Like it or not, the days of asset fees, life insurance commissions and other forms of so-called “variable income” are numbered. This conclusion is not based on mere speculation or on my wishful thinking. Rather, it is the only reasonable conclusion that can be reached from the plain words of English in FASEA’s Code of Ethics, which commences on 1 January 2020, supported by an updated Guidance document which published recently.
The Code of Ethics contains 12 standards which should be read together in order to understand the immense impact that they will have on the financial advice industry. The key standard impacting on “variable income” is Standard 3. It states: “You must not advise, refer or act in any other manner where you have a conflict of interest or duty”. This will prove to be a momentous change for an industry that has spent decades justifying its systemically poor behaviour by reference to the discredited concept of disclosure.
Readers of Professional Planner familiar with my columns might appreciate that I have heard all the excuses for justifying the existence of conflicts before, a summary of which includes: “We disclosed everything to the clients in writing, at length and in considerable detail. It’s not our fault that they didn’t read and understand what we told them. Therefore, any damage they suffered is their responsibility. It’s their fault, not ours”.
As a result of the FASEA Code of Ethics (especially Standard 3), all of this is about to change for the better, at least from the viewpoint of consumers. From 1 January 2020, advisers will be legally obliged to avoid the remuneration-based conflicts that they have previously (merely) disclosed. This means that it will be mandatory to avoid all forms of conflicted remuneration, not just some of them (as is possible under the “Future of Financial Advice” laws).
Just in case financial advisers need convincing about this, FASEA had added a helpful explanatory paragraph on page 17 of its recent Guidance document. It reads: “You will breach Standard 3 if a disinterested person, in possession of all the facts, might reasonably conclude that the form of variable income (e.g., brokerage fees, asset based fees or commissions) could induce an adviser to act in a manner inconsistent with the best interests of the client or the other provisions of this Code”. Note the deliberate use of the word “could” in the text, not “would” or “has”. Therefore, variable income in all of its forms is precluded because of its likely (rather than actual) effect.
I suppose someone may mount a creative argument that a disinterested person might not conclude that variable income could induce an adviser to act in a manner inconsistent with the best interests of the client, etc. Frankly, even the most optimistic advocate would be fighting an uphill battle to win that one, given what we know of the industry, including recent revelations in the Royal Commission.
To illustrate how the “disinterested person” test would work, I have offered below some common examples, sourced from my extensive work in consumer financial education. In each of these cases, a “disinterested person, in possession of all the facts, might reasonably conclude that asset based fees could induce an adviser to act in a matter inconsistent with the best interests of the client or the other provisions of the Code”:
1) A client inherits $100,000 and consults an adviser who uses asset based 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 an asset based fee can be earned, rather reducing debt on which nothing can be earned;
2) A client is thinking of using an industry superannuation fund and asks an adviser for a recommendation. The adviser who uses asset based 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;
3) 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 asset based fees. The adviser cannot charge asset based 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;
4) 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 asset based fees on term deposits, so he recommends the use of a platform or a product on which he can so charge;
5) A client has $250,000 in a managed equities fund/platform through an adviser who uses asset based 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 an asset based fee through keeping the money where it is, but would earn nothing if the money was moved into cash; and
6) 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 asset based fee adviser is inclined to persuade the client to leave all or some of the money where it is, so that the funds may be invested in a product or platform on which he earns an asset based fee.
In addition to these examples, there are many others involving life insurance commissions and other forms of variable income. The conclusions reached by the “disinterested person” would be exactly the same. That is, such a person could reasonably conclude that the variable income (whatever form it takes) could induce an adviser to act badly, resulting in a breach of the Code of Ethics, in particular, Standard 3.
Lest the reader is thinking that there must be a way around these conclusions by, for example, relying on profit shares from an invariably recommended white label product, or an in-house or preferred platform, I strongly recommend thinking again. That’s because this Code is about a whole lot more than “black letter law” that creative lawyers may seek to circumvent. It’s about ethics, their intent and their serious professional obligations to the public we serve, including the imperative to act without conflicts of interest.
Therefore, finding creative ways around the Code is precisely the wrong attitude, even though that’s been a common approach over the decades in dealing with many other commercially inconvenient reforms. This time, however, more so than ever, such an approach is fraught with danger. In that regard, it’s worth noting the words on page 17 of the Guidance document: “You will breach Standard 3 where the dominant purpose of providing advice to clients is to derive profits from selling those clients ancillary products or services from which you personally benefit”.
So whichever way you look at it, FASEA’s Code of Ethics will force a fundamental review of the motives and business models of the industry’s participants, and not before time. The losers will be those who are unwilling to change their thinking and practices. The winners will be those who embrace the Code’s intentions in a constructive spirit of goodwill and in support of the public interest. Those industry participants will have a positive, satisfying and lucrative role in the emerging profession of financial advice.