Why FOFA's annual renewal requirement increases risk for investors

Paul Barrett commends the Future of Financial Advice recommendations, but warns that the annual renewal requirement will create more risk for investors.

Colonial First State (CFS) commends the Minister for Financial Services, Superannuation and Corporate Law, Chris Bowen, on the recommendations made in The Future of Financial Advice paper.

As a financial services organisation, we are committed to working with the Government to accelerate improvement of professionalism.

The reforms outlined in The Future of Financial Advice paper are designed to improve the quality of advice, strengthen investor protection and underpin trust and confidence in the financial planning industry. Substantial changes have been proposed in order to achieve these goals.

Specifically, the changes include:

• a ban on commission and any form of payment relating to volume or sales targets;
• a requirement for advisers to negotiate their fees directly with clients and disclose the charging structure in a clear manner, including as far as practicable, total adviser charges payable, expressed in dollar terms; and
• the introduction of a statutory fiduciary obligation requiring advisers to act in the best interests of their clients and to place the client’s interests ahead of their own when providing advice to a retail client.

Importantly, both the Financial Planning Association and the Investment and Financial Services Association (ISFA) have recently released standards for members with respect to remuneration.

The Government reforms described above, when viewed together with these industry standards, are significant controls that ensure clients of financial planners will be aware of, and can negotiate, the fees they pay for advice.

The Government has also recommended that “if an adviser is to provide an ongoing service, the adviser must send an annual renewal notice to the client. If the client does not renew the services, the adviser cannot continue to charge the client.”

Investor protection

We are concerned that reforms that are designed to increase investor protection could be compromised if the negotiation of longer-term advice relationships is made more difficult.

The recommendation that clients must renew their advice on an annual basis shifts the risks associated with a changing environment to the investor.

Some of the benefits of financial planning are immediate, but the majority are realised over the longer term.

Constant changes in personal circumstances, attitudes, markets and legislation can drive the necessity for ongoing contact and review.

The best decisions are made with advice from those with a thorough understanding of the client’s needs and circumstances.

Investors who do not annually choose to access ongoing advice will have little recourse to licensees in the event of loss when circumstances change.

The impact of this recommendation is similar to the decision of some employers to move from defined benefit superannuation schemes to defined contribution schemes.

In the latter case, the level of retirement savings — and consequently the standard of living in retirement — became dependent on an individual’s contribution levels, the use of the Government concession, asset allocation and asset selection decisions.

The financial risks of retirement were passed to individuals. That being the case, an ongoing advice relationship that can be facilitated in a practical way should be encouraged.

There has also been some commentary comparing ongoing financial advice to general insurance renewals. If consumers are required to annually renew an insurance premium, why should advice be different?

There is, however, an important difference. If consumers cease paying premiums, the insurance cover ceases. If advice ceases, investments remain in place, while the strategy of the client is frozen. The onus, and the risk, then falls solely on the client.

Long-term advice and macroeconomic issues

The Government emphasises that longer-term challenges such as the ageing of the population, as well as recent events such as the global financial crisis, underscore the need for quality advice.

Part of the problem of an ageing population is the growing risk that Australians will exhaust their assets before they die. IFSA and Rice Warner recently investigated the problem by quantifying the retirement savings gap.

Their research concluded that, despite the gap being partly closed by the age pension, there was a deficit of $695 billion in 2008. When the research did not allow for the age pension, the gap was $1,579 billion in 2008, up from $823 billion in 2004.

The 2010 Intergenerational Report also addresses some of the consequences of an ageing population. It proposes that the ageing of the population will significantly increase spending pressure in the areas of health, age-related pensions and aged care.

It states that: “Currently, more than a quarter of Australian government spending is directed to health, age-related pensions and aged care. Australian government spending on these areas is projected to increase significantly, pushing their share of total spending to almost half by 2049-50.”

As identified earlier, the financial risk of retirement for the vast majority of the population falls on the individual. The Government provides generous concessions for superannuation savings.

The more people who access ongoing advice to ensure their contributions, concessions and financial situation are continually optimised, the more quickly the retirement savings gap will be reduced.

Some have argued that the solution lies in the expansion of intra-fund advice. Indeed, the value of initial advice has been recognised by The Cooper Review in its recommendation that intra-fund advice be a compulsory element of MySuper.

It is appropriate that advice is made accessible to members of a default fund. There are, however, a number of Australians who choose to take greater personal responsibility for their financial outcomes.

Australians who choose funds other than MySuper, including self-managed super funds, will not necessarily have access to intra-fund advice.

Furthermore, the nature of intra-fund advice means that it is unlikely that complex issues will be catered for — nor will questions regarding savings or insurance outside of super.

Conclusion

The suggested reforms and other measures initiated by industry groups contain significant protection mechanisms for investors, and ensure that clients of financial planners will be aware of the fees they pay to advisers and the services they are to receive from them. Clients will pay fees for service.

As discussed above, the annual renewal requirement complicates the certainty of ongoing advice relationships, shifts risk back to the investor and reduces investor protection.

Arguably, no other profession operating under a fiduciary obligation is subject to this level of regulation in relation to remuneration.

Ongoing advice provides better outcomes for Australians. Advisers and clients should be free to agree to the term of their service relationship before an express renewal is required.

Future terms should be governed by the same principle.

Further, members/clients should not be prohibited from agreeing to an ‘ongoing’ term if that is their preference.

As reflected in industry standards, members are still protected because they can cease paying their advice fee at any time if they choose to cease their relationship with their adviser.

This creates an opt-in environment, as follows:

• clients who do not seek advice will not be charged for advice;
• clients seeking transactional one-off advice will have this option and be charged appropriately. They will not be charged ongoing advice fees; and
• clients seeking an ongoing advice relationship will make an informed choice, explicitly approving ongoing advice fees and services. As an additional safeguard, clients will have the right at any time to bring that arrangement to an end.

We believe this delivers the appropriate balance between issues of investor protection and the risks of a changing environment.

Paul Barrett is the general manager of Colonial First State Advice.