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Planning's Dirty Little Secrets - Eureka Report Article

August 9, 2006
Planning's dirty little secrets
By Scott Francis

PORTFOLIO POINT: Investors should think hard about getting rid of any planner who merely pushes them into a managed fund and collects an ongoing commission.

Financial planning is an industry riddled with compromise, cosy deals and the kind of flimsy standards that would be unacceptable in any other sector. It's time to blow the whistle.

The industry would like to see itself as a profession, but the continued existence of these issues means the term "profession" is not yet appropriate. Much of the industry's ugly side has been revealed since ASIC's surprise decision to act against AMP Financial Planning, Australia's biggest force in financial planning.

I am convinced there needs to be an industry-wide cleanup and hope ASIC has made the first move towards that. Such a clean up would see products and commissions replaced by an emphasis on service, strategic advice and transparent fees. As ASIC monitors the 1600 financial planners inside AMP, it's time to look at the flaws at the heart of financial planning.

1. Diplomas in eight days

When most people enter into a relationship with a professional financial planner, they expect to be dealing with a highly qualified professional who will be able to guide them towards their financial goals. It is worth understanding that the minimum standards for financial planners are very low compared to other professions, such as teaching, accountancy, law and medicine.

Of course, it is not as though you can get the basic financial planning qualification, the Diploma of Financial Services, in a week. It will take at least eight days.

It will take a further eight days to achieve the Advanced Diploma of Financial Services (ADFS) qualification. This exaggerates the situation somewhat, as the example is based on the time for the shortest course available; however, it is still a course that is available.

What is more, it is a course without any exams, relying instead on ongoing assessment over the 16 days taken to complete the ADFS. Still, would anyone want to trust their financial circumstances to someone with only 16 days of training? I completed my own ADFS through a training provider in less than four months. (I have other qualifications, including a Master of Financial Planning degree, that make up for the lack of rigor in this course of study). Even the most rigorous Advanced Diploma of Financial Services consists of eight courses and would be comfortably completed in a year.

The Financial Planning Association (FPA) website says the highest professional certification for a financial planning is the "CFP" designation. This requires a financial planner to complete a further five subjects of study, have three years of practical experience and abide by the FPA's code of practice. This means that a financial planner with an ADFS and a CFP will have completed 13 subjects of study in total. This is a markedly lower level of study required than any other profession that I am aware of, yet results in the "highest professional certification" available. From 2007, this standard will be lifted for new people entering the CFP program, because an undergraduate degree will be required.

2. The gearing trap

Financial planning should be about successfully investing your money; too often within the financial planning industry it quickly broadens to include personal borrowing. "Gearing", borrowing funds to expand you investments, is not for everyone yet it is pushed as a panacea by many planners.

Why? Because the more you borrow the more the planner makes from you. It's simple: once you "gear" your portfolio the planner gets commissions on the enlarged amount.

Consider the way a simple financial strategy such as borrowing to invest is corrupted by commissions. If a client with $100,000 to invest approaches a commission-based financial planner, they may be urged to go for a wrap service and managed funds that pay total commissions of 1%, or $1000 a year.

However, the financial adviser may just as easily recommend that the client borrow a further $100,000 using a margin loan and invest $200,000.

While the client is lured by the larger tax deductions they can get from their geared portfolio, the planner now receives 1% commission on $200,000 plus another trailing commission of 0.5% on the margin loan, $2500 a year in total. Borrowing to invest is a legitimate and powerful financial planning strategy, but the commissions in the example make it difficult to know whether it is a strategy in the best interests of the client or the financial planner.

3. Percentage corruption

Most reasonably astute people now understand that upfront and ongoing commissions paid by financial service products such as managed funds and insurances have the potential to influence planners' advice. The "structural corruption" in the financial planning industry runs deeper than this, and the following are two further examples worth keeping in mind.

Most sections of the financial services industry express their fees in the form of percentages. Managed fund fees are expressed in percentages, as are wrap account fees, industry super fund fees, and trailing commissions. Even many independent financial planners express their fees in percentages.

The risk of this is that investors will look at a percentage-based fee, and not really comprehend the impact the fee is having on their expected investment returns. For example, the average long-run return from Australian shares has been about 12% a year. That means that paying 1.8% for a fund manager to manage your Australian share portfolio is equivalent to paying 15%, or close to a sixth, of your expected investment returns for that management. This is a significant portion of your expected returns. Think about it: imagine you invest $180,000 into a fund with an MER of 1.8% over 10 years you'll pay $32,400.

Or consider the situation where an investor is paying a 1% fee to an adviser, a 1% fee for a wholesale managed fund and a 1% fee for a wrap account, a total fee of 3% of the value of their portfolio. This is equivalent to paying a quarter of their expected 12% return from an Australian share investment in fees. It means a quarter of your investment rewards are ferried away to the financial services industry! Over 10 years a $180,000 portfolio will have paid $54,000 in fees!

The impact of percentage fees on a balanced investment portfolio, where the expected return is lower than a share-based portfolio, is even more significant.

4. The myth of independence

To call yourself an independent financial planner requires that you are not owned by a financial institution and you do not keep any payments from financial products (such as commissions). Commissions that are received need to be rebated to clients.

An "independently owned" financial planning firm is not "independent" if it bases its revenue on accepting commissions from financial planning products. The Association of Independently Owned Financial Planners had a number of member firms involved in advising client to invest in high-commission Westpoint schemes that have since collapsed. Being "independently owned" might help protect clients against any bias to recommending investments from an institutional owner, but it does not help protect against the bias to recommend commission-driven financial planning solutions.

5. Managed funds not the only option

Managed funds have been the core of the financial planning industry. They are a simple way to manage money that usually pays the planner an ongoing income stream, in the form of a trailing commission, for the life of an investment. It also sounds great for the client: they have a professional fund manager taking care of their money! The only problem is that it does not work particularly well. Managed funds, particularly the large managed funds run by big financial institutions, do not add enough value to cover their fees. For example, in a recent Eureka Report article entitled Planner's Money Drain we saw that managed fund run by the financial services firms listed in the ASX100 underperformed the market index by an average 1.7% a year over the five years to June 30, 2006.

In an effort to create a need for services, the financial services industry tends to promote the idea that investing is too difficult for an individual to manage on their own.

Warren Buffett is perhaps the greatest investor of all time. In his 1997 letter to shareholders of his Berkshire Hathaway group, Buffett writes: "Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals." As an aside, Buffett's letters to shareholders, posted on Berkshire Hathaway's website are well worth reading. The are simple, clear, thoughful and amusing.

You should be thinking hard about sacking your planner if all they do is help you pick managed fund investments. Building and adding regular additional investments to a well diversified portfolio of growth asset using simple index funds such as an Australian share index fund, an international share index fund and a listed property trust index fund will provide an effective investment solution.

6. The fee wrap

"Wrap" accounts or "platforms" are the administrative structures the majority of financial planners now use to manage client portfolios. These are very useful for financial planners, cutting down on much of their administrative load.

Wraps are replacing managed funds as the way that financial institutions capture fees from clients. Putting all clients into the institutional wrap platform means that regardless of what managed funds are recommended the institution is still receiving an ongoing revenue stream from the client. The use of wraps make financial institutions appear more independent.

Rather than relying on commissions from managed funds financial planners can now add a percentage-based fee on to the wrap fees and collect an ongoing stream of payments. These payments, however, appear to allow the financial planner to appear more independent.

All of this would not be bad but for the dubious value that wraps add for clients, given their relatively high cost and simple function.

7. The last resort

One of the least-known and most controversial issues within the financial planning sector is the buyer-of-last-resort agreement between planners and product-selling institutions. It allows the business to be sold to the institution as a "last resort" and has acted as a de facto insurance policy for many planners; the downside is that it promotes a distinct bias towards the institution during the life of the business.

Buyer-of-last-resort agreements mean a financial institution pays a planner a "capital value" for their business when they retire. The value is based on the level of funds they have placed with investment managers, often with higher levels paid for the funds placed with the financial planner's institutional owner. The agreement effectively encourages advisers to recommend in-house products to increase the capital value of their business.

In a first for the indusry , the NAB subsidiary MLC announced on July 31 it was terminating its buyer-of-last-resort program. Having dumped the scheme, MLC promptly confirmed what everyone already knew: MLC said it had changed its approach to "remove the bias towards the sale of in-house products and to minimise the potential for a conflict of interest". MLC will now use an external valuer to determine the valuation of a planning business. But the majority of institutions still run buyer-of-last-resort schemes.


The financial planning industry has much work to do if it is to continue its progress towards being considered a profession. It must change its fee structure, the level of training required by financial planners, and its focus from investment products to investment advice. This does not mean clients should stay away from using financial planners altogether; they should just make sure they take the time to find one who really is working in their best interests.

Far beyond just building an effective investment portfolio, which you now know that you can do yourself, an effective financial planner should also help you maintain a disciplined approach to saving over time, stop you from chopping and changing your investment strategy, and devise effective financial planning strategies to help you make the most of your financial position.