Skip to main content
rss feedour twitterour facebook page linkdin
Reforms won't stop the shonks - Eureka Report article

Reforms won't stop the shonks

By Scott Francis
April 28, 2010

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.

Eureka Report members can chalk up another win. After our five-year campaign against commission-based advice, the government has caved into pressure from Eureka Report and others by delivering a proposal that addresses many of the fundamental problems with the financial services industry.

The announcement by Financial Services Minister Chris Bowen came one year after the Financial Planning Association decided to take a position and phase out commissions from July 1, 2012, a deeply divisive reaction to the bad publicity surrounding the actions of some financial advisers in the wake of the GFC.

But do the recommendations go far enough?

In my opinion that the new reforms don’t do enough to prevent catastrophes such as Storm Financial from happening again. However the government has chosen to ignore two changes that could have a very real impact.

The first is addressing the qualifications required of a financial adviser, and the second is the conflict of interest that occurs when a financial adviser is employed by a financial service product provider – as most financial planners are.

Investors might be interested to note that some financial planning courses take less than a year to complete. And the CFP qualification – described by the FPA as the “highest professional certification” – now requires planners to complete an undergraduate degree first; this doesn’t extend to financial planners who have previously completed a CTP.

If you consider professional financial advice to be as important as teaching, engineering, healthcare, accounting or legal advice, it stands to reason that it should be supported by similar educational standards.

For years AMP and others have referred to financial planners as being “advice-based distribution”. They see their large sales force of financial planners as a competitive advantage. AMP is, of course, currently involved in a takeover that would see its army of planners swell considerably. Nothing in this overhaul of the financial planning industry sees any move to separate financial planners from financial services firms.

As Eureka Report showed in this article, the majority of recommendations from financial planners flowed to the financial services institutions that owned/licensed them. This is not consistent with any reasonable measure of independence of financial product recommendations, which is presumably the aim of the reforms.

Meanwhile, three of the reforms getting the most attention are:

  • The banning of commissions.
  • The requirement of financial planners to act in the best interest of clients.
  • Ban of asset-based fees when clients borrow to invest.
It is therefore useful to ask that if these reforms would have prevented two of the big catalysts for the reform, namely the collapse of Westpoint in 2005 and Storm Financial in 2009.

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.