Cleaning out the cupboards: product rationalisation

A recent Investment and Financial Services Association (IFSA) industry forum heard compelling evidence as to why product rationalisation is an issue that will increasingly occupy the minds of both regulators and those fund managers with legacy products.

IFSA’s new chair, AMP Financial Services chief executive officer Craig Dunn, and PricewaterhouseCoopers Financial Services partner Peter van Dongen outlined the case for legislative reform to facilitate product rationalisation in the financial services industry, and detailed an IFSA proposal that we will be releasing for discussion in the coming months.

Legacy products

Many of IFSA’s established member companies have a large business component in managed investment products that is old, is no longer offered for sale and operates on older systems. In industry parlance, these are what we call ‘legacy’ products.

Companies, when considering their legacy book are conscious that being off-sale means the profitability of these particular products is waning. Consequently, companies are tending to focus on cost reduction, capital efficiency and consistency in terms of maximising returns to shareholders.

The harsh reality is that our members are finding the compliance obligations for legacy products a challenge, given a reasonable desire to ensure that servicing such products remains viable.

Most financial services products will eventually become legacy products. This is because they are long-term in nature, technology constantly evolves, new products are developed and, of course, companies evolve too. Moreover, they become legacy products because the ability to close such business components — a logical option available to all other industries where business components become sub-optimal — is severely constrained by the legislative difficulties involved in closing wealth products.

A climate of change

Mergers and acquisitions also mean that customers and products are ‘inherited’ and along with the products, in many cases, the software that keeps these managed funds ticking over too. Added to these challenges, we have our elected representatives regularly implementing changes to our tax laws and other regulations and legislation governing the industry, which inevitably means that managing these products never gets any cheaper or easier.

Professor Berna Collier, commissioner of the Australian Securities and Investments Commission (ASIC), acknowledged the legacy problem at an IFSA member lunch in October.

Commenting on IFSA’s work in this area Collier said, “we understand that these products can be an administrative nightmare as they were created before the advent of computer software programs”.

The legacy issue isn’t just a technical one — it is also one of managing risk. Finding people who still have technical knowledge of these older products can sometimes be a challenge.

And advisers cannot keep pace with the proliferation of products. There are a lot of younger advisers coming into the industry who have to learn about the old products as well as the latest offerings. The reality of this is that additional costs are inevitably borne by the consumer.

US comparisons

Narrowing the range of products out there will make it easier for advisers, both in terms of their capacity to give good advice and in reducing costs. While I was in Washington recently for the annual meeting of the International Investment Funds Association, I looked back at Australia’s marketplace of 7,000 funds and compared it with the 8,000 or so funds on offer in the USA.

As Peter van Dongen observed at the IFSA Forum, comparing the number of funds in Australia with the number in the USA, comparing the relative levels of money managed and keeping all other things equal, the Australian industry is having to manage 15 more unit prices per $1 fee revenue than what is managed in the USA. This obviously comes at a cost — and a risk — ultimately borne by investors.

Per capita, we seem to have somewhat of an oversupply of products — and it’s not because administration of legacy products is something that’s a whole lot of fun. This is a very good point and further compounds the need for product rationalisation, particularly when you consider the fact that some Australian companies have actually decided that they are not prepared to wait for our legislators to tackle this problem and have made the decision to shutdown legacy funds and return the money to investors.

Impact on consumers

This is not necessarily the best result for the consumer, as such a decision may trigger a capital gains tax event that can erode a person’s savings at a stage in the wealth accumulation cycle that could have been avoided if the option to ‘roll’ their investment into a modern product offering was available.

In response to consumer demand and a desire to improve operational efficiency, many contemporary products are more transparent and less complex. Legacy products, on the other hand, tend to be more complex. Complexity is not only an issue from a cost perspective, but from one of operational risk as well.

Legacy products are an increasing burden on the compliance regime. IFSA chair Craig Dunn said that the industry must admit that, in the past, it has been guilty of making things complex, and that there is a responsibility to build new products today that don’t suffer from the historical issues of the past.

The regulatory regime

While the existing regulatory regimes do allow for some rationalisation it is simply not working, and this is clearly evident in the current lack of uptake. The summary of the three relevant regulatory regimes demonstrates the complexity of the current system (see Table 1).

The legislation that helps to facilitate rationalisation is expensive, cumbersome and high risk. For example, under the Corporations Act requirements 50 per cent of investors Australia-wide must vote on this type of move. “How do you manage this?” asks van Dongen.

The rationalisation of insurance products (under Pt 9 of the Life Insurance Act) involves having to go to court, which is costly and time consuming. Industry is understandably of the view that there needs to be a simplification of the process and adherence to a consistent set of principles across the different classes of investments. It must also be remembered that many of these policies only have a handful of customers in them.

Van Dongen maintains that simply having three different systems for the industry is a problem in itself. “If you have products that are similar in terms of wealth management, you should have, as a minimum, a consistent set of principles to allow product rationalisation. By and large, people aren’t moving to rationalise these products,” he said at the IFSA forum.

We need to successfully address all stakeholders — customers, advisers and shareholders — and we are demonstrating to the Department of Treasury that rationalisation is going to be of benefit to consumers, as well as an efficiency exercise for providers. In addition, we are liaising with our prime regulators, ASIC and the Australian Prudential Regulation Authority.

The business case

Certainly, when you have a business case for rationalisation coming through the trustees, senior management and board, the first question we must ask is, ‘Okay, there’s a benefit to the shareholders — but what is the benefit to the consumer?’ We must demonstrate that customers will be as well off, better off, or that they’ve got an option to deal with rationalisation in a fair way. It is critical for industry to get this right.

In the development of the product rationalisation proposal, IFSA has been incredibly mindful of the need to highlight the benefits of reform for all concerned. The diagram below emphasises how different stakeholders will gain from reform.

The proposed rationalisation process is intended to provide customers holding a financial product, subject to the rationalisation process, with a fair and equitable outcome. Our proposal was sent to the Treasurer in July 2005 and has been shared with Treasury, the regulators and other stakeholders — and so far the concept for reform has received broad support from all concerned. The IFSA product rationalisation proposal is a four-step process (see Table 2, MM Nov 17, 2005).

Submission recommendations

We have recommended that the Corporations Act be amended to create a process under which providers of financial products can close a product, or part of a product, by transferring all of the people in that product to a different, but similar product.

Also, that income tax law be amended to provide tax neutrality where product rationalisation has been undertaken.

Finally, consequential amendments need to be made to other relevant legislation as is necessary to give effect to the product rationalisation initiative.

Conclusion

IFSA believes that the legislative mechanisms proposed can deliver significant benefits to investors, and reduce operational costs. The ongoing ability to move clients out of legacy products to newer and more appropriate financial products will also enhance investor protection by reducing product risk.

The reforms IFSA is seeking are critical to facilitating a dynamic industry that operates in a competitive and forward-looking business environment that rewards efficiency. The industry is behind this initiative and has adopted product rationalisation as its key reform priority.

Richard Gilbert is chief executive officer of the Investment and Financial Services Association.