Here's some free advice for the advisers

BY SIMON HASSAN

Consumer's recent mystery shopper survey had its limitations – journalism is journalism – but it would be dire folly to imagine this means it can be ignored. No matter how you see it, the report showed up real shortcomings in some of the financial advice on offer in New Zealand today.

Kiwis deserve better, and if our little, vulnerable economy is to thrive – for everyone's sake – things have to change. Here are some thoughts on how we got to where we are, and what should happen next from a leading adviser and commentator on the New Zealand scene. For years Kiwi financial advisers took pride in small numbers of complaints and even fewer court cases. This led many – including me – to conclude that all was pretty well. There will always be a few bad eggs, but on the whole we thought of financial advisers as an honest lot who meant well and generally did the right thing by clients.

I am still sure this is the case. But it's time to admit that the futility of a complaints process without redress, paired with the very high cost of seeking satisfaction in court, have had more to do with our tranquil past than the quality of the financial advice.

Things are rapidly changing. The information age, more discerning consumers, the public shame of finance company failures and the credit crisis and now regulation. With or without mystery shoppers there are real problems to be addressed.

When I joined the industry about twenty years ago most financial advisers worked for insurance companies. They were called "agents", a word that accurately described their role in selling financial products for commission. The first insurance-based investment products were typically locked in savings schemes. But there were also lump sum investment products. These were usually "balanced funds", in which investors' funds were pooled and participated in a wide range of underlying investments, with the overall mix managed by professionals to reduce the risk.

The agent's initial commission from sales of lump sum products was typically four or five% of the amount invested – that's $400 or $500 for an investment of $10,000. There were often also ongoing "trail commissions": typically 0.25% per annum of the value of the investment.

Of course these commissions – and the additional commissions paid to the agent's sales manager, his regional manager, her national manager and others, all had to come from the same place: the client's money. But these people played important roles, especially in training and supporting the agents, and (albeit with the unavoidable bias that comes with vested interests) in understanding the products that were to be sold. Commission was a drain on returns, but there were other weaknesses in the system: Costs and the internal workings of funds were often not clear

As a natural corollary to this there was a lack of accountability and too many opportunities to sweep mistakes under the carpet

The fees charged by fund managers and others involved in the internal workings of funds were high

On top of this most funds were over and inefficiently taxed Unsurprisingly, all this often led to poor returns for investors. But there were few alternatives, and even with poor performance, nest eggs that might not otherwise have happened were built.

The 1990's saw huge changes in the industry, some of which made things worse:

Deregulation and rising living standards fed a growing interest in investment products, and insurance companies faced new competition from fund managers and banks.

At the same time, falling demand for traditional insurance products was squeezing their profits.

And new breeds of adviser – financial planners and investment advisers – were entering the market, tightening the squeeze. Many of these new players were professionals and the new models they brought were to transform the financial advice process.

But there were plenty of sharks too – looking and sounding like professionals, and driving fancy calculators, but in reality little more than commission-hungry managed funds salesmen.

Insurance companies responded by rapidly changing the way they worked. Their agents were encouraged to become "independent advisers", tempted out by enhanced commissions. These higher commissions were funded by a wholesale clear-out of middle management – including most of those who had held training and sales management roles. Higher commissions were not the only attraction to newly untied agents. The change saw the best of them move up the professional scale. Many accepted the challenge of going back to school for a professional qualification, and many embraced the financial planning model and fee-based remuneration. But others joined the sharks: paying lip service to professionalism and coat-tailing on their peers while joining the commission-fed frenzy without concern for the interests of clients.

The story was that advisers would spend their commission increases on training and support, and of course, many did. But the others: yeah right! Even more jaw-dropping, looking back, was that the lawmakers and regulators just stood by and let it happen.

Freed of their old responsibilities for supporting and training those who sold their products, product suppliers now only needed contact with advisers to get their product out the door. Rather than the intensive training and support of the old days, newly independent advisers were besieged by business development managers whose friendly smiles and marketing budgets were intended simply to help their bosses win market share. As a result many advisers went without vital training and guidance, and were seriously under-equipped to deal with clients. And as always the clients were typically none the wiser, until things went wrong.

The decimation of their tied agency forces, and the money to be made drew product providers into distribution wars that are still raging. While the professionals worked at "raising the bar" and doing a better job for clients, the sharks were free to forage: and some suppliers were happy to cooperate. Commissions were ratcheted up, back room deals were done, and without the controls of the old tied agency world, unprincipled "advisers" churned and burned their way to quick bucks – while hapless consumers – and the profession – paid the price. As an example of the abuses these circumstances spawned, look at what's happened to trail commissions. The "market rate" for these ongoing rewards for getting clients to invest in managed funds has rocketed from a modest and almost universal 0.25% of fund value per annum in the mid 1990's to an obscene one% per annum with a group of product suppliers. To their credit others have resisted this abuse, and some still don't pay trails at all. Bear in mind that trail commissions need not be a reward for service. There are virtually no requirements for an adviser who is taking the full trail other than to recommend a supplier's products to clients that are naive enough to go long with the "advice". Let me be clear: 1% per annum might be very reasonable remuneration for a professional who is adding value in other ways. But where it is simply a regular payment taken from the a client's funds and passed to an "adviser" – perhaps without the client's knowledge – by a fund manager with no goal other than the adviser loyalty (to the fund manager of course) it looks more like complicity in theft. A uses B's money to reward C for their loyalty to A. Of course it's all in the fine print somewhere, and if the trail is variable I am sure the client will have signed something that amounts to agreeing to it. But I'd like to see Consumer ask Kiwi investors how much they know about the trail commissions being deducted from their funds and paid to people they may never see.

Never see because in some cases these trail commissions are a permanent entitlement for the adviser who sells a product, or whoever they sell the business to. Say again? A promises C that if B invests say $20,000 in A's product A will slip C, or C's successor, $200 a year from B's investments for as long as B's investment stays in place! Whose investment was it again?

There are variations on the theme. Some advisers rebate trail commissions to their clients. But even this doesn't guarantee that they are clean. Using a "master fund" or "wrap" platform can mean they are charging fees as great or greater than the rebated trail commissions – still with no requirement to earn them. Once again these payments may be entirely justified – or not. Generally it is harder to call the master fund manager or wrap provider complicit, and these fees are likely to be paid under a separate agreement, so it is far more likely the client will know about them. But I believe this still places the fund manager or wrap platform provider under an moral obligation to ensure that those they allow to use their products are likely to be doing the right thing. One way to do that would be to that they belong to a recognised professional body which sets enforced professional standards and requires members to act in the interests of clients. There is only one of these: the Institute of Financial Advisers.

It is not surprising that many 'prudent but uninformed' consumers are more confused now than they were before, or that the general level of trust enjoyed by financial advisers has fallen in recent years despite efforts of those who have been labouring to lift standards. To be fair current lower levels of trust are likely to owe more to the financial disasters of recent years than to poor advice. And despite the impressions of journalists advisers did not cause these, and (I believe) that only a small minority of professional advisers could be held responsible for the damage that these collapses did to the wealth and confidence of Kiwi investors.

But it was too much to expect a self-regulated profession to flourish in this environment. It was not for the lack of a real need: many financial decisions are too complex for the average person to make without advice. There is more need that ever before for trusted professionals to fill this role. But our unregulated environment left too many gaps. Even without pressure from IOSCO; the urgency added by finance company collapses and the credit crisis, or politicians who eventually saw a political imperative to ride with: we were ripe for regulation. And for better or worse (and I'm firmly in the 'better' camp) it will soon be here.

Professional advisers will welcome regulation, and so far as I can see it will be largely effective. It's just a pity its taken so long. I do see one gap in the initial framework for AFA's (those offering financial planning or investment advice). While a Level 5 qualification may be sufficient for an adviser who operates in a supervised or team environment, I don't think it will always be enough for a sole practitioner, especially one who will operate in a remote area. I would add a requirement for this group to be in a structured 'peer-review' relationship (akin to and extending the initial 'mentoring' they will be required) until they have accumulated at least five years of relevant professional experience.

It's easy to focus on bad eggs in the advisory community, and the shortcomings of the good eggs, but as suggested earlier much for the blame for recent abuses belongs with product providers and regulators. In some ways New Zealand is still a financial product wild west. (Better late then never) the heat has also come on finance companies and other non-bank deposit takers. Bigger players in that sector will soon need credit ratings, and market disciplines may prove effective regulators of the others. Credit ratings can be wrong, and are always out of date, but at least this is a start.

There has also been useful tax reform. Now that the difficult transitional year is behind them most investors can look forward to more of their returns staying in their hands and less going to the IRD. But there is one anomaly I'd like to see fixed: the de minimus regime under the FDR rules was intended to give smaller investors a break. But last minute changes in its final stages saw the legislation change at the eleventh hour, and one result of this was that the de minimus regime now penalises smaller investors (individuals who have invested less than $50,000 in qualifying investments, $100,000 for couples). These typically smaller and older investors are stuck with the old rules and still have to pay tax on distributions even in years where their investments lose value. I believe it would be easy to fix this, and I have written to the Minister about it, but with no joy.

But it is an indictment on successive Governments, officials, state watchdogs and regulators that there has been little other meaningful regulation for the suppliers of financial products and those they work with. The way I see it the suppliers of financial products (including managed funds, savings vehicles and insurance products) and services (including master fund administrators, custodians and wrap providers) should face the same kind of tests required of the advisers who recommend or use them. The rules should generally be principles-based (rather than prescriptive) with the overarching principle being the interests of consumers. The aim should be flow through accountability that catches suppliers of products and services in that same way adviser are caught.

Offerors of financial products and services should have to make effective disclosure in offer documents. Disclosures should use plain English, graphs and tables (all in standardised formats to facilitate comparison). The information disclosed should include everything, a reasonable consumer or adviser might find helpful in working through the process of deciding whether to use them. These documents should be short, exclude marketing material, and be accompanied by single sheet summaries of key details (true "factsheets"), also consistently formatted to aid understanding and comparisons. Those offering financial products should have to be authorised and subject to a code just like AFA's. The supplier code would place the interests of consumers to the fore, and cover things like:

Responsibilities to consumers and advisers, including the duty to exercise of care, diligence and skill.

Performance reporting standards. The CFA Institute has published Global Investment Performance Standards (GIPS), compliance with which should become a condition of authorisation.

The provision of MERs disclosing the gross costs borne by investors in a fund over and above the costs they would be likely to face as direct investors in the same underlying assets. These should include estimated MERs (for the current year and any previous years for which actual data is not yet available) and the most recently produced actual MER.

Commissions should be banned for most forms of investment. The only exceptions should be for situations (which might include KiwiSaver) where commission may – in some instances – be the only practicable remuneration method. Where exceptions are granted commission rates and disclosure should be standardised, and if fees are charged there should be a transparent offset to ensure fairness to all.

Were possible investment products should be structured in such a way (eg, by requiring an equity contribution) to align the interests of promoters and fund managers with those of investors.

Related party dealings and all conflicted arrangements should be banned.

Trustees: of what and for whom?

Another group that I believe is poorly regulated at present are corporate trustees.

The only reason there are trustees of investment vehicles are to protect the interests of investors. But apart from bringing in receivers – typically when it is too late to salvage the bulk of investors' money – they seem to do very little of value at present. My perhaps cynical impression is that trust deeds are drafted by fund promoters, who do all they can to limit the rights of investors, then look for a trustee who is willing to accept a healthy annual fee in return for going along for the ride.

The power of trustees to take effective and timely action to protect the interests of investors needs to be strengthened.

And why not standardise trust deeds?

The accountability of the trustees of investment vehicles should also be boosted. A trustee that fails to meet it obligations should suffer meaningful penalties.

Trustees should not be permitted to take on conflicted roles, such as that of investment adviser or investment manager. In the same way advisers and investment managers should not be trustees.

Where trustees act for disempowered or underpowered beneficiaries (as is often the case, especially where corporate trustees act for minors and deceased estates) they should be subject to active scrutiny and spot audits by a readily accessible commissioner or ombudsman.

The future: healthy financial system, trusted financial sector Two groups create the financial services industry, and the interaction between these two creates the need for a third.

The two essential groups are:

Suppliers of financial products – including their aligned distributors (agents and staff), and

Consumers of these products

The natural conflict between these groups, and the "knowledge gap" that tends to disadvantage consumers when dealing with suppliers, creates the need for the third group:

Professional financial advisers

The most important roles played by members of this group are in helping consumers develop strategies and select products likely to meet their needs, and (where appropriate) acting as their advocates with suppliers. This is the group to which I am proud to belong, and that I have been privileged to take leading roles in over the last decade.

The Institute of Financial Advisers represents financial advisers who put their client's interests first. This is its first rule for members.

But it's early days. There are still many (some inside, and many more outside, IFA) who – while they may claim to be, and even believe they are, professionals – lack either the competence, the objectivity, or the integrity that this important role demands. IFA and that all who share its genuine concern for the interests of clients have to help them pick up their act, or move out.

It is inevitable that the arrival of a safer, better environment for consumers will be marked by 'bad news' stories like the mystery shopper report: Over the next decade, as those consumers who are not frightened off by bad news stories benefit from the new, safer and better environment; those advisers who have what it takes to survive will prosper, but they will also need safer, better systems and processes, and a very clear idea as to just what they have to offer their clients.

That way we'll be part of a bright future: professional financial advisers with access to good financial products earning the trust and regaining the confidence of Kiwi consumers.

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