Provocateur: So, can you justify your product choices?

Sorry to pull you away from the cricket, but March 11 is now much closer. Among your new obligations, you must now explain how you decide which specific product recommendations to make (PS 175). This may mean discussing products you are not able to sell.

When you provide product advice, you must justify your recommendations. Justification means showing that you have considered real alternatives and the one you are making is most suited to meeting the client’s needs within the client’s financial scope and risk tolerance.

Where does this justification begin?

There are five levels at which you need to consider alternatives: the investment structure; the asset allocation; active or passive management; fund manager selection; and choice of product(s). This consideration requires a clear process that leads to the product recommended:

1. Structure

2. Asset Allocation

3. Active versus Passive

4. Fund Manager

5. Product

The structure must be determined first because it provides the tax treatment, level of accessibility and ease of management. Retail clients generally focus on four investment structures — superannuation, managed investments (unit trusts or insurance bonds) and direct ownership.

Justifying super versus personal

Justifying the recommendation to invest in superannuation is relatively easy because the tax efficiencies cannot be easily replicated. Recommending personal investments can also be justified where the individual needs access, has considerable superannuation savings, will have reasonable benefit limit (RBL) issues, and/or is paying the super surcharge. A case for structure diversification can also be made where the individual indicates concern over the potential tax and regulatory changes in superannuation. All that needs to be done is to show the individual’s current superannuation savings rate will meet (with other sources of income) their retirement income needs. Assuming you have appropriate projection software, a client sign-off process and a good paper trail, your justification should stand.

Justifying managed investments versus direct

Justifying managed investments over direct investments is a well-established process. Most investors lack expertise, a high enough risk tolerance, the money and sufficient interest in managing their investments, so that managed investments are more appropriate than direct.

A diversified managed investment might also be justified over a portfolio built up using sector funds because of the work involved in rebalancing and monitoring fund managers.

Justifying unit trusts versus insurance bonds

This will be challenging. While many product providers offer insurance bonds, financial planners are not fully trained on their features and cannot effectively compare their use and outcomes to those of a unit trust. Here is a quick refresher for those not familiar with insurance bonds (see table at right).

Where clients are not in need of an income stream, you need to consider after-tax returns.

A simple model compares the average annual after-tax returns for a series of portfolios (redeemed after year 10) from a portfolio of all cash and fixed interest (Portfolio 1) to a portfolio allocated 100 per cent to growth assets (Portfolio 7) held in a unit trust and an insurance bond for different marginal tax rate payers:

Positive numbers mean the insurance bond produced a better outcome. Negative numbers mean the unit trust produced a better outcome. Assuming a 0.5 per cent difference is considered significant, the shaded cells show where a client would be better off in a unit trust.

It is interesting that, where a client’s risk tolerance would mean an asset allocation to say Portfolio 4 within a unit trust, due to the dampening effect of reserving for tax within the insurance bond, the client might be comfortable in a Portfolio 5 asset allocation in an insurance bond. Clearly, higher returns would be expected from a higher allocation to growth assets.

Early redemption is also not the issue you might expect. In the ninth year, two-thirds of the value of the redemption growth component is assessed for tax purposes and within the 10th year, only a third of the value of the redemption growth component is assessed. However, they can still be tax effective if redeemed in earlier years because a tax rebate is available covering the tax already paid. In fact, this tax rebate is more tax effective than franking credit rebates because the value of the insurance bond rebate is not added to assessable income before calculating the individual’s tax liability. This is illustrated in the following table:

Can you justify using a unit trust over an insurance bond? If you do not have access to insurance bonds, can you say to a client, ‘Well, you would probably be better off investing in an insurance bond, but since we do not have any (or the ones we have are sub-optimal) I have recommended a unit trust structure’?

Justifying asset allocation

I almost hesitate to mention it, but in my well-publicised view, an asset allocation can only be reached (and justified) after the client takes a standardised risk tolerance assessment, used as a tool to assist the client to make decisions on how much they will save, how long they will work and what level of income they expect in retirement. Their ability to sustain investment risk is the balancing item.

This type of risk tolerance assessment does not automatically dump clients into an asset allocation, but rather indicates to clients the trade-off between comfort with their investment portfolio and the asset allocation likely to deliver their financial goals.

Often clients will not be able to achieve their goals unless they undertake to save more, work longer, accept a lower level of retirement income, or accept a higher level of investment risk.

Justifying active versus passive management

Can active managers provide higher after fees returns than a passive manager? Who knows! However, it is certain that a poor performing manager will not do so. Can you consistently pick the best performing manager? In my humble opinion it is unlikely and even if you could, the transaction costs (including capital gains) would wipe out any advantage. To justify using active managers you need to show success from doing so in the past.

Justifying fund managers—products

If you have clearly justified the structure, the asset allocation, and the use of active or passive management (or some combination), it will be a simple process of elimination to select the fund manager and specific product.

Justification of products goes to the very heart of the financial process where meeting the needs of clients is paramount. You have to understand both the products you can sell and the ones you can’t to justify your recommendations.

Paul Resnik is an industry provocateur. You can argue with him at [email protected]