Most commentary surrounded the ‘fee for no service’ scandal broke during the Royal Commission – with AMP and the four banks’ wealth businesses caught in the net. ASIC has been quick to pounce on these institutions with hundreds of millions of dollars spent on remediation, class actions in the process – with more to come.
Grandfathered Commissions face the chop
In addition, you would most likely have seen the Government’s announcement regarding draft legislation banning Grandfathered Commissions from 1 January 2021. This was a key recommendation emanating from the Royal Commission.
We are certain that most people would have no idea what “Grandfathered Commissions” means, so we thought we would clarify, explaining the history, context, where we are now and where this could eventuate.
Before going through the detail, most people would accept and agree with the proposition that if a service is provided, some form of remuneration should be paid to the provider of the service. This is an economic principle in business – especially if the service is delivered according to some agreed standard.
The adviser fee debate has been raging for years.
- What is a fair fee?
- How should it be charged?
- Fixed dollar amount;
- Asset-based i.e. a percentage of the portfolio;
- From within the Product, or
- Invoiced directly to the client.
- Is a commission or payment from a Product Provider a ‘fee in another format’
- Insurance commission;
- Grandfathered commission – what does this mean?
In the desire to move the advice industry into a profession, certain methods of remuneration are no longer deemed desirable – even though they may be the more practical option. Unfortunately, as has become the case in recent times, when the Government steps into the picture, one normally has to accept a less than desirable outcome.
The regulators sadly have lost sight of what the end consumer wants or how they may wish to pay – even though we live in a democracy where one would assume some level of choice should be available.
So let us explain some of the terminology and then consider some of the questions posed above.
Historically, brokers / sales agency people involved in the distribution of superannuation and investment products (some of whom were genuinely financial advisers), were rewarded for their efforts by receiving part of the total expense ratio paid by the Consumer to the Product Provider. A total expense ratio is a fee built into the price of the product. This combined fee includes an investment fee, an administration fee and a distribution fee. The distribution (or ‘trailer’) fee was paid by the product provider to the entity, agent or broker who initiated the sale.
As the financial product sales industry transformed itself into an advice industry – from the mid ‘90s and early 2000’s the requirement to disclose these fees to clients was imposed – around 2002.
When FOFA (Future of Financial Advice) became mandatory on 1 July 2013, this income stream was carved out of what became defined as fees; and was allowed to continue and became known as a “Grandfathered Commission”. Essentially a ‘fee’ by another name – and continued to be paid by the Provider to the adviser.
The key difference was that this ‘fee’ did not have to be disclosed in the FDS (Fee Disclosure Statement) provided by advisers to clients – and there was no obligation to provide any service for this fee.
These were typically older products, and for advisers to earn a fee, they would have had to move clients to a new product thereby possibly incurring CGT for the client on the transfer. Thus, the client may well be better off staying in the existing product.
However, as mentioned earlier, the word ‘commission’ has become unpalatable, and the Government and Royal Commission have deemed that this type of remuneration be banned with effect from 1 January 2021.
A more simple and logical answer would be to legislate that any financial product income – from any source – needs to be disclosed and serviced by an Adviser.
This is the approach that Horizon Wealth has taken.
For the last 5 years, we have disclosed all income (whether fee or commission) earned, on our FDS (Fee Disclosure Statement), regardless of source. In addition, we have ensured all of our clients have been actively serviced.
It is generally regarded as a common business practice to include a commission in the premiums charged for insurance. This approach, managed in an open and transparent manner, has been shown to balance the requirements of the Insured, the Insurer and the Adviser.
Although the Royal Commission did not recommend that these types of commissions be banned, Hayne did suggest that they should go to zero unless ASIC believes that they should not – as part of their Life Insurance Industry review in 2021/22. ASIC’s previous attempt had been to review the quality of life insurance advice through the limited sampling of the advice provided by the largest dealer groups in Australia – which happened to be AMP and the four banks (they simply sampled from the bad apples in the industry).
It is always advisable to consider the practical alternatives. So let us say ASIC decide insurance commissions will be banned. Then what? There are only three options of which the first two are not practical:
- Advisers work for free;
- Insurance is no longer sold by Advisers;
- A fee is charged for Insurance Advice and paid directly by clients.
The time taken from the first meeting with a client – through information gathering, education, modelling, Statement of Advice, application, underwriting, negotiation of amended terms to an inforce policy – can take as many as 100 ‘man’-hours! Moreover, there is no guarantee of success – as the application may be declined.
Given we have agreed the first remuneration option above is uncommercial, and the second option may leave many Australians underinsured, let us consider the 3rd option.
Where an insurance application is declined, the adviser receives no remuneration from the product provider or the client.
It is clear therefore that the adviser essentially takes on an insurance advice case at substantial risk.
We should also add that the tax treatment of premiums from which commissions are paid are treated differently for tax purposes to an upfront adviser fee. Some premiums (like Life and TPD) can be funded from superannuation and are therefore tax deductible at 15%. Some premiums like Income Protection are tax deductible at one’s marginal tax rate.
Most clients choose for cash flow purposes to pay their premiums monthly. The commission payment lump sum which is soon to be 66% (including GST) of the first year’s annual premium (from January 2020), is essentially funded by the life company and recovered from future premiums.
Upfront Adviser Fees charged directly to the client to establish a financial product are NOT tax deductible.
You would have noted that Horizon Wealth rarely charges an upfront advice fee as the tax treatment is unfair for our clients. Over the course of the relationship we have with our clients, it may take us 2 years (or more) to recover our costs to both provide the advice as well as establish the client’s accounts.
Even if an adviser charged a fee similar to the commission foregone, the clients would have to fund the fee from their own cash flow and it would not be tax deductible.
Why would that solution be desirable to the client? As it is, life insurance is a grudge purchase.
The legislators, in their wisdom, believe that a commission is a conflicted way of being remunerated – yet they have not offered up a practical alternative. Again, everyone has lost sight of the end game, which is to ensure that individual Australians are:
- Adequately insured – to reduce reliance on the public purse as a consequence of uninsured people experiencing a “Black Swan” life event associated with accident or illness.
- Able to access appropriate advice at an affordable price.
From a consumer perspective, commissions can be a fairer system.
- The commission is essentially tax-deductible through the premiums;
- The commission is only paid by the Life Company if the consumer obtains the insurance (alignment with the client).
It should also be noted that every adviser is bound to act in the best interest of the client, and that all commissions have to be legally disclosed in the Statement of Advice – before the submission of an Insurance Application Form or Personal Statement.
All commission rates are uniform across all Providers, so the only way an adviser can inflate commission income is through the recommendation of a product with more expensive premiums. Legally that would undoubtedly fail the best interests test!
What happens if ASIC bans insurance commissions?
It is likely that most advisers will stop advising on insurance, as it’s uneconomical – and the life companies sales will significantly reduce. That will have the effect of pushing up premiums as more claims are received on an ageing insurance book without enough new younger clients on the books.
So what about some of the other points raised above.
What are the options?
We are all familiar with the method of remunerating lawyers and accountants by the hour. We also are probably aware that the hourly rate is not set by the Law Society or by Chartered Accountants Australia – in other words, the hourly rate varies between firms and cities.
There are a number of models as noted earlier. Before discussing each of the models, it should be noted that there is no perfect model.
The most appropriate model we believe is the one that both the adviser and the client is comfortable with and that is fair.
After all, no one should pressure the adviser to work for less than the price that they are willing to work for, and by the same token, no client should pay more than the perceived value of the service they are receiving.
Is this model practical in the advice world? Most people would be aware that unlike a lawyer who does work for a client based on a request, need or a solution to a problem, the nature of the work an adviser is required to do is quite different. It mostly is long term oriented, forward-looking, proactively considering issues, seeking solutions, structuring assets in various entities to avoid future tax and other problems, researching products, meeting with Fund Managers etc and therefore it would be impractical to charge hourly as most clients actually don’t know what they don’t know.
Fixed Dollar versus Asset-Based Fees
Whilst there is some logic to the fixed fee model, it is unfair for lower-value clients (typically those below $600,000) who face being significantly overcharged. Most advisers would say that the minimum annual cost to service a client is around $6,600 pa inc GST. So consider a client who seeks advice with a $200,000 initial investment; but with strong future earnings and therefore savings potential, coupled with some insurance requirements. An adviser who charges say, an asset-based fee starting at 1.1%, would charge an annual fee of $2,200; versus an adviser who sets a minimum fee would charge that client $6,600 ie 3.3%. We think that is inherently unfair and that an adviser fee should grow proportionately with the client’s assets (albeit diminishing at higher portfolio levels).
However, one cannot have it both ways – the reality is that most clients are essentially ‘financially assisted’ at some early point in their investing life whilst they have smaller balances. What that means is for a number of years the adviser may essentially support that client until they cross over their minimum fee. At Horizon Wealth, we charge our clients an asset-based fee but the fee percentage reduces as the client’s balance grows.
We believe that this is the fairest of all the methods, as the clients’ interests and those of the adviser are aligned perfectly in that the more the portfolio grows, the more we get paid (although the asset-based percentage does reduce as the portfolio grows and this diminishes significantly for clients with large value portfolios). Conversely, if the portfolio value reduces, our revenue reduces.
From within the Product or invoiced directly to the client
This point has arisen recently during the Royal Commission where they suggested that it is more desirable that an adviser fee should be paid from outside the investment/superannuation product. At this point in time they have not yet prevented adviser fees being funded from the Product.
Let us examine this suggestion.
Most advice today is centred on Superannuation. After a person’s home, the value of their Superannuation is their second-largest asset. For most people until age 60, this portfolio is illiquid.
So imagine a client who wishes to obtain advice but they do not have sufficient cash flow to pay for advice other than from their superannuation portfolio. If the law did preclude adviser fees being funded from the Product, and forced clients to pay for advice from their personal cash flow, then they may be prevented from obtaining advice.
Would that be fair?
So is all of this a step too far?
You be the judge of that but we think so.
Where are we today and what protects you
As far as advice fees are concerned, advisers are obliged to issue an annual FDS (Fee Disclosure Statement) stipulating the fee that the client paid for the past 12 months, the services they received as well as those services that they are entitled to receive. Further, every 2 years clients are obliged to Opt In to the fee arrangement – if they do not, advisers are required to terminate that arrangement.
Nevertheless, most importantly as is the case with most business relationships, the client can terminate the relationship at any stage, as can the adviser.
How does Horizon Wealth differ from the rest of the market?
Our business model has always been based around providing a ‘first/business’ class service to a limited number of clients. We strive to provide exceptional service to these clients together with solutions that are meaningful, well-considered and which deliver value to you. That is the basis on which a fee should be evaluated. It is really about the quality of output, not the quantity of time that may or may not have been spent on your affairs.