Getting into gear

Gearing clients because they can is great for the financial adviser — but meeting the client’s needs and abilities often seems to be missing from the equation. Also missing is the client’s informed consent to implement the strategy and protection for the financial adviser if things go wrong in investment markets, as they are at the moment.

Before we discuss informed consent, we need to clearly state that we are discussing tactical gearing — that is, entering into a gearing package because the client can afford to and is willing to borrow to invest. Strategic gearing, gearing because a client must gear to achieve their long-term goals, is a more complex strategy.

Informed consent

You may have heard this term at a seminar or seen it in an article. In the context of a gearing strategy there are four areas that a client needs to understand before they can give informed consent. These are:

* Their ability to tolerate financial and investment risk (volatility);

* How underlying investment assets are likely to behave;

* How gearing works, including the impact of increased interest rates, volatile markets and potentially lower personal earnings; and

* How various risk management tools work and their impact on the success of a gearing package.

Financial advisers cannot assume that clients have knowledge in any of these areas. Each has to be thoroughly explored with clients before recommending a gearing strategy. While this may seem like a lot of work, and may mean that some clients reject a gearing strategy, it is our experience that fully informed clients more often than not accept the strategy recommended.

Benefits from completing this process accrue to the client, the financial adviser and the dealer group, and include:

* The client deciding that gearing is not for them in time for an alternative strategy to be implemented. This eliminates messy problems when clients who should not have geared sue when they panic at costs/market downturns;

* The client taking on the risk and being able to sustain the costs/volatility as it is expected and understood;

* The adviser being confident that the advice they have given is appropriate to the clients;

* The dealer group being confident compliance requirements have been met and that there are no looming issues or law suits.

So, why these four areas/sets of information?

Risk tolerance

You know gearing exacerbates the normal volatility of growth assets. Thus, a thorough understanding of a client’s risk tolerance, by a client and their adviser, starts the process of obtaining informed consent.

If a client is assessed as having a high risk tolerance, there is a higher likelihood that they will be a survivor. Survivorship, the ability to ride out the ups and downs and maintain the gearing package long enough to achieve long-term expected results, is the key to successful gearing. Long-term can mean 7-10 years.

Where a client has a moderate risk tolerance level and still wants to consider gearing, the next step, a thorough grounding in investment outcomes, will be critical.

Where a client has a lower risk tolerance, it may be unwise to recommend gearing, even if the client is insistent. Work with them to identify alternative ways to achieve their goals or possibly lowering them. If they finally decide to gear, prepare them for volatility and look after them when things go awry.

Investment returns

Gearing requires a unique set of investment returns to make the strategy successful. It is frightening how many advisers do not realise that gearing into cash and fixed interest is inappropriate, as the interest earned will be lower than the cost of borrowing and there is no growth component.

Many advisers also do not understand that because of the franking credit system, fully franked Australian shares frequently provide a higher after tax return than listed property trusts.

And while international equities do provide significant diversification and usually higher long-term capital growth returns, a carefully selected portfolio of Australian equities can provide a higher longer-term after tax return.

Crash testing and otherhorrors

Most advisers who recommend gearing have software that will show how gearing works — but only in a positive market. Few have the software to do sensitivity or ‘what if’ analysis.

For example, how many advisers can put into a 10-year client cash flow the impact of a rise in interest rates? Or match that interest rate rise with an almost certain slowing in the equities market?

When this type of analysis can be done with clients, and the clients can ask questions, they will be informed about what can go wrong and make their own decision as to whether to proceed. That is what informed consent is about.

Gearing assurance

Even the most risk tolerant clients need some level of assurance that they are making the right decisions regarding using risk management tools. Some of these tools offer more psychological than technical assurance. For example, ensuring that a client can afford to (and does) reinvest all income from their investments means:

* A buffer is built up within the portfolio that moderates total portfolio volatility;

* A higher portfolio value as the compounding effect sets in; and

* A significantly larger end balance than would have otherwise accrued.

Other forms of assurance require the client to have adequate income protection insurance and establishing an emergency fund, so that the client does not need to sell their geared portfolio at an inopportune time. Starting with a small amount of borrowed funds and then working up to a larger amount over time is also a good ‘assurance’ technique.

The results

If you can and do work through this process and clients then agree to implement a gearing strategy, they will have done so from a position of informed consent.

Case study

Allison and Wesley have $300,000 equity in their home they can borrow to invest. They have an interest in building personal wealth and are considering gearing. The steps that their financial adviser took were:

1. A risk tolerance assessment, which determined that while Wesley had a reasonably high risk tolerance, Allison was slightly less tolerant. The adviser understood that she must focus more on Allison’s comfort levels to ensure that she could comfortably give informed consent to the strategy.

2. The adviser discussed the specific portfolio/product that she would be recommending, going through its historical and expected returns and the historical and expected levels of volatility with Allison and Wesley. Allison asked a number of questions, which the adviser answered by showing her rolling performance charts that included the experience of geared investors for both the product and the market in general.

3. The adviser discussed the impact of down markets. Using their current cash flow, she showed them the impact of increases in interest rates on their savings capacity and their ability to meet interest payments, while reinvesting all income returns. Again Allison asked the most questions, which assisted the adviser in feeling comfortable about Allison’s level of understanding.

4. Finally, while Wesley was willing to borrow the full $300,000, it was agreed that at first they would ‘only’ borrow $100,000 and work closely with their adviser over the year. At their annual review, the situation would be assessed and if Allison was comfortable, additional funds could be borrowed.

Paul Resnik is head of the PaulResnik Consulting Group and co-authored the book,‘Borrowingto Invest, the fast way to wealth?’with Noel Whittaker.