Another Decade, another financial crisis - but this time it's different

This short reflection on the aftermath of the ’87 crash is for those who are navigating the current financial turmoil.

When any historical event is compared to another, there are more things different than there are similar. As one of my teachers shared with me late one night over a cask of cheap red, there is one characteristic shared by futurologists and historians: one predicts the future and the other predicts the past.

It was just over 21 years ago that I found myself sitting in the melting maelstrom that was the ’87 stock market crash. I was in my mid-30s and had spent the previous five years developing an understanding of the new superannuation rules and training planners on how to best manage the regulatory opportunities that followed.

As luck would have it, the company that employed me was very short of staff, so I had the opportunity to pursue my interests in a number of areas I really had little right to play in. I wrote and delivered several financial planning training courses, and in the balance of my time designed investment, super, insurance and retirement products for the fast growing world of independent financial planners. Unencumbered by a long industry history but filled with optimism, I had an excellent vantage point to view the waves buffeting the industry.

For those of us making decisions on how we do business in the future, I believe there are three issues from the ’87 crash that we can learn from.

Remuneration model couldn’t support planners’ businesses

Post the ’87 crash, planner-focused businesses initiated the first master funds, which were the fundamental weapons in the destruction of the prevailing institutional product and pricing hegemony. While on the face of it these funds were simply an application of new technology to reduce the number and cost of owner registrations, they effectively transferred pricing power and income splits to financial advisory groups. In essence, planners were able to decide what they wanted to sell and at what price.

The movement from upfront to ongoing commissions that commenced in the mid-80s was given a real kick along by the introduction of master funds.

Up until the ’80s, product manufacturers had been the dominant players in the financial services marketplace.

In essence, they decided on both the price to customers and the revenue to distributors.

The sale of risky investments was rewarded with high initial commissions; there were no trails.

The harder it was to sell something, the higher the initial commission. The product manufacturer took all of the risks and all of the benefits associated with retention. Consequently, planners simply could not afford to run their businesses when new clients became scarce, which always happens after significant market corrections. This was the necessary precondition for master funds to flourish.

Similarly, in the current environment, I suspect with declining asset values and lower new business flows, the inherent inefficiencies and cross subsidies of percentage-based fees will be more visible. Many planners and planning groups will have to revisit their fee structures to stay in business. Fixed fees, hourly fees and percentage fees will need to be integrated into a new pricing model.

Managed funds difficult for planners to manage then and now

Planners found it difficult to manage the switches and redemptions that followed the ’87 crash as investors sought to rapidly realign their investment portfolios.

Advisers fairly readily accepted that master funds, with their easy promise of simple one-stop registrations and switches, were a more practical platform to run a business.

Similar preconditions exist now for the switch away from trusts to direct investments and separately managed accounts (SMAs), as well as from wraps to multi-manager SMAs.

The trust structure has always been a flawed vehicle for investors, not helped by the double taxation treatment the Australian tax system imposes on them. When there were no alternatives, it was a reasonable risk to take. Now that we have seen some trusts freeze somewhat publicly and others disgorge taxable profits even though the unit price has reduced 10, 20, or 30-plus per cent, there will be a greater reluctance by both advisers and investors to use them if a viable substitute is available.

Similarly, the attraction of multi-manager SMAs, where several fund managers with differing approaches to the market run consolidated portfolios for the direct benefit of their customers, now look to be very attractive compared to wraps. Not only do they promise more control, both planner and client can see what is happening in the underlying stocks and intervene if necessary. There are also the saved taxes and fees created by pooling.

One of the major differences between ’87 and the current environment is the number of self-directing customers. Infinitely more questioning than his or her delegating parents, the challenge will be to further develop services that this highly influential group values and is willing to pay for.

In ’87 there was no do-it-yourself market of any significance; it now represents something in the order of one-third of super moneys.

I suspect the long-awaited shift to SMAs will now start as high-end financial planners see they are a viable way of distancing themselves from the problems of the 2008 market.

The question, ‘Who is the client: me or my money?’ is still being resolved

Post ’87 investments moved strongly into the property market, which was moving through a different valuation cycle and still held out promise of further growth. By 1990, the property market was also in decline and a number of geared unlisted property funds froze redemptions.

Rather than sell the underlying properties into an unsympathetic market, many managers listed their funds to provide unit holder liquidity. Values were severely punished as the market heavily discounted the second and third-rate investments in those funds.

One of the questions raised then was that of the role of financial planners in the period just prior to the freeze. It was argued that many had acted to protect the funds rather than look after their customers. There was pressure exerted by property managers on planners not to redeem prior to the freeze to which many succumbed. Eventually, clients paid the price. This has a strong parallel now, as industry funds actively discourage their members from receiving independent advice.

I am not a conspiracy theorist, but it seems implausible that planner bashing has escalated just as industry funds are most vulnerable to mass switching and redemptions. The most likely agents for a recommendation to switch out of overvalued assets are, of course, financial planners.

I suspect there are significant assets not yet valued at market prices in the industry funds’ very large default portfolios. I would assume many trustees are struggling with real valuations and are not comfortable marking to market. An industry fund’s primary goal is its own survival. That is not to say they do not have a general interest in the wellbeing of their members and their satisfaction as clients, but the trustee’s role is not to provide a fiduciary service to members.

The financial planning community and industry funds have much in common here. They both wrestle with the challenge of putting the client first.

I firmly believe the best way forward — if planners wish to maximise their relevance, efficiencies and commercial impact — is the collaborative path. Planners can provide an environment where they can collaboratively help their clients prioritise their life goals, how, what and when they plan to spend and, particularly, how much financial risk they choose to take on. Clients want both choices and, I would argue, have a growing preference for fiduciary services.

This is quite different to the behaviour of industry funds, which clearly know what is best for their clients. Their default funds are generally more exposed to risky assets than most members would have selected for themselves.

This is somewhat ironic in that many industry fund members are unlikely to receive significant material benefit from the extra risk that has been delivered to them. Many have relatively small balances and while the benefits in nominal terms are probably higher by having a fuller exposure to risky assets, in material terms the outcome is not likely to have a significant impact on their spending in retirement.

One wonders how many members are comfortable with the volatility industry fund paternalism subjects them to when relevant personal advice would illustrate that they could achieve their goals with relatively minor lifestyle changes without such levels of risk. The industry funds’ emphasis on performance and fees is simplistic; in some cases it’s clearly misinformation designed to scare members away from financial advisers and financial advice.

One of the reasons older members move so readily away from low-cost industry funds despite their palpably and strongly advertised superior investment performance is that industry funds have not yet developed an alternative choice that suits their members.

Change is in the air

The financial services industry is rarely capable of anything more than incremental change in normal circumstances. However, when external forces exert themselves, survival instincts come to the fore and significant alterations can occur quite quickly.

The world is too complicated to be reduced to the aphorism that history repeats itself. At the other extreme, it is only a fool who would argue there are no lessons to be gained from history. We do alter behaviour when the old behaviour no longer rewards us appropriately. There is everything to suggest there will be many changes to our industry in the months and years ahead.

Paul Resnik is a financial services industry commentator, critic and activist. Contact him at [email protected]