Fugu, or pufferfish, is one of the most celebrated delicacies in Japanese cuisine.
Prepared by expert chefs and served in paper-thin slices, fugu juxtaposes luxury with a high-stakes gamble because, if prepared incorrectly, the tetrodotoxin contained in fugu may cause paralysis, asphyxiation and death.
One can draw an analogy between an expert fugu chef and a financial planner giving gearing advice. If prepared and executed well, a gearing strategy can be very rewarding. If prepared poorly, the outcome can be catastrophic.
The risks don’t just lie with the diner or the financial planning client. It also lies with the chef and financial adviser.
Advisers should be aware of the potential liabilities to themselves and their business if their gearing advice goes wrong.
Before recommending a margin loan product, advisers should consider aspects of the client’s situation that could be impacted by the recommendation. This forms part of the assessment they are required to undertake as part of meeting the best interests’ obligations. Some key considerations include a client’s cashflow and liquidity; income and tax; and investment objective and investment horizon.
As a general rule of thumb, a client should be able to demonstrate in a detailed budget that they have the positive cashflow to service the margin loan and that they have the funds to meet at least three months of their debt repayments. Many licensees also impose a stress test that the client’s cashflow should be able to withstand a 2-3 per cent rise in interest rates.
It is also industry practice that the client’s marginal tax rate should be 30 per cent or higher in order to be considered suitable for a margin loan. Prima facie, retail clients who are not employed on a permanent basis are unlikely to be suitable given the uncertain nature of their employment arrangement.
Further, consideration should be given to the client’s investment horizon. For example, a margin loan may not be suitable for a retiree who may have a shorter investment horizon. Similarly, a couple looking to start a family or purchase (or renovate) a home may also not be suited to margin loans given the potential risks of loss of capital.
Insurance arrangements should also be investigated. If a margin loan is considered to be suitable for the client, it is standard industry practice to ensure that income protection insurance (over the period that matches the margin loan) is obtained.
In looking at some of FOS’s determinations relating to gearing to date, the following observations can be made:
- If the investor had little or no ability to resource the loan facility, aside from investment proceeds, it would be difficult to establish that the recommendation was suitable.
- If the adviser’s recommendations could only be achieved through the use of gearing and were in conflict with the investor’s investment objectives and risk profile, it would be difficult to establish that the recommendation was reasonable.
- If the loan was secured over an investor’s primary residence with few other liquid assets in the investor’s portfolio, it would be difficult to establish that the recommendation was reasonable; and
- If the recommendation to enter into a gearing strategy was based on general or limited advice, it would be difficult to establish that the facility was appropriately entered into.
In forming its views, some important factors that FOS may turn its attention to include:
- What type of investor was involved? Was he/she an aggressive/growth-oriented investor or conservative investor? Consistent with industry’s view, gearing is in general a strategy for high-income earners who have a reasonable period of their working life remaining and have a suitable tolerance for risk.
- Did the investor have any prior experience with a gearing strategy or margin lending?
- What was the extent of the investor’s existing debt liabilities prior to adopting the gearing strategy?
- Was there double gearing? Had geared securities been provided by the investor as collateral for further lending?
- Did the strategy rely upon dividends to service the borrowing costs? Had the adviser discussed the history of dividend payments and stability of company earnings with the investor?
- Were potential tax deductions being used to finance the loan repayments?
- Had the adviser explained to the investor the nature of the loan to valuation ratio (LVR) and its potential impact on the investor if the value of the investor’s portfolio reduced in value?
- Had the adviser explained any clause of the finance contract relating to the effects of a suspension of trading in a stock?
For the reasons above, the fugu chefs of the financial planning industry must regularly refresh their gearing policy.
