“There must be a recognition that conflicts of interest and conflicts between duty and interest should be eliminated rather than ‘managed’”. Kenneth Hayne wrote this in the Royal Commission into Misconduct into the Banking, Superannuation and Financial Services Industry Final Report, Vol.1, page 45.
This important message about ethics is at the core of Commissioner Hayne’s recommendations. It is restated in various forms throughout the 2,000 pages of his report.
The same message is at the core of the mandatory Code of Ethics issued in February, 2019 by the Financial Adviser Standards and Ethics Authority (FASEA) in the form of a legislative instrument under paragraph 921U(2)(b) of the Corporations Act.
I congratulate both the royal commission and FASEA for taking such a strong leadership position on this fundamental standard of professional ethics. It’s Ethics 101. Acting upon it comprehensively is in the best interests of advisers and clients alike because it will lead to the creation of the trusted financial advice profession which hitherto has been out of the financial planning industry’s grasp.
While there are many forms of adviser remuneration where conflicts may need to be addressed, I want to focus on percentage-based asset fees on investment products, also known as commissions paid by clients, not third parties, the latter having being banned by the Corporations Act as “conflicted remuneration”.
Many in the industry argue that unlike life insurance commissions or other types of commissions, percentage-based asset fees are not commissions at all and therefore are not conflicted remuneration. They say they’re just a fee collection method, but the reality is they are a whole lot more than that.
Of course, it’s true that percentage-based asset fees are not technically conflicted remuneration within the relevant definition in the Corporations Act. It was a political compromise to exclude them. But they transform into conflicted remuneration in that Act when gearing is involved, thereby recognising their inherently conflicted nature. This was another political compromise to cover-off problems with suspect margin lending practices.
In recent years, the industry has become so bold as to argue that a percentage-based asset fee is actually a professional fee for service. Most of the industry’s leaders privately acknowledge this is nonsense. It’s like arguing that black is white. But they cannot accept the argument that a percentage-based asset fee is just another form of commission because they fear the commercial consequences on the flow of funds under management should advisers become truly independent of conflicted remuneration. And they know that such a concession would lead to considerable criticisms, if not resignations, by members of their associations.
Would other professions do it?
I often explain percentage-based asset fees to consumers by asking them to imagine a doctor who stopped his $85 flat fee for service and replaced it with a 15 per cent fee for service based on the value of the drugs he prescribes. A moment’s thought would indicate that such an arrangement would never be accepted by the public and government because it would lead to the over prescription of drugs. Note that it’s not a commission paid by a third party.
Instead, it’s a commission paid by a patient, but it would clearly lead to the same conflicted result. And yet, that’s what the financial advice industry does every day of the week, arguing with a sense of artful unreality that its conflicted remuneration of choice is merely a conflict-free fee for service, except when it comes to gearing, when it isn’t!
This reminds me of the rather embarrassing story of the accounting profession’s financial planning standard, APES230. In short, the Accounting Professional and Ethical Standards Board (APESB) publicly announced its decision on conflicted remuneration in late 2012.
The decision banned commissions in all of its forms, as it should for a true profession, including life insurance commissions, mortgage-broking commissions and percentage-based asset fees. However, only three months later, the APESB was forced by its shareholders (the accounting bodies), to back down due to intense public and private lobbying by the financial services industry.
As a result, APES230 was diluted into its current and uniquely strange “optional ethics” form, allowing either disclosure or elimination of conflicts at the adviser’s choice. This neutralised the Standard’s ethical impact and rendered it ineffective (which was the whole idea of the complainants in the first place).
I should mention that even though the diluted version of APES230 allows percentage-based asset fees through a disclosure-based workaround, the APESB commendably makes the point that such arrangements are inherently conflicted and that a genuine fee for service (hourly rate or flat fee) “is the most effective method to eliminate threats from conflicted remuneration”.
Enshrined by FASEA
I sincerely hope we will not see history repeat itself. That may occur either through a dilution of the words in some of the more commercially inconvenient standards in FASEA’s Code of Ethics – through an industry-friendly or ambiguous interpretation (“clarification”) of the Code’s plain English words – or simply through silence from FASEA, thereby allowing professional bodies, financial advisers and ethics course designers to reach their own conclusions about the true meaning and consequences of the Code.
Having said that, it’s hard to imagine how the Code could be ‘read-down’ or diluted and retain any credibility. This is especially so given the conclusions of the royal commission about the imperative for conflict elimination and the key statements by FASEA that “this Code imposes ethical duties that go above the requirements in the law” and “the primary ethical duty of this Standard is that if you have a conflict of interest or duty, you must disclose the conflict to the client and you must not act”.
Here are some common examples, sourced from my extensive work in consumer financial education, that demonstrate how percentage-based asset fees lead to poor outcomes for consumers:
- A client inherits $100,000 and consults an adviser who uses percentage-based asset fees. The client seeks advice on whether to pay down a mortgage or invest in a managed product. The obvious problem here is that the adviser may be conflicted into recommending investment of the inheritance in a product from which a percentage-based asset fee can be earned, rather reducing debt on which nothing can be earned;
- A client is thinking of using an industry superannuation fund and asks an adviser for recommendation. The adviser who uses percentage-based asset fees cannot easily charge them on an industry fund, but can easily do so if the client uses a fund from the adviser’s approved product list;
- A client is a public servant or military retiree thinking about how much of his defined benefit superannuation entitlement to commute to a lump sum. He seeks advice from a financial adviser who uses percentage -based asset fees. The adviser cannot charge percentage-based asset fees on a government defined benefit pension, but he can charge them on a superannuation platform he promotes, so he advises the client to commute his government-guaranteed pension entitlement to the maximum;
- A client has $250,000 in term deposits with a bank maturing next month. He asks the adviser for a recommendation about where to invest. The adviser can’t charge percentage-based asset fees on term deposits, so he recommends the use of a platform or a product on which he can so charge;
- A client has $250,000 in a managed equities fund/platform through an adviser who uses percentage-based asset fees. The adviser believes it would be in the client’s best interests to move some of the money into cash at a bank (noting the $250,000 government guarantee), but is not inclined to offer that advice because he continues to earn a percentage-based asset fee through keeping the money where it is, but would earn nothing if the money was moved into cash; and
- A client has $500,000 in savings and seeks advice about moving the money into direct real estate or a combination of direct real estate and cash for renovations. The percentage-based asset fee adviser is inclined to persuade the client to leave all or some of the money where it is.
The list goes on, including where self-described ‘independent’ advisers promote their own ‘white label’ products and in-house platforms. Given these circumstances, it beggars belief that the industry persists with the claims that there are no inherent conflicts in percentage-based asset fees, that they are not a form of commission and that they are merely a fee collection method which should be characterised as a professional ‘fee for service’.
If the sad (and I sincerely trust, unlikely) day comes when FASEA accedes to these representations, the mandated Code of Ethics will become little more than a box-ticking exercise, joining many of the other politically compromised laws and regulations that have been introduced with good intentions in recent decades, including the Future of Financial Advice legislation and the flawed ethical standard, APES230. As a result, the Code will not be the much anticipated catalyst for comprehensive cultural and behavioural reform that the Australian community expects and that FASEA was established to achieve.
In those circumstances, we can look forward to more mistrust, more scandals, more ineffective and costly compliance rules, more legislation and eventually, another royal commission. The far better alternative is for the industry to show some much-needed leadership. It should unambiguously support the professional and ethical intent of the Code and accept the obvious conclusions about the detrimental impact of all forms of conflicted remuneration.
Then the industry should get on with building the true profession to which it aspires, rather than trying to hold back a tide that will eventually engulf it should it fail to act in the public interest as the royal commission, FASEA and the community demand that it should.