Provocateur: Lawyer proofing your advice

Looking over the past year, it is rather frightening to see how much more responsibility financial advisers (and of course their licensee) must carry.

The really frightening thing is this new burden is only marginally linked to the Financial Services Reform Act (FSRA), more significantly linked to PS 175, but rather imbedded in new interpretations of common law obligations, now including lost opportunity costs and pain and suffering relating to financial loss.

Over the past year we have seen:

* a financial adviser who neglected to tell a client getting a divorce they needed to update their will and superannuation nominations or else their estranged partner would inherit, being sued by the intended beneficiaries who received nothing from the estate;

* a financial adviser, who neglected to go further than asking a client if they had a will, was sued (along with the solicitor) because the will did not have a testamentary trust to protect the client’s assets. The creditors took the lot and the surviving partner received nothing from the estate; and

* a financial adviser who neglected to explain the intricacies of superannuation nominations so that their client’s intention of passing on their superannuation benefits to their sister failed. The sister sued.

Then, of course, there is the Financial Wisdom case and the ongoing reverberations from the Hartley Poynton case that showed licensee responsibility goes wide and deep and basically lasts forever.

How would your existing plans fare if they were brought before a judge to read?

You will have seen a number of articles warning advisers (and licensees) about self-managed super funds (SMSFs) and trustee liabilities.

We also know the number of clients borrowing from the equity in their homes, and possibly leveraging that money through a margin lender, has grown significantly.

As a licensee, can you prove that advice to shift money out of a professionally managed, low cost and regulated superannuation fund into an SMSF has not been given with reckless disregard to the implications for clients and has not only been given to increase adviser remuneration?

Can you prove clients needed to gear, or were at least knowingly taking on gearing risks and the advice given was not recklessly given with disregard to the implications for the clients and was not given with only an eye to leveraged fees?

Do no harm

The Hippocratic Oath requires doctors first and foremost to do no harm. In a financial planning context, this means clients cannot be in a less favourable position after advice than they were when they came through the door.

This begs the question as to what methods the adviser is going to use to determine the client’s initial state.

But ‘do no harm’ is obviously not enough. Doctors must then look to heal. Financial planners need to enhance the client’s financial position — but their advice cannot be more radical than the client can stand, and it has to be the client’s informed decision to act on the planner’s advice.

Consider a recommendation to pull a client out of low cost, Australian Prudential Regulation Authority/Australian Securities and Investments Commission regulated, reasonably well-performing industry fund and put them into a costly and dangerous SMSF or even just a more costly public offer fund.

Or, consider a recommendation for a client to borrow 50 per cent of the equity in their home, say $200,000, then borrow $200,000 from a margin lender and invest $400,000 into the Australian share market. They were debt free before.

How are financial advisers going to establish they have done no harm in these instances?

The five proofs

In order to prove no harm has been done, and furthermore, that recommendations will leave the client better off, advisers need to work through five proofs with each client.

1. Know the client. Do advisers really know their clients? If they did, they would understand many are fair-weather investors that really have a low tolerance to risk. When the markets are going well, they’re happy as Larry. When markets get shaky they get scared, take losses and get litigious.

Do advisers really know what their clients need to achieve their long-term goals? Do they do sufficient cash flow analysis to ensure current needs are met, that short and medium goals are also met and excess cash flow is directed to the right spot — saving to meet long-term goals — before it gets spent?

2. Explore with clients the four trade-offs, the gamut of strategies and the ‘what ifs’ of each of these strategies. Does the client appreciate the impact of saving just a bit more, working a bit longer, being more conservative in their goal expectations or taking on a bit more risk?

Can the adviser model each of these decisions and show the impact of a conservative ‘just a bit more’ approach? Surely if a client is willing to do their little bit in each of these areas, it will produce a better outcome than radical approaches like going into significant debt and betting on short-term volatility in share and interest rate markets.

Where a radical approach is necessary or tactically feasible, can the adviser de-sensitise the client by ‘what if’ work-outs, so that clients can get a feel for the road ahead?

3. Know the product. Do advisers really know how gearing works? Do they know that to give a more likely positive net present value, the total borrowing has to be allocated to growth assets and that to get a positive outcome in the client’s eyes, dividends need to be reinvested?

4. Explain the risk in the product and the strategy. Explain means ‘in the context of the client’s needs, goals and ability to sustain investment and strategy risk’. A few mumbled words about leveraged risk are not sufficient.

5. Properly informed commitment. Financial advisers can no longer allow clients to ‘let them do all the work’. Literally, if a client is not willing to take the time and effort to understand their options, and commit to a plan, the financial adviser can no longer afford to take on the client. The risks are too high.

Start from a baseline

If advisers have to start from a ‘do no harm’ baseline, where can they start? Basically they need to establish a ‘risk free zone’. For example, a non-super baseline for investments might be an ING Direct cash management account. For super savings it might be an industry fund costing $1.50 per week with management expense ratios of 0.21 per cent. For growth investments it might be an indexed fund.

How does the recommended strategy compare to the baseline? Can you prove you are adding benefits? Follow these steps:

Step 1: Bring the client’s portfolios back to the baseline situation and analyse the outcomes. If this does not achieve the client’s goals, go to Step 2.

Step 2: Have the client agree to do a ‘little bit’ more — save more, work a bit longer, and so on, then analyse the outcomes. If this does not achieve the client’s goals, go to Step 3.

Step 3: If they have not met their goals, have them agree to save more, work longer, increase the riskiness of their portfolio, then analyse the outcomes.

Repeat step 3 until the plan achieves the client’s goals.

Test these steps and proofs against what you do when you recommend SMSFs and/or gearing strategies.

Do you think everyone should have an SMSF? Should everyone use a gearing strategy? Can you prove to clients that they should take your recommendations? Can you provide to ASIC that you have worked through the proofs before you gave the advice? Or will you run the risk of being charged with reckless disregard for client’s needs, goals and ability to sustain asset, product and strategy risk?

Think about it — have you been SMSFing and gearing because you could or because the client needs to?

Paul Resnik is principal of Paul Resnik Consulting Group. Disagree with Paul? Share his views? Either way, you can contact him at [email protected]