Investment Trends recently released its 2018 Financial Advice Report, an in-depth survey of the appetite and use of financial advice among Australian adults. The Financial Services Royal Commission has profoundly affected perceptions of the financial planning industry and trust in financial planners and banks is at all-time lows.
Among the major issues at the Commission, fees for no service, charging fees to dead people and dud insurance policies are easy concepts to grasp. However, grandfathered commission is more difficult for most people to get their head around. Various groups have been vocally calling for blanket bans, and banks have been backing away from commitments made to financial planning groups in order to placate an angry population.
How did it all start?
The dictionary definition of grandfathering is to exempt someone or something from a new law or regulation. In the financial advice context, grandfathering concerns investment commissions, superannuation commissions and insurance policies linked to super accounts.
Let’s step back. In the 1980s, financial institutions started marketing managed investments, where investors could access the share market by pooling their money with other like-minded people in a managed fund. The investment managers did not have a means to sell the concept: no sales force, no client service departments and no real way to communicate with potential end-investors. They enlisted the support of intermediaries. They charged the investor entry fees into the managed fund which they passed to the intermediaries as upfront commission. Since July 2013, these commissions have been banned.
The intermediaries were also paid ongoing (trailing) commission, usually 0.3% or 0.4% per annum on the value of an investor’s account balance. It is these commissions which most of the fuss is about. The payments were intended to subsidise the cost of providing ongoing service to people who bought the managed funds.
Who pays it and who gets it?
Two important factors to note.
First, the trail commissions were paid by the investment manager out of their management fee. It was not an added fee that was deducted from the investor’s account. Consequently, it did not (and still doesn’t) show up specifically as a debit on investor statements. If an investor didn’t invest via a financial adviser, the fund manager invariably retained the money and didn’t rebate it to the investor. These managers didn’t really want a direct relationship with investors, and they certainly didn’t want to jeopardise their adviser distribution arrangements. At the time, any fund manager who ‘went direct’ or discounted fees risked being blacklisted by angry advisers.
Second, these commissions were not paid directly to financial advisers, and still aren’t. The vast majority of financial advisers are authorised representatives of a ‘licensee’ (sometimes referred to as a ‘dealer group’) rather than take on the responsibilities and risks involved with having their own licence. This spawned the creation of a group of independent licensees, some of which attracted large numbers of financial advisers. Investment managers paid commissions to the licensees who passed them on to financial advisers after deducting a percentage to cover the costs and profit margins of the licensee.
Along came vertical integration
In the late 1990s, banks recognised the profit opportunities that vertical integration could deliver, and retail banks bought fund managers, administration platforms and licensees. They derived profits from the management fees created by fund managers, admin fees from the platform and a share of the commissions created by financial advisers. Furthermore, their profits were bolstered by the mushrooming size of the superannuation market which grew from virtually nothing in 1992 to more than $2.7 trillion today.
Over time, the legal and compliance demands on financial planners grew to such an extent that trail commission was nowhere near enough money to cover the costs of financial advice. Consequently, many advisers tacked on an adviser service fee to the client’s account. This fee had to be agreed with the client in writing, via a signed copy of the application form, and was directly deducted from the client’s account and was specifically itemised on the client statement.
Some adviser groups rebated the entire trail commission and covered their costs by charging adviser service fees. Others used a combination of trail and adviser service fee.
The ban on commissions
Rumblings about commissions had been growing for a while but really blew up when the industry funds started spending big money on advertising. These ‘compare the pair’ advertisements graphically revealed how much money could be ‘lost’ by ordinary Australians over the course of a lifetime. The Labor Government introduced a package of measures designed to eliminate commissions and increase transparency, including:
- A ban on upfront and trail commissions on all new investments.
- Super funds had to invest all new super contributions into new low-cost investment options which didn’t pay commissions.
- All existing super accounts would have to be transferred to the new low-cost investment option unless the member had actively selected a non-default option, or the fund received notification from the member saying they wanted to remain where they were.
- Advisers had to provide Fee Disclosure Statements every year.
- Clients had to sign an Ongoing Service Agreement every two years which clearly stated the services that were to be provided and what they were being charged.
The key date was 1 July 2013 but many of the measures had grace periods and different implementation dates. This confusion was amplified when the Coalition won power and announced they would roll back some of the changes, but the cross benchers objected.
Grandfathering of commissions
The measures that were eventually introduced contained some sweeteners, omissions or mistakes, depending on your view. The major concession was that trail commissions on existing investments were grandfathered. In other words, if an investor remained in an investment, trail would continue to be paid until the investment was redeemed, in theory forever.
Due to the forcible transfer of commission-based superannuation accounts to commission-free accounts, grandfathered commission was expected to die out relatively quickly. However, they are an important part of the revenue structure of many advice groups, although certainly not all.
What isn’t generally recognised is that many superannuation members are actually better off in commission-paying investment options.
First, low cost super funds often underperform other investment options, even after fees. Second, when MySuper and FoFA were introduced, many retail super funds found other ways to earn revenue, ostensibly because of the additional legal and risk costs. While they deducted the trail from the management fee, some increased their administration fees, inserted an adviser service fee or added a regulatory reform fee to cover the costs of compliance. Overall, management fees went down but perhaps not as much as expected.
Some workplace super funds also changed their fee structure so that management fee discounts were lower on the new MySuper products. These discounts often started when the workplace super fund reached $1 million but following the introduction of MySuper, the starting point for the discounts on some new low-cost options moved $5 million. This sometimes wiped out any cost savings accruing from MySuper. Also, many financial advisers were rebating some or all of their trail commission, and this benefit was lost to MySuper members under the new fee regime.
Grandfathering rights were also extended to allow advisers job flexibility and retirement options:
- If a financial adviser leaves his current licensee and joins another licensee, the trail continues to be grandfathered and the new licensee receives the commissions instead.
- If the adviser retires and sells his business to another financial adviser, the new financial adviser can inherit the commissions.
- If the adviser’s licensee buys his business the licensee inherits the trail commission.
In my opinion, these allowances are reasonable otherwise it creates a restriction on advisers to practice, dramatically limits their employment options, decreases the value of their business and reduces their retirement choices. Grandfathering is an expected concession when changes are made to legislation (and listen to the howls of complaint when it is denied!) so why should financial advisers be treated any different?
Bigger FoFA mistakes
I believe the biggest mistake the government made when introducing FoFA was that Fee Disclosure Statements and Ongoing Service Agreements did not have to disclose trail commissions. This gave advisers the opportunity to be economical with the truth, and it is probable that many investors remain completely unaware of exactly how much money advisers are making on their investment. Many advisers did not disclose trail commissions. In their view, commissions are payments made by the super fund from their management fees and not a direct cost to the client.
While history is on their side, the future is not.
Before retiring in June 2018, I spent 26 years in the investment and financial planning industry including with two fund managers, two banks and three financial planning organisations. Even with this background, I may have overlooked an important aspect of commissions so please feel free to chime in!
Prior to retirement, Rick Cosier was a financial adviser for 26 years and Principal of Healthy Finances Ltd. This article is for general information only and does not consider the circumstances of any individual.