Why the sophisticated investor scheme is a shambles

The status is meant to offer exclusive access to special investments but is clearly abused by both investors and their advisers. It’s time to fix it.

A call to remove the family home as an asset that can be counted towards “sophisticated investor” status is common to many submissions.

The shambles that is the “sophisticated investor” scheme is being rapidly revealed, as key stakeholders in the finance industry move to lobby the forthcoming Quality of Advice review.

It is now clear this status – granted to those with either $2.5m in assets or $250,000 per annum income – is antiquated, loosely regulated and abused by both adviser and investors.

The status grants investors access to the potentially lucrative wholesale market – where there are wider opportunities but less consumer protection. However, it has become a free for all which has now drifted very far from its original intention.

The original concept was created in 2001 as a way for top private investors to operate as equals at the institutional end of the market.

This week the Self Managed Super Funds Association has waded into the debate, suggesting the current rules are ambiguous. “There are several areas where the rules are not clear and the whole regime needs a total review,” says Tracey Scothbrook, the policy manager at the SMSFA.

Scothbrook points out that laws governing SMSFs, such as the permanent “retail” status of superannuation products, openly contradict sophisticated investor conditions: A trustee might count their SMSF funds to gain qualification, but then pre-existing laws ensure that key superannuation products – such as rollovers – are always regarded as retail products.

Critics suggest the ability of an investor to cobble together assets such as SMSF funds – or even the family home – to qualify for sophisticated status makes a joke of the notion that it relates to “investable assets” – the family home invariably must be retained for accommodation, the SMSF must be able to provide retirement income.

The essential problem with the sophisticated investor regime is that it has not been reviewed or updated in more than two decades.

Moreover, the criteria is strictly quantitative (or based on dollar values), with no need for understanding or genuine “sophistication” on behalf of investors.

Sophisticated investor status can be granted through an accountant’s certificate to any investor – there is no formal application to any other authority.

After a string of failures and losses among sophisticated investors in recent times, the regime is now sufficiently bloated that an absurd 3 million Australians qualify for the status. When it was launched in 2001, it was expected only a niche group of investors would qualify.

While there is an ongoing concerns that investors may be misled into losing consumer protections, Scothbrook says there is also a growing problem of financial advisers seeking to “alleviate regulatory burden” when their clients apply for the status.

“We know from a flood in the number of inquiries around sophisticated investor certificates the issue is now demanding attention,” she suggests.

One clear danger from the enlargement of the area is that the best advisers are being tempted to make their client books “sophisticated only” – at a stroke this change greatly reduces the amount of paperwork, disclosure and risk faced by an ever shrinking population of advisers. In 2018 there were 28,000 financial advisers in Australia, today there are less than 17,000 – a 40 per cent reduction.

Whether the forthcoming Quality of Advice review – to be handed down in December by lawyer Michelle Levy – will present a solution remains unclear.

Though it is very clear the industry is hoping for a breakthrough, with a range of potential solutions being put forward across the industry.

Among the proposals is a suggestion from prominent fund manager Geoff Wilson, which recommends a financial knowledge test for applicants. However, considering the furore over recent knowledge tests for advisers this is unlikely to be taken up.

More commonly, key stakeholders just want to make the financial criteria more exclusive – the removal of the family home as an asset that can be counted is common to many submissions. Virtually all submissions also recommend the criteria be indexed in common with tax and pension thresholds.

The Financial Planning Associations – chaired by adviser Marisa Broome – says the criteria should correspond with the transfer balance cap ($1.7m) but the annual income should be lifted to $350,000. (Under present rules the income criteria must be achieved for two years in a row.)

Meanwhile the Financial Services Council has come in very strongly and suggested the entry level asset test should be lifted to $5m.