Re-thinking financial planning

There is a fundamental re-appraisal underway of how portfolios are matched to client needs, built and maintained as well as what it is that financial planners do for their clients.

This is as true here in Australia as it is in the UK. In fact, UK planners’ anxiety to reposition their businesses provides an insight into a parallel set of challenges to our own.

The key to our success will be through our willing suspension of ego and the adoption of a client-centric process.

The investment world has changed forever

Those of us who have been around for a long time often reflect on what we have learnt from the past when facing current issues. For me, the current news has much in common with the aftermath of the ’87 crash.

There seems to be a startling similarity between the life office number one funds then and banks and property companies now. This major shared feature is their opacity.

Today, we struggle to understand what is going on underneath the headline company disclosures. In ’87, when push came to shove, we discovered that life offices could not maintain the crediting rates from their statutory capital guaranteed funds. Their assets did not match their liabilities. They rapidly lost the confidence of both planners and the investing public, never to recover. All of the major life offices either demutualised or have been merged into the banks.

The banks, many property ‘plays’ and other assorted businesses today have a similar problem, albeit many would argue, more likely to be a temporary one.

We can hardly guess what is likely to be disclosed next. Investors and their advisers struggle to answer two critical questions: are the liabilities appropriately accounted for and are the assets appropriately valued?

There are several more pivotal changes underway in the investment world as we know it.

> There is a fundamental alteration to the structure of American capitalism. It has shifted almost seamlessly from entrepreneurial capitalism, where those who put up the risk capital took the returns, to managerial capitalism, where those who found themselves in senior management took the returns without capital risk, to sovereign capitalism, where risk capital is emerging from countries with little history of capitalism as we know it or democracy as we might like it to be. Who knows where this trip will take us and its consequences, one thing we do know is US banks will have very different shareholders with very different goals going forward.

> A primary driver of change is the deleveraging of the investment world. This is not something we have seen before. We are about to see the rationing of low cost credit. Lower cost borrowings will be difficult to access for all but prime borrowers. As a consequence, businesses will rely much more on their own internally generated capital to fund growth. Dividend streams will be less likely to grow. In the Australian context, this will have fundamental consequences for how we construct portfolios, particularly our reliance on dividend imputation to reduce personal and super taxes.

> Australian DIY investors were richly rewarded for the concentration risk they took by primarily investing in the banks and geared property. Stock picking has become significantly more dangerous. Banks will take some time to rebuild both their balance sheets and confidence in their management. Deleveraging will see the end of the property bubble just as it has in the UK and the US. The only questions are how far the property markets will deflate and how long it will take before they stabilise.

> Some DIY investors will be tempted to seek professional advice but will be nervous about the relationship between managed funds and adviser remuneration.

> The benefit of managed funds has always been the convenience and lower costs of pooling. When no alternatives were available, investors and their advisers lived with the challenges of low transparency. In the current reporting season many are going to be disappointed with both the performance of their funds and the disclosure. They will struggle to reconcile the assets at balance date with the performance reported, particularly the break-up between income and capital losses. I see industry funds, separately-managed accounts (SMA) and index funds being the alternatives many will want to explore:

> industry funds with their fundamentally lower costs, integrated implementation capacity and wider investment choice should, all else being equal, do relatively well in the next reporting cycle and are likely to continue their marketing challenge to traditional planning;

> SMAs that deliver similar asset allocations to managed funds with more regular and current disclosure of assets and risks will increasingly distinguish themselves from managed funds in the minds of discerning investors; and

> the move to passive investment and market exposure via index funds will continue to accelerate. ‘I know the growth markets are the right place to put a substantial portion of your money, I just don’t have confidence I can find the exact companies given the experience of reporting failures of the last year or so’ is a story I hear from many experienced planners. Current market turmoil withstanding, planners are anxious that clients do not run away from growth asset exposure and see broad-based index funds and exchange-traded funds (ETF) as a viable alternative.

This brings me to one of the issues that has worried me for some time. The core part of an individual’s needs in retirement was traditionally met by life annuities. With the demise of Centrelink protection and the enthusiasm of planners to promote investments via wrap accounts, the planning world has left itself vulnerable to claims of self interest.

I believe the time has come to re-appraise the role of annuities in retirement portfolios. With Australians living longer and many with investment account pensions that are inadequate to meet their long-term needs, we need the compulsory projection of assets and income for 10 to 15 years beyond life expectancy in all financial plans.

Lessons from the UK

My recent trip to the UK raised something that I have not encountered in Australia.

Under the innocuous heading ‘treating clients fairly’, top end UK planners were wrestling with personal, business and ethical issues in a way I had never experienced.

I found that there was a fundamental challenge facing UK planners.

Their core product, the insurance bond, is now at a distinct tax disadvantage to alternatives.

Insurance bonds in the UK have traditionally lacked transparency; they have opaque costs and rely on a range of current and deferred guarantees to retain investors, but they at least had tax advantages. However, following tax changes, insurance bonds became inappropriate for most existing and new clients.

UK planners have no alternative but to change their product suite, and in so doing they are also searching for a new value proposition.

The answer there is the same one we are developing here in Australia. We call it needs-based planning. The client must be actively involved in a process that clearly enables them to make an informed decision in relation to the financial risk they take on.

In making portfolio recommendations, the planner needs to have taken into account and show the resolution between three competing risks: the financial risk that the client needs to achieve their goals, the risk capacity of the client and the risk tolerance of the client.

For example, Bob needs 100 per cent exposure to growth assets to achieve his goals. However, he can afford to lose no more than 10 per cent of his assets without having his life markedly changed and he has a low risk tolerance which, all else being equal, will lead him to maintaining growth assets in his portfolio of around 35 per cent. This, of course, assumes there is an inherent integrity in the portfolios constructed.

In Australia, we would rarely explore the insurance bond sector except in specific circumstances. There are greater after tax benefits through super and outside super if non-retirement goals are in play. We almost never disclose the benefits (and risks) of lifetime annuities and explore their role in an investor’s financial plan.

Clearly, there are three different asset allocations leading to three distinctly different lifestyle outcomes in play here.

Which is the right one for Bob? What are the options that cause Bob the greatest and the least anxiety? What is the right way to proceed recognising the substantial differences in long-term outcomes? Who should make those decisions, the planner or Bob?

The answer is clearly Bob, because he is ultimately the one who has to live with the results of the decision.

Obviously, he also needs the advice and input of the planner to illuminate the consequences of each option.

In fact, this trade-off is one of the critical components of subsequent plan reviews and the basis for a long-term relationship with the planner.

Risk tolerance is the quickest and easiest of the three risks to assess accurately.

A psychometric assessment, which has been proven to be the only methodology to deliver defensible, academically rigorous results, would take less than 15 minutes to complete. Financial risk tolerance should never be mistaken for risk needed or risk capacity. The former is a psychological trait, the latter two are financial constructs.

Armed with a robust risk tolerance assessment, the planner has a firm foundation of the client’s needs at the start of the risk trade-off decision process. The other two are then a matter of financial illustration, comparison and discussion.

Advisers often look to medicine as a parallel discipline to financial planning.

They suggest that surgeons still tell their patients exactly what to do.

Nothing could be further from the truth. Visit a medical professional today and they will explore a range of options. They generally provide explanations of each alternative and explore their risks and benefits. In addition, a surgeon has up to 10 years training and peer review before being allowed to wield a scalpel autonomously.

By comparison, most financial planners’ investment competency and expertise is usually declaratory.

In my experience, most planners cannot say, ‘I have both proven expertise and competency in building successful portfolios that meet or exceed the benchmarks that I jointly agree to with my clients’.

Commonsense tells us that it is imperative to have a value proposition that reflects a known and verifiable competency. Unless a planner has hard evidence that they add consistent value through portfolio construction, they should emphasise more predictable benefits for clients.

We need to promote our competencies not our egos.

The world of financial planning has changed fundamentally in recent months. Issues that could be ignored when markets were high will increasingly need resolution in the months and years ahead.

The importance and value of financial planners in our community is increasing exponentially. The benefits of our experience, however, will not be delivered to maximum effect if we do not engender community trust. The best way to do that is to be honest with ourselves and our clients and have a value proposition based on what we can consistently deliver. Not what we would like to believe we do well.

Paul Resnik is co-founder of FinaMetrica (paul.resnik@finametrica.com).