How financial advice regulators are missing the mark

Regulators perpetually struggle to create a healthy environment for the provision of financial advice, however, Robert Keavney identifies several areas where they have missed the mark.

October saw the 70th anniversary of John Lennon’s birth. Lennon wrote that “every day in every way it is getting better and better.” To judge by developments in Australian financial services, he was exaggerating.

Of course, in many respects our industry has progressed. However, this article explores three areas where change has not occurred or where it has been retrograde. How did we travel so far to get back to here?

The history of Australian financial ‘advice’ has its roots in tied sales forces. From the 1960s to the start of the 1980s, Australian Fixed Trusts (AFT) dominated the managed funds industry to an extent that has never been repeated. It relied overwhelmingly on a network of tied agents and direct marketing.

According to the FCA’s Fifty Years of Managed Funds in Australia, AFT direct mailed every name in the phone book of every capital city, biannually.

The major life offices, notably AMP and National Mutual, also distributed their products, mainly through a large tied agents system.

Stockbrokers were the only significant source of non-tied investment advice, though a handful of pioneers of independent financial advice had emerged by the early 1980s.

Over the next three decades the influence of financial planners grew continuously, at the expense of the tied sales forces of institutions.

This reflected the desire of investors to obtain advice directed to their own interests. While it must be acknowledged that there have been cases where advice was biased by the planners’ interests, the trend towards ever more impartial advice seemed unstoppable.

The banning of commission has been a fundamental advance in this direction.

However, it was accompanied by a development that was a significant setback in the trend to client-focused advice.

The expanding of intra-fund advice has created conditions for a resurgence of tied (ie, biased) advice.

And one step back

The regulators have tried to create rules to prevent intra-fund advice from becoming a sales process, but history is against them. For many years the rules governing financial advice have required it to be in the interests of clients.

Accordingly, all advisers purported that their recommendations were appropriate to the needs of clients. Much was genuinely client focused, but in other cases this was a masquerade.

Consequently, the authorities decided it was necessary to ban commissions.

The lesson from this is that merely requiring appropriate behaviour will not be effective where there are financial incentives encouraging other behaviour. Why will it be different for intra-fund advice?

The institutions that employ intra-fund advisers have a financial interest in that advice resulting in fund members retaining their holding in the institutions’ products or perhaps adding to them.

This will inevitably bias the process in many institutions, though of course under the masquerade that there is no selling involved.

Some of these institutions are the same banks whose employees complain they are pressured into selling products that are inappropriate for clients.

At some point in the future there will be calls to review the intra-fund advice process, to make it more client focused. This is always required, sooner or later, with tied advice.

Sponsorship

There is one widespread form of payment from institutions to dealer groups that has failed to attract the scrutiny it warrants: sponsorship of conferences.

Conferences offer a benefit to dealers and advisers. They serve multiple purposes including rewarding qualifying advisers and providing an off-site environment to address business issues. They are a mainstream cost of business for dealers.

Many dealers’ conferences are sponsored by fund managers. There will be a broad range in the scale of this sponsorship.

At the upper end the sums are substantial, reported to be as high as $40,000 for an hour presentation. The purpose of these presentations is sometimes described as adviser education.

To put this is in context, $40,000 of fees would buy a lot more than one hour’s education at the finest universities in the world.

Further, there are businesses that offer a panel of expert or celebrity speakers on a range of topics.

For example, the Australian Speakers Bureau offers speakers in a number of price ranges, the highest of which is “$20,000 plus”. Most of the individuals in this category are significant international celebrities.

Using these as comparisons, it seems reasonable to conclude that the education provided at these conferences is among the most expensive in the world.

However, the striking thing is that those being educated at the conferences aren’t paying for the service, rather fund managers are paying $40,000 per hour for the right to provide education.

And, coincidentally, they have a product which planners use.

I hope I don’t seem too much of a sceptic to suggest that there might be more than education involved when such sums change hands.

It might seem that dealers are selling fund managers access to their advisers, however, I think this would be rare. Few fund managers would be willing to pay this sort of money unless there was a clear likelihood of inflow.

Only managers who were already supported by the dealer would see merit in spending so much.

This, I think, brings us nearer to the heart of the matter in most cases. Many fund managers see this as part of the price of doing business with dealers.

They pay because they feel it might affect the relationship (ie, the future inflow) if they don’t.

Why else would they give large amounts of money away, if they did not feel it would protect or grow their business?

I first became aware of this as an issue at a function where the chief executive of a fund manager commented to me that “this is a great industry, the only thing I don’t like are the constant requests by planners for money. It feels like extortion”.

Following this conversation in the mid 1990s, the dealership I ran adopted a policy of never seeking or accepting such funds from product providers.

Sponsorship is not a form of commission in that it is not strictly volume based. However, there will usually be a relationship between the order of magnitude of funds placed and the amount managers are willing to pay.

An institution that receives, say, $100 million of annual inflow may feel justified to pay $20,000 to the dealer (with or without the right to present at a conference), whereas one that receives only $5 million would not.

In this sense, sponsorship rewards dealers for delivering funds under management. Whether a sum is described as ‘sponsorship’ or as a gratuitous payment makes no difference, it still goes to the bottom line of the dealer.

This practice should be addressed under Future of Financial Advice.

I should make clear that I believe the situation is different for sponsorship paid to associations like the Association of Financial Advisers or the Financial Planning Association.

These associations do not give advice and cannot influence advice given to clients. In no way can these payments be considered a reward or incentive for product recommendations.

I’ll close this topic with one anecdote from a fund manager business development manager (BDM).

She reported being at an industry event and having some drinks one evening with the BDM of another manager and a small group of advisers, none of whom supported the funds of either manager present. One of the advisers asked: “Which of you two managers is buying the drinks?”

Of course, there are many financial advisers who would never show such discourtesy, but there is a portion of planners who routinely seek freebies. This is inconsistent with the professionalism the industry is moving towards.

Separation of powers

In 1998, towards the end of an extended period of healthy markets when — as always happens at such times — any awareness that things could go wrong had evaporated, trustees were removed from managed funds.

Prior to this, managed funds had both a manager and a trustee whose duties included holding the assets and protecting the interests of clients.

There were two main arguments for eliminating trustees: they added a small cost and they had not prevented the collapses of Aust Wide and Estate Mortgage.

It was a flawed argument to claim that several collapsed investment schemes were evidence that the structure of managed funds needed to be changed. Many investment schemes have collapsed in recent years — more than at any time in the previous several decades.

Does this prove the current system is worse than the one it replaced? It is impossible to prevent all investment collapses under any structure.

In any case, The Aust Wide and Estate Mortgage collapses arose as a result of decisions made by the managers, not the trustees. It was a strange conclusion that this justified removing a layer of scrutiny of managers.

There is an obvious problem with the current arrangements. When there is only one entity responsible for a fund, it can face conflicts of interest. For example, many funds were frozen during the financial crisis.

One of the options facing such funds was to wind up and distribute the assets.

Winding up a fund terminates a revenue stream for the manager. In contrast, if the fund is frozen it locks in the revenue stream.

Product providers rarely favour terminating a fund, but they have a financial bias in making this decision. The situation is similar in regard to proposals to replace a manager.

I recall a proxy battle for control of a fund almost two decades ago. The manager was legally required to provide a copy of the unit-holder list to the aggressor party.

They complied, by typing the list in red font on shiny red paper, photocopying it and providing the illegible copy.

This illustrates how far some organisations are prepared to stretch the rules to preserve funds under management.

ortunately, at that time, funds had trustees and a unit-holder meeting was duly called by the trustee.

While I am not calling for a return to exactly the same system as operated earlier, when a manager has a conflict of interest, having a second party with the power to call unit-holder meetings to consider important matters is beneficial to investors.

This is not present under the existing structure.

Robert Keavney is an industry commentator.