Reforms won't stop the shonks - Eureka Report article
Reforms won't stop the shonks
PORTFOLIO POINT: Proposed reforms on financial advice are a step in the right direction, but would still leave investors vulnerable to being caught up in another Storm Financial.
In both instances the advice given to investors lined the pockets of those selling products without providing the investor with an adequate risk assessment. In the case of Storm Financial it was heavily geared investments in the equity market; and in the case of Westpoint it was investment in risky mezzanine funding for property development.
The banning of commissions
There are two key conflicts of interest in the financial services industry: one is commissions; the other is the ownership of financial planning firms and financial planners by financial service institutions. These changes will not affect that ownership.
While a ban on commissions would have almost certainly helped in the case of Westpoint – where advisers were paid commissions of up to 10% to sell risky mezzanine finance for property developers – the outcome for clients of Storm Financial may not have been as clear-cut.
Storm Financial had people so eager to invest in a strategy that was presented as their realistic shot at wealth, that they would have just found another way to charge fees, given the unrealistically high client expectations.
The requirement to act in the client's best interest
The key question around this requirement is to ask whether the financial planners that recommended investment strategies such as Westpoint or Storm Financial expected it would lead to financial ruin for their clients?
I don’t think planners intentionally acted in a way that would lead to their clients being hurt, often ruined. It was simply due to their lack of education or poor understanding of investment markets that led to them recommending flawed strategies and investments.
Many planners have been quoted as saying that they too lost money in the collapses, which is really just another way of saying that they were too stupid to know that the investment or scheme was flawed.
On that basis, I don't see the requirement to act in a client's best interest as being likely to prevent the Westpoint and Storm Financial style failures of the industry, unless it is supported be a greater emphasis on financial planners understanding what the client’s best interests are, and ensuring planners have appropriate educational standards.
Banning of asset-based fees when advising clients to gear investments
Of the three, this is the most useful change to the financial planning landscape.
Eureka Report has often written about the conflict of interest between a financial planner who encourages a client to borrow, and the additional fees this brings. This overused practice was highlighted in Eureka Report as far back as 2006 (see Planning’s dirty little secrets) – more than a year before the global financial crisis.
If this change can be enforced, planners will no longer receive an additional financial benefit from encouraging clients to borrow to invest. Some of the biggest collapses of the past few years had excessive borrowings at their heart – including failed mortgage schemes such as Westpoint, agricultural investment schemes and Storm Financial.
The reason was simple: it made outrageous sums of money for those prepared to recommend them.
Consider a typical Storm Financial client, say 60 years old and on a modest income. If they had $250,000 of equity in their house, they were urged to borrow $250,000 against the value of their home, use that money to borrow a further $300,000 and invest the $550,000 total into a share fund paying Storm Financial a commission of more than 6% upfront plus trailing payments in perpetuity.
What is the value of an upfront commission of 6% on $550,000? A cool $33,000 upfront and at least $5000 a year – for just a few hours’ work with one client. Nice work if you can sleep at night.
The same formula suggests how the 10% commissions paid on the failed agricultural and Westpoint schemes became even more lucrative if clients could be persuaded to gear up, and why the fallout from of such failed investments was greater, often costing investors their homes.
If this recommendation can be effectively enforced it will be a big win for consumers.
The changes put forward for the financial services industry are a step in the right direction. They may even have helped avoid some, but not all, of the recent failures of the financial services industry. The focus on restricting some of the gross conflicts of interest that come with recommendations to borrow and invest being the most useful.
However, the structural corruption of the financial services industry remains as long as financial product providers – from big financial service firms like AMP and the big banks through to industry super funds – can employ financial planners, who naturally are in a position that is susceptible to influence.
Further, the lack of a reasonable minimum educational standard means that even those financial planners who are driven to act in the best interest of clients may not have the knowledge to do so – which makes them and their clients still vulnerable to poor quality advice.