The hidden price of fees-for-service in financial planning

The financial planning industry, retail superannuation funds and the investing public may all emerge as long-term beneficiaries of the industry funds’ campaign against financial planning commissions.

It is likely that the effectiveness of the campaign was one of the many factors that prompted the Financial Planning Association to take its bold stand on fees. Assuming this leads to a more widespread adoption of fee-based service, the financial planning industry will both attain greater credibility and adopt a more robust business model.

Over time, retail superannuation funds will also be able to separate from their management expense ratios any commission paid to an adviser, reducing the core cost of their product. This will enable them to compete with industry funds on equal terms.

The investing public will, in turn, benefit from the reduction of commission bias in advice and from the lower cost of retail funds.

However, the industry funds themselves may be disadvantaged by financial planners adopting fees. It must be acknowledged that commission-based advisers generally will not have considered recommending non-commission paying investments. However, fee-based advisers, who can’t be accused of any such bias, have also broadly shunned industry funds (perhaps with some exceptions).

Ironically, if commissions were to disappear, with a consequent reduction in the costs of retail funds, industry funds would lose their marketing edge. How would industry funds then be placed to compete for the recommendations of financial planners or corporate superannuation advisers on merit?

In considering this question, it is important to recognise that superannuation funds provide members with asset management and insurance benefits. Both of these need to be competitive in terms of quality and price.

The following contains many generalisations and it must be explicitly acknowledged that exceptions will exist. However, I believe the views put are broadly justified.

Insurance

The automatic acceptance level (AAL) is the limit on the amount of cover that an eligible member can obtain without undergoing medical underwriting. This is one of the benefits obtained by obtaining insurance within superannuation, allowing otherwise uninsurable individuals to gain cover or escape exclusions or premium loadings. Naturally, with a lower AAL more underwriting is required, with the corresponding risks of refusal of cover, exclusions, etcetera.

The AALs for most industry funds are usually low, often whatever cover can be obtained for a premium of several dollars per week. Furthermore, most industry funds offer a non-negotiable AAL, whereas many retail master trusts will negotiate a level of AAL (and an insurance formula) appropriate for a particular employer (eg, a fund may offer a much higher level of automatically insurable cover for the partners of a law firm than for a business with much lower average salary levels). Negotiability in this area is a key factor for an adviser attempting to find the best product in the market for a particular corporate client.

Quality of cover is largely a matter of the strength of definitions (eg, whether pre-existing conditions are excluded, whether a flexible definition of salary is available and so on). The comment above on generalisations needs to be noted here, as some retail products have poor definitions and some industry funds may provide quality ones. Nonetheless, the industry funds’ Product Disclosure Statements I have seen often have limitations.

Furthermore, whereas the asset management of industry superannuation is at the low cost end of the market, their insurance premiums tend not to be. In one case, a retail and an industry fund each use AIG as their insurer, yet the standard premiums for income protection insurance are notably higher in the industry fund. Both of these are public offer funds, with membership not limited to a single industry.

In at least one case, the fund trustee receives a portion of the premium as a commission, say 10 per cent of death and 30 per cent of income protection. It is to be hoped that no fund in this position is contributing to an anti-planner commission advertising campaign.

Perhaps those industry funds with expensive premiums are subsidising their management fees in this area, enabling them to promote their ‘low cost’ in the asset management side.

Any competent corporate superannuation adviser knows that the important cost comparison for a corporate client is total costs for asset management and insurance to the desired levels of cover. Given the willingness of many retail funds to negotiate prices, industry funds are not always the cheapest option. In some instances the aggregate cost across all employees of a corporation are more expensive in an industry fund than a retail fund, even though the retail fund pays brokerage.

This raises the prospect that, should retail funds move to separating this commission payment from the cost of running the fund, they may become the low cost offering for some sections of the market. This makes intuitive sense, as larger average balances ought to lead to lower costs.

Of course, none of this changes the fact that, today, industry funds are generally at the lower cost end of the spectrum for individuals who want no more insurance than the offered AAL compared to retail funds at standard (not negotiated) rates.

Crediting rates

Retail funds tend to adopt unit pricing whereas most industry funds adopt crediting rates (there are exceptions such as ASSET Super, which moved to unit pricing in the 1990s). The relative benefit of this is an old debate. However, our subject is the appeal of industry funds to fee-based financial planners, and their preferences are clear. In the 1980s reserve-backed retail funds that provided an annual crediting rate were popular. These were primarily offered by the major life offices.

However, few if any planners today use them. In the market downturn of 1990 questions arose about the realism of valuations of unlisted assets in the funds, particularly directly-owned property. This exact issue has again arisen today in regard to many industry funds. Planners then abandoned retail funds with crediting rates in favour of structures where they believed their clients were buying or selling at current values.

Those industry funds that wish to attain the broad-based support of fee-based advisers will need to adopt unit pricing. Naturally, daily unit pricing is more expensive than a monthly or weekly estimate of returns, which need not be exact.

Breadth of investment offering

Over the years, retail funds have expanded their range of offerings to enable planners to tailor recommendations to a diverse client base. Thirty plus available investment options, and in some cases far more, are not uncommon. The most widely supported retail master trusts offer a range of high to low risk diversified funds, plus a number of single manager/single asset class specialist alternatives in each of the major markets. Further, they are receptive to adviser input on managers that should be added to the platform.

I have seen industry funds offer as few as four investment options, with no capacity to spread over more than one. This is an area in which industry funds are improving, but a broad range is essential for planner support.

A number offer only monthly switching. Few clients or advisers engage in frequent switching, and those who do are unlikely to achieve much benefit from the practice. However, there are occasions where clients do legitimately require a quick adjustment to their portfolio (as have a number of clients in the last two years when they found portfolio volatility beyond their tolerance).

Further, planners have experienced client complaints when a decision to buy/sell an asset was agreed to but took several days to implement, and the market moved against them in the interim.

Sitting for up to a month waiting for action would exacerbate this risk.

Certainly industry funds will need to reduce their fascination with unlisted assets to gain broad acceptance from planners. (Anyone who wants to argue the merit of large exposure to illiquid, hard to value assets should consider the plight of US banks today whose solvency is threatened by this very problem.)

Integration

When planners take on a platform, which is what most industry funds are, they need it to integrate into their general service offering. Among other things, this requires:

• total portfolio reporting of superannuation and non-superannuation assets and income in one consolidated report;
• individualised fee collection. For example, a client may agree to a fee of $X per quarter or per month. The platform must be able to deduct this from the client’s funds, remit it to the planner and include this itemised payment in all reports to clients, including annual tax statements; and
• online access to client data, research reports, and so on.

No platform can gain substantial support from fee-based financial planners without these functions, which are essential for efficient operation. However, they involve increased platform costs. Nonetheless, the centralising of these functions at a platform level enables such cost savings in planners’ offices that total client costs can be kept as low as possible.

Many corporate fund managers have substantial promotional budgets. These are paid from corporate shareholder funds and the motive for the expense is to achieve long-term shareholder profits. If planners ever realised that the institution was using their clients’ funds for promotional purposes, a serious review of its recommendation would follow.

Industry funds present themselves as existing solely for the benefit of members. It is therefore hard to understand the rationale for expending substantial sums on television campaigns, sponsoring sporting teams, and general advertising. (A similar issue existed when funds management was dominated by mutual life offices. They purportedly existed for the benefit of policyholders. They spent large sums on advertising telling the market how much they cared for their customers — at those customers’ expense.)

Future directions

I first joined the ranks of financial planners 27 years ago. Every decade the industry has looked very different. There was a period where banks had nothing to do with financial planners, now they employ them in large numbers.

With an increase in financial planners moving away from commissions, it is possible that the relationship between advisers and industry funds may change over time. However, for this to occur the industry funds will need to adapt their offering to meet the needs of planners and their clients. This will require a psychological change, as fee-based planners today find dealing with most industry funds very difficult.

I know a corporate superannuation adviser who recommended to an employer that it use an industry fund for one sector of its employees. It was an industry where portability was important due to transient employees.

However, the industry fund has behaved as if the adviser was a creature from the dark side, even despite the recommendation in its favour. This has not been a positive experience for that adviser, who is still prepared to look for industry funds where there is an understanding of a co-operative relationship.

Planners commonly report that industry fund personnel either can’t provide requested information or even display hostility when the caller reports they are a planner (and apologies to any industry fund for which this statement is not appropriate). The historical distrust of planners is understandable given the risk of bias against industry funds when commission is involved, however, this should not be extended to those who show no bias.

A relationship with a quality corporate superannuation advice business will require responsiveness to research queries about the fund and queries about fund members who are now mutual clients. To gain adviser recommendations, funds will need to be able to negotiate fees and premiums where an employers’ staff profile justifies it.

Retail funds have gradually increased their service offering over the years, so there is no reason why industry funds could not do likewise if they wish to move in this direction. Inevitably, these increased client services will drive up costs. Conversely, the cost of retail funds has been declining (and there was plenty of room for reductions from the ridiculous master trust fees of the early 1990s). They have been moving closer over time.

To return to the theme with which I began, I believe that the television campaign will have produced long-term benefits for a number of parties, as it has contributed to the pressure to move away from commissions. However, it may also result in an evaporation of current industry fund positioning. It will be interesting to see how they respond to this over time.

It will also be no surprise if, in the fullness of time, some industry funds ‘demutualise’, raise capital and become profit-making. This has occurred in so many areas that it surely represents a precedent.

Disclosure of bias

The relationship between planners and industry funds has been volatile. Each time I deal with it I make clear that I do not have any axe to grind. I am no longer employed by any dealer group and only do a day or two a week in part-time consulting (the rest of the time I don’t think about financial services).

The financial planning business I ran previously was fee-for-service. We had a positive relationship with an industry fund, recommended their funds in limited situations and ran seminars for their clients.

On the subject of disclosure, it would also be revealing to hear the basis for the adoption of default funds in the recent award modernisation process. Planners need to have a sound basis for their recommendations and, despite lengthy disclaimers, know there is a risk of liability if their advice is negligent.

For their own sake, it is to be hoped that the bodies that selected the approved funds have some protection in law should anything go wrong in the funds. If there has been bias in these decisions — a question that the lack of transparency and consistency of selection of industry funds raises — it should be viewed in the same light as biased advice from a financial planer.

Or is there only a duty of care when advising a single client, but not when making decisions which impact tens of thousands?

Robert Keavney is an independent spirit of no fixed industry address, who believes financial planning is a noble profession.