30/03/2009

The obvious constant between two of the biggest investment fund failures in the last few years, Westpoint and Storm Financial, was the high commission rates these products paid to financial planners.  So if excessive commissions are likely to undermine the quality of financial advice available, we should not use a bludgeon to ban all commissions and affect the livelihoods of many good financial planners – but rather a scalpel to fix the problem.

 

One commentator has estimated that Westpoint paid up to four times the going rate of commission to so-called “financial planners” who convinced their clients to invest and a further 8% commission to convince their clients to accept “rolled over” promissory notes after default on the original notes.

 

Publically-listed litigation funder IMF has estimated that up to 100 planners put clients into these investments driven purely by the high commission rates.  That means many more planners did the right thing and ignored the product.

 

Storm Financial’s commission offerings were similarly generous with reports of 7% commission being paid to planners. Clients’ accounts may also have been manipulated to ensure higher trail commissions.

 

Now it’s been many years since my science high school classes but I seem to remember that a catalyst is something that doesn’t take part in a chemical reaction but helps it along.  Is that a good way to describe the payment of unusually high commission rates?  They weren’t the reason for the failure but certainly helped along the interaction between the investors and the products and therefore may have been indirectly responsible for the losses by those investors.

 

So if it is appropriate to describe unusually high commission rates as a catalyst then does it not follow that future products with that feature should attract early attention from industry bodies and regulators just to be on the safe side? Early investigation of such products could prevent another disaster.

 

That is if commission payments are to survive at all.

 

It just doesn’t seem that difficult to say that if a product pays commission rates that are 2, 3 and 4 times the average that there must be a reason worth checking.  No-one is guilty of anything and the investigation would be confidential.  But if such investigations were carried out and issues discovered then an awful lot of heartache could be avoided. If no problems were found then it would be like, “Good luck – off you go”.

 

Jo-Anne Bloch, Chief Executive of the Financial Planning Association, is reported as saying “There’s no way in the world we could have prevented” the likes of Storm and Westpoint.  If the FPA can’t offer a solution which greatly reduces the chances of another catastrophic failure that leaves thousands of well-meaning retirees penniless at the most vulnerable time of their lives, then Government may step in.

 

ASIC have the necessary power for such investigations and the payment of outlandish commission rates and the connection of high rates with previous failures suggests that it should have checked those products earlier.

 

Ms Bloch has warned that ‘remuneration practices’ in the financial services sector are becoming a concern to the Government and that if the industry does not develop its own strategies in that area it would face potentially damaging regulation. The Government enquiry into the Storm Financial failure is an ominous development on that front which may give our political masters all the ammunition they need to ban commissions altogether.

 

The commissions argument is not helped by stories like the recent Rice Warner survey that found advice on the Government’s co-contribution payment had attracted a fee of $660 while commissions on the same advice would have amounted to $3,876 and that research showed commissions up to 13 times greater than advisers’ fees when tested over a five-year period.

 

So the issue becomes: just what steps the industry could take to allay Government fears and thereby prevent a ban on commission payments, particularly in light of Ms Bloch’s admission of defeat in respect of preventing another Westpoint or Storm.

 

The use of excessive commission rates as a lead indicator of disaster should be (and indeed should have been) an important factor for both the FPA and ASIC in flushing out problems at the earliest opportunity.

 

The other step that could be taken in this area is to make fees deductible. This should be done regardless of whether commissions survive or not.

 

The Australian Taxation Office has issued a number of pronouncements (Tax Determination 95/60 and Tax Determination 2004/139) on the deductibility of fees over the years, which mostly have a solid grounding in tax principles.  As a result of those pronouncements our tax system discourages fee-for-service in favour of commissions.

 

When the investor pays a commission the amount is deducted from the investment and tax is payable on the earnings of the remainder.  When fees are paid it is necessary to work out which components of a person’s wealth the fees relate to (eg social security, superannuation, investment income, capital gains etc) and whether fees are deductible in respect of that component.  For the most part they are not, generally because the fees are said to be not associated with the derivation of assessable income – most often because they are on capital account.

 

The maths on a number of different scenarios invariably show the tax treatment in the commissions scenario is more beneficial than in the fees-for-service example.

 

The Government could codify the law in this area, not worry about basic tax principles, and ensure that all financial planning fees are tax deductible. This will help address the imbalance between fee-for-service advisers and those insisting on commissions. It will help the fee-for-service proponents to better argue the case for fees as opposed to commissions, particularly if they are armed with Westpoint and Storm stories.

 

Much has been said about the need for greater financial education for the general population and no-one, except the seriously malevolent, can argue against such a proposition.  But there is no way that such education could ever teach retired people to understand fully a Westpoint or a Storm financial product. 

 

One forensic accountant has pointed out that his clients were required to sign every page of a 150-page Statement of Advice which stated they had read AND UNDERSTOOD the document, even though one of them had an intellectual disability. It later took the accountant 10 hours to read and understand it!

 

The education we need to provide our citizens needs to be simpler and focussed around basic principles - the difference between investing and trading, the risk versus return see-saw, the “if it looks too good to be true …” rule and perhaps the fact that deductible fees are more likely to produce a totally independent result.

 

And before I am pilloried by the many terrific financial planners out there who charge commissions and still provide wonderful independent advice, many of whom I’ve met and worked with over the years, let me say you are why I am not in favour of a commission ban but rather on greater effort by regulators to police our system, greater public education and a better balance between the tax treatments of the two methods.

 

For more information contact Townsends Business & Corporate Lawyers on (02) 8296 6222.