The impact of financial services reform on superannuation and SMSFs

Philip La Greca examines the possible impact that the outcomes of the forthcoming government reviews will have on superannuation and, in particular, SMSFs.

The industry is in the middle of a new round of reviews and reflections about whether the system for retirement savings needs to be overhauled in relation to the tax concessions, the way that superannuation funds operate and behave as well as the role of advisers and any distortions that occur in the delivery of advice.

To that end, there are three significant reviews, namely:

• the Joint Parliamentary Committee on Corporations and Financial Services (Rippoll Inquiry) considering financial products and services and the roles of financial advisers, commission arrangements, licensing and marketing in the recent product and service provider collapses, which reported on November 23, 2009;
• the Australian Future Tax System Review Panel (Henry Review) undertaking a comprehensive review of Australia's tax system to create a tax structure that will position Australia to deal with the demographic, social, economic and environmental challenges of the 21st century and enhance Australia's economic and social outcomes; and
• the Superannuation System Review (Cooper Review) examining and analysing the current superannuation framework for improvements in the areas of governance, efficiency, operation and structures in three phases, with the first preliminary report released on December 14, 2009. The final issues paper on structure and self-managed superannuation funds (SMSFs) was also released on this date, with the other reports due for release in March-April 2010 and April-May 2010.

This article aims to look at the potential outcomes of these reviews and how they will affect superannuation and, in particular, SMSFs.

Ripoll Inquiry

The Rippoll Committee has handed down its report and made 11 recommendations for the Federal Government to consider in addressing some of the deficiencies it believes has led to inappropriate behaviour and conflicted practices in the financial advice industry.

The report has made clear that payments which cause conflicts of interest are to be ceased. This will cover commissions, volume overrides and marketing allowances. Presumably, the Cooper Review will tackle it from the other side and prevent funds charging shelf space fees and badging fees.

The decision to stop these payments is in fact the easy part. The hard part is how to do this without disruption to advice being given as clients move to a transparent, non-subsidised, user-pays system.

Of course, this will only work if all superannuation funds permit the deduction of advice fees on request from the client irrespective of whom their adviser is.

Without this type of payment mechanism we will have a situation where only clients with sufficient cash to write a personal cheque for advice will be able to afford fee-for-service advice.

The other consequence of this will be a shift from a retainer structure where access is available when needed to a transactional structure where every time a client wants to know something or asks a question they will be charged.

An unintended consequence of this removal of commissions could be that all insurance products will be forced into superannuation where there is money to cover both the premiums and advice, and this will have significant impacts on the adequacy of retirement benefits, particularly if only the SG contribution level is maintained.

In relation to the proposal to make advice costs tax deductible, this has been left to the Henry Review on taxation, but Treasury’s argument that the cost will be too high can be mitigated to some extent if you consider that commissions built into managements fees are currently deductible.

And with these being phased out, the introduction of a tax break on advice fees (which can be done as a tax offset if the plan is to fix the amount of tax relief) may still produce a near neutral revenue result for the Government.

A proposal to create a professional standards board will move the design and structure of education, competency and designations from the Australian Securities and Investments Commission’s (ASIC’s) jurisdiction to an independent industry body.

In effect, the proposed standards board will shoulder the process of setting the different levels of education required for a ‘full’ financial planner, an ‘affiliated planner’ or a ‘product adviser’.

This also includes the designation provided to the client along with the explanation of the differences between these types of advisers.

Thus the problem of people only providing product recommendation or being tied to a particular product manufacturer is solved and the consumer knows the restrictions that may apply in regards to the person who is providing advice.

It will also permit the specialisation of advice through targeted education and competency envisaged by RG 146 but not taken up by the use of lowest common denominator training rather than true specialisation.

Obvious areas for this are SMSFs, estate planning and social security. It will possibly lead to the removal of the accountancy carve outs on advice as it is possible that competency rather than licensing will be the focus.

The formation of the professional standards board will allow ASIC to focus on ensuring licensees and advisers meet their obligations.

This theoretically means that more pre-emptive action can be undertaken by ASIC to ensure the advice given is in the client’s best interest and has proper disclosure of the type of advice they can provide as well as any limitations.

This should fit neatly with the expanded powers to be given to ASIC, which will allow it to take action due to concerns over business processes or behaviour rather than having to wait for a client to be adversely affected before they can act.

Henry Review

The main thrust of this review seems to be one of equity in relation to access to options and the value of the tax concessions. The two main areas under attack are the concept of salary sacrifice and the impact of the progressive tax scale on the value of the deduction.

The interim report with the 2009 Federal Budget raised the spectre of vertical equity and that super may not be seen as a universal savings mechanism but more of an incentivised targeted savings structure.

Possible changes are restriction of employer contributions to 9 per cent by banning salary sacrifice coupled with the removal of the 10 per cent requirement for personal deductible contributions.

This solves the salary sacrifice issues (eg, as salary sacrifice is not available to all employees and is being used by some employers to reduce their SG obligations) as every individual will be able to make personal contributions that receive tax concessions rather than access being dependant on employer policies.

This allows the removal of the SG from the contributions caps (simpler) and means you can have a single personal contribution cap of say $200,000 per year or $600,000 with the bring forward rule, and within that amount a maximum of $50,000 per year can receive tax concessions.

The tax concessions themselves may be changed to a tax offset (rebate) rather than a deduction, that way every dollar gets the same amount of tax break irrespective of the person making it.

From a targeting approach, it seems that the best way to do this is via a tax offset in the order of 25 per cent to 30 per cent.

Doing this means concessions are given to the lower tax brackets as a higher incentive; if you used the 25 per cent rate it may even be possible to remove the 15 per cent contribution tax.

This will then lead to simpler fund administration as virtually all contributions will form a tax-free component, and this will reduce the concern about death benefit taxes because the only source of taxable component will be accumulated earnings in the benefit.

There may also be some movement on the pension drawdown rates between preservation age and age preservation.

It will not be surprising to see the introduction of an upper cap for pension draw down levels prior to age pension age as this will reduce the diminution of balances before that age.

Along with this, we may get a change so that the tax-free status of lump sums moves to age pension age rather than age 60.

The final aspect from the Henry Review will be the possibility that earnings tax may apply to pension assets.

This may be done on the basis of a fiscal argument that the hole in the Government’s revenue will continually increase as more super fund assets are used to support pensions and therefore the tax on earnings will reduce.

Based on the current size of the super pool ($1 trillion), every $100 billion that switches to pension phase may cost the Government up to $1 billion of revenue per year.

The arguments for this will also focus on the simplification to the system it will bring by reducing the complexity of administration, as the need to segregate assets for pension and determine which expenses are deductible or in what proportion they are deductible will disappear.

We will then have a system that will fundamentally have no taxes on money going into super as contributions, no taxes on benefits paid from super and a concessional tax rate on the earnings of the investments.

These changes will have some effect on the attractiveness of super, but overall it will still maintain a regime where incentives are given to both capital and earnings as well as adding some simplification to the system.

Cooper Review

This review will have its third report specifically deal with SMSFs, but changes that arise from some of the other sections will also have major repercussions for the SMSF sector.

Cost reduction is a major concern and part of the focus is on whether or not some superannuation funds are economically viable and whether there should be mergers of funds to enable better economies of scale and increased bargaining power in the arrangements.

If retail and industry funds get substantially larger but the overall number of super funds falls, differentiation between funds will become less discernable and to help reduce costs certain investment activities may be taken ‘in house’.

This may result in each fund having their own diversified investment suite of conservative, balanced, growth and high-growth options, but no other options in these categories.

As funds become larger, additional services will become part of the differentiators and this may lead to an increase in the number of super fund employed advisers and the amount of limited intra-fund advice provided to members.

One of the key points being examined seems to be choice of investment options for the sake of choice. This has led to increased costs with very little benefit. It is expected that superannuation funds will split into three dominant types:

• ‘vanilla’ funds that offer a single diversified investment option;
• sophisticated funds that have a larger menu of options, but the client will need adviser sign off given to the trustee for an investment strategy; and
• SMSFs that are fully customised as the trustee and member will be the same.

As a consequence of this, it is possible the Cooper Review will require super participants who wish to invest in choices other than ‘vanilla’ diversified options to either seek advice or confirm they have an understanding of the investment matters that is greater than the ‘normal’ retail client.

In effect, this will mean creating a class of investors that sits somewhere between retail and sophisticated investors.

For SMSFs there will be a range of aspects to be addressed, starting with the appropriateness and competency of the participants.

This will commence with the question of whether trustees need to have mandatory training or need to show a level of investment sophistication as previously discussed. It will almost certainly mean that the advice givers in this sector will need mandatory competency levels, and this most likely will be regulated by ASIC.

If one considers the recent requirements imposed to cover margin lending at both the licensee level and adviser level, it will be hard to argue that similar conditions not apply to SMSF advice.

As a consequence of this, the current accountant ‘carve out’ from needing an Australian Financial Services Licence (AFSL) will need to be adjusted to ensure that the accountant has adequate knowledge, even if they are not under an AFSL.

Other participants in the sector will also come under scrutiny, with enhanced obligations for SMSF auditors, and it will not be surprising to see some form of registration of other key service providers such as administrators.

One other issue to be addressed is a lack of sector information, which means the Government and regulators are often making policy without sufficient facts.

It is expected that increased reporting will be required of SMSF trustees to address this issue.

Some obvious areas for this type of enhancement include quantifiable asset allocation as measured against the SMSF’s investment strategy and a standardised formula for the calculation of the rate of return by the SMSF so it can be compared to other superannuation fund performance.

There is no doubt these types of changes may drive up the costs of SMSFs, which will mean some SMSFs may need to consider whether they are viable, but ultimately these changes will increase the requirement to professionalise the industry participants supporting this sector.

The outcomes of these reviews in the first half of 2010 together with a potential Federal election will make this year one where the financial services industry will be under scrutiny for its reactions, only this time it will not hopefully relate to issues surrounding investment performance.

Philip La Greca is technical services director at Multiport.