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.
If you can demonstrate within reasonable measures how the client benefits from insurance commissions in opposition to paying direct fees for insurance advice you within the code of conduct mitigate any disinterested person concluding that the form of variable income could induce the adviser to act in a manner inconsistent with the best interests of the client. And i don’t think it would be hard to measure this in direct financial analyses.
Anyone who is genuinely arguing for the abolition of conflicted remuneration would, as a matter of high principle, be advocating for the removal of hourly rates. The silence of Robert and others on this point is deafening.
My suggestion – how about we get the Code right? Some meaningful engagement with professionals would help our ham-fisted friends at FASEA. The Code has to be more than an aspirational expression. It has to be able to function. I can’t see that happening in its current form.
Great response Christoph, thankyou.
The bottom line is, people benefit from good financial planning advice – structuring, asset protection, retirement planning and estate planning. This takes time and even if charged as a fee, is likely not to be profitable. It requires ongoing engagement.
The fees for asset management have subsidised the real advice so there is a real Horney’s dilemma presenting itself.
I would simply ask the author does he think that him charging a fee by an hourly rate or flat fee (whatever he does) is not a conflict of interest?
It invariably is and as he seems to think it is not which makes me wonder how his licensee and himself is satisfying his “conflict management obligation” under the law if he cannot even correctly identify a conflict of interest.
“Again, the implication is that these alternative compensation models are free from
the conflicts that plague other models – and again, the moralistic hyperbole reflects
a naive understanding of basic economic principles”
J. R Robinson
“No moral High ground in Financial Planning Fee Debate” – 10 Aug 2015
It seems also that an accountant with an AFSL, who recommends that a family have a family trust for their share portfolio, may have a problem with Rule 3. Unlike a SMSF trust , a family trust is not a financial product, but does the accountant with the AFSL still have a conflict of interest problem if he provides accounting and tax services to the trust? If the accountant does not have an AFSL and recommends the above , he appears not to have a problem?
Very interesting. There were some very perceptive and pertinent replies to Robert Brown’s previous article in Professional Planner but Robert isn’t answering them in this article and seems to just repeat his opinions.
Replying to his points:
1) This is simple. It needs a good argument to recommend anything other than paying down the mortgage. Also too small an amount to charge an asset-based fee. However, not too small an amount to charge a fixed fee – the conflict here is actually the other way around.
2) The question is very clear. Either recommend an industry fund and write a statement of advice and charge the client for that or point out that there are vast differences between industry funds and what to look for and not give advice. Asset-based fees are not an issue.
3) Any adviser who recommends anything other than keeping the defined benefit pension in full, at least until retirement or when the defined benefit feature runs out, is doing something very dangerous. Asset-based fees are not an issue.
4) The question is whether the client wants one-off advice or an ongoing relationship. Asset-based fees don’t arise in the former and any ongoing fees – of any kind – are unlikely to be paid if the client stays with the term deposits. Both the fixed fee and the asset-based fee adviser have the same ‘conflict’ – that they will do better if there is an ongoing relationship.
5) If you can’t give advice that is in the interests of the client and to your financial detriment, then I doubt you are a good adviser. A fixed fee adviser has the same ‘problem’ – the amount they manage has shrunk but their fee hasn’t.
6) This happens all the time and an adviser who cannot give good advice here breaches all sorts of FASEA code items. The fixed fee adviser would just as clearly end up with reduced income – very few clients will pay for ongoing advice on investment properties.
Every adviser is constantly in the situation where they are asked for advice that will affect the adviser’s income. If they lie to the client, then they are not doing their job.
The same applies to accountants – is it true that many accountants refuse to allow perfectly legitimate tax deductions in order to not be flagged by the ATO? I have heard plenty of anecdotal evidence of that. Is it true that lawyers have been known to recommend litigation in marginal cases (or worse cases) as it will lead to extra income for them? Is it true that an accountant can double their turnover per client if they open an SMSF for that client, regardless how well the SMSF is doing for the client?
All professionals have major opportunities to give bad conflicted advice.
Fixed fees are great but what about older clients whose pension balance is rapidly shrinking but not their fixed fee? Asset-based fees immediately align payments with amounts invested. Usually that is a good idea – the client wants to do well and or preserve their assets, same as the adviser. There are lots of good arguments either way and the major issue is elsewhere – that it is legal for product providers to employ, control or influence financial advisers. It is the latter that reliably has lead to bad advice in my experience.
There seems to be a problem for accountants with an AFSL who recommend a SMSF to their clients and also provide accounting, admin and tax services to SMSFs. Will that be deemed a dominant purpose? Will the Chinese walls come up again or the quid pro quo between accountants – like it has with audits in the past? It seems like this ethics code is telling accountants they can either provide accounting, tax and admin services to SMSFs or AFSL services but not both. So much for accountants getting more involved in the AFSL advice industry in future.