in aggressive investments – namely share funds – with the aim of generating growth.
As the investor draws down on the first bucket to cover expenses, funds from the second bucket are drawn upon to replenish the first bucket, and so on. The strategy is reviewed regularly; when market returns create balances which exceed the needs of each bucket, a redistribution occurs from three-to-two, two-to-one.
Adopting the adviser’s recommendations, the client invested according to this approach. During the rise of the sharemarket to its peak in November 2007 Australian investors enjoyed unprecedented returns. In that climate, the client made significant investment in the ‘third bucket’ in geared share funds.
Onset of the GFC
The third dynamic was the onset of the GFC, experienced in Australia in early 2008. From this time, the adviser and the client communicated about what to do with geared share fund investments.
Storm cell formed
The storm cell was now complete: the client rolled a lump sum component of his defined benefit into market-linked investments, a portfolio of managed funds losing an effective capital guarantee; those funds were structured according to a non-standard asset allocation, the time segmentation approach, with a proportion invested in internally geared managed funds; and the GFC magnified capital losses of the client’s investments, particularly those allocated to the ‘third bucket’.
Lessons to be learned
– The adviser must take proper steps to know its client and why the client needs a lump sum;
– In order to demonstrate it has satisfied the best interests duty it would need a persuasive reason to relinquish a guaranteed pension;
– Advisers must ensure that their explanation of the nature and risks of the advice is thorough and recorded in a SoA and file notes;
– In recommending atypical asset allocation models, advisers should ensure that they assess the risk profile of their client. They should test in discussions the client’s tolerance to risk of capital loss and the risk that that strategy may not produce its intended benefits. Central to that discussion should be an explanation of the impact of market downturn and reduction of balance available to pay a pension; and
– One of the challenges for the adviser faced with an allegation of inappropriate advice about the rollover of a guaranteed benefit is calculating the quantum of the client’s loss, or amount required to restore them to their original position.
