Financial advisers brace for regulatory crackdown

Most clients don’t understand the compounding effect of a percentage asset-based fee.

It’s hard to see how asset-based fees and brokerage commissions can survive the new ethics regime for financial advisers that kicked off on January 1.

It’s early days and the grim reaper of government regulation scythes but slowly through the paddocks of vested interests and conflicts, and stray heads of wheat are sometimes left standing, protected by powerful lobbies.

But a few things have been done that will be difficult to undo.

In response to the Hayne royal commission, the government has created the Financial Adviser Standards and Ethics Authority, which has in turn issued a code of ethics with 12 standards covering ethical behaviour, client care, quality process and professional commitment, which apply from January 1 this year.

Standard 3, under ethical behaviour says: “You must not advise, refer or act in any other manner where you have a conflict of interest or duty”.

The guidance note for standard 3 says: “You will breach standard 3 if a disinterested person, in possession of all the facts, might reasonably conclude that the form of variable income (eg 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 the code.

“You will also breach standard 3 in the case where you provide financial advice to invest in a retail product or service from which you benefit and where a reasonable assessment of the circumstances of the client would conclude that the best course of action would be that there should be no change to the client’s circumstances or plan.”

So … a reasonable person might reasonably conclude that the income could – not would, mind, but could – induce an adviser to act in a manner inconsistent with the best interests of the client. That is a low bar, or at least it is open to those enforcing the code for it to be a low bar.

Note also that the guidance specifically mentions brokerage and asset-based fees, as well as commissions, which are banned under the FoFA legislation.

In fact, if standard 3 of the code of ethics was only about stopping commissions, there would be no point to it, since that has already happened. So we can only conclude that on the subject of advisers’ incomes, the FASEA code of ethics represents an attack on brokerage and asset-based fees.

This is potentially momentous because in 2014 the Coalition government strangely created an exemption from the ban on commissions for products that are floated on the ASX – listed investment companies and trusts.

That has led to a flood of LICs and LITs, as fund managers have taken advantage of the loophole so they can effectively pay advisers a commission in the form of brokerage and therefore induce them to flog their products.

These commissions are typically between 1.5 and 3 per cent and have been a huge source of income for advisers: it’s been reported that $250 million of these payments was handed over by fund managers in 2019 alone.

If FASEA does not intend the code of ethics to close this loophole, then why mention brokerage as an example of a breach of standard 3?

As for asset-based fees, most financial advisers charge a percentage of “funds under advice” (FUA), rather than dollars per hour like accountants and lawyers.

It’s usually somewhere between 0.5 and 1 per cent and adds to the percentage investment fees charged by fund managers and the percentage administration fees charged by the platform operators, and the percentage custodian fees charged by the custodians, so that upwards of two percentage points or more can be lopped off the client’s annual return.

There are two problems with this: most clients don’t understand the compounding effect of a percentage asset-based fee, and it induces an adviser to induce a client to invest, even if it’s not in his or her best interests to do so.

Here’s how the compounding works. A client has $1 million and agrees to pay the various helpers a total of 2 per cent, or $20,000. It’s a fair bit, but you get what you pay for right? He or she probably thinks that’s going to be the fee each year. Wrong.

Assuming $1 million grows by 8.4 per cent a year (the total compound annual return of the ASX200 over the past 10 years), that $20,000 fee becomes $21,680 next year and so on. In year 10, it’s $41,332. Over 10 years the fees deducted total $295,293, almost 50 per cent more than simply 10 times $20,000.

The second problem – the potential for conflict - is what the guidance note for standard 3 is getting at: it’s telling advisers they will be in breach if they advise a client to invest in a product – any product, even there is no commission or other inducement – if a “reasonable assessment” of the client’s circumstances suggests that they shouldn’t do anything.

It will come down to who is going to enforce the code of ethics, and how, and we don’t know either of those things yet.

Treasurer Josh Frydenberg and Assistant Minister for Superannuation, Financial Services and Financial Technology Jane Hume said in a press release in October that “a new disciplinary system and single disciplinary body for financial advisers” would be established, as recommended by Hayne.

“The government will work towards establishing the new body in early 2021…”

This blinding speed from the government that actually inserted the brokerage loophole and tried to repeal the ban on commissions, but was stopped by the Senate.

But things have changed since then and the financial services industry is no longer getting the lobbying traction as it used to.

So we’ll see how the new disciplinary body enforces standard 3, but it’s hard to see brokerage for advisers and asset-based fees surviving far into 2021 if it’s properly enforced.

* Alan Kohler is Editor in Chief of InvestSMART.com.au