Although these changes will be designed to improve risks for the public and increase focus on the interests of financial service clients, the changes are not without unintended consequences.
What is wrong with the financial services industry?
The Royal Commission revealed a number of failings in the financial services industry, including:
- strong alignment between product sellers and product manufacturers, resulting in cross-selling of products and conflicts of interest
- low transparency with and respect for customers, and making the best interests and objectives of the customer secondary to those of the financial services provider
- boards and senior management acting in their own best interests (or to the benefit of shareholders) to the detriment of customers
- a lack of voice and accountability in identifying, escalating and dealing with risk and compliance issues
- significant cultural and leadership issues exhibited across the industry which Senior Executives and Boards have either failed to influence or failed to manage and address
Changes to the management of business
In general, we will see increased accountability for boards and senior management, with greater accountability and governance of non-financial risks, improved decision-making, improved dealings with customers and enhanced identification of emerging risks and remediation.
We will also see a significant rise in the influence and authority of the risk management and compliance functions across the organisations, including training and constructive debate. Risk and compliance teams will become more independent of the business and will have a stronger voice within the business and through to the Board. Risk committees will play a very important role moving forward and they must be structured, sufficiently experienced and resourced to handle a diverse range of risks, including emerging risks.
There will also be a stronger imperative for all businesses to always act in the client’s best interests and to adequately identify and transparently manage actual and perceived conflicts of interest. This will be particularly important in financial services where the ‘client’s best interest’ has been enshrined in law. Out of the Royal Commission will emerge a greater focus on the culture of businesses through ethics, compliance and risk management.
Changes to the financial services industry
It is anticipated that changes to the educational requirements of the financial planning industry brought about by the Royal Commission may, in the short to medium-term, spark a large exodus of financial advisors nearing retirement, as well as a shortage of new advisors entering the industry. There is now a requirement for new entrants to hold relevant degree qualifications and to undertake a supervised professional year, whilst non-degree qualified advisors will need to undertake bridging courses. Ongoing examinations to keep skills and knowledge current, will also become compulsory.
The financial planning industry needs to be formally recognised as a profession and setting standards at a level equivalent to or higher than other professions is a starting point. A comprehensive Code of Ethics will follow and the professional bodies will be expected to play a greater role in shaping the industry.
We should expect further demergers from the banks and financial services providers as they spin-off or sell investment, insurance or financial advisory divisions. This may result in a number of smaller, more nimble, financial services practices which will compete within the advisory space.
We also anticipate that a number of financial advisors will look to further differentiate themselves from these brands. This could lead to the creation of more independent firms, eventually leading to further mergers as these firms are faced with a significant compliance burden.
Advisors who have been banking on retiring by using the proceeds of the sale of their ‘book of business’ may find that the value of this book is significantly diminished. Guarantees of ‘buy-back’ from the licensee may not even eventuate if the licensee sells the business. To make matters worse, prospective buyers may not exist or are concerned that they will be taking on potential litigation risk. We believe they should be concerned as there is potential for class actions to follow the Royal Commission. Put simply, ‘Buyers Beware’. At the very least, these books will be trawled through by prospective buyers with only some clients being cherry picked for their value and future potential. Many clients may simply be discarded and will subsequently discover they no longer have an advisory relationship.
We also anticipate movement away from commissions within the insurance space. Don’t be surprised if insurance is paid for in a substantially different way in the future. A person may be charged one fee for an initial review and placement of insurance. They may then choose to pay for a review when and as agreed with the advisor. Finally, we expect that claims will be charged separately and possibly not even by the person who wrote the insurance in the first place. A new service may arise that is directed towards assisting people with claims management, including estate management.
Changes to the scope of ‘retail investor’
It is very possible that many traditional ‘retail investors’ of existing practices will not be serviced due to the advisor shortage and the higher compliance costs. Those people targeted by the legislation, and indeed the Royal Commission, may in fact be the real losers in the future. We think this could result in significant underservicing of the traditional retail customer. If so, there will be many missed opportunities for retail investors, which could lead to even greater disparity between the ‘haves’ and ‘have nots’.
The definitions of retail, sophisticated and professional investors are likely to be substantially reformed in the near future. For the ‘sophisticated investor’ test, the lack of indexation on the $250K income and $2.5 million net asset tests (unchanged since 1991) and the substantial increase in real wealth due to superannuation and property prices means that the intention of the original legislation is no longer being met. Expect the eligibility test to be tightened, with a number of investors who currently qualify as ‘sophisticated’ under the dollar-based eligibility tests to no longer be eligible. This will come about by higher (probably indexed) dollar-based eligibility tests and/or the removal of certain assets, such as the family home, from the test. Dare we also suggest that investors will be required to undertake a test or assessment before qualifying as ‘sophisticated investors’? Will the knowledge of the investor become more important than the magnitude of their wealth?
Changes to the definitions and eligibility of wholesale investors are likely to have large implications for those licensees who have created a business model that targets the wholesale investor market. If they hold an AFSL limited to wholesale investors and they have designed their business processes around this test, they may suddenly discover they cannot service a significant portion of their client base. Advisors who do not satisfy the Financial Adviser Standards and Ethics Authority (FASEA) requirements will also be challenged if they do not qualify for advising retail investors. As a result, we may see advisors targeting a much smaller wholesale space – in effect a crowd attempting to service very few.
Any changes to the interpretation or eligibility of wholesale investors is also likely to have a significant effect on fund managers and their wholesale funds. It may even lead to mergers in this space.
Changes to superannuation funds
The Royal Commission raised a number of questions around traditional retail superannuation funds and the conflict of interest between shareholders and members. Two parties want to eat the same pie. This was music to the ears of the industry superannuation funds.
We think a variety of changes might result over the coming years. FirstIy, retail superannuation funds are now at risk of being ‘sold off’ or ‘wound up’. If compliance costs rise and margins shrink, we don’t expect it will be business as usual as the companies demand minimum returns for shareholders. The second point is the forced evolution of the retail funds industry. To compete, they will need to re-price and go head-to-head with the industry superannuation funds, potentially beating them at their own game. As for the industry funds, the issues around a lack of minimum accountability, independence and governance and investment experience will continue to be voiced and we should expect further regulation in these areas.
The Royal Commission might also become a trigger for a review of the criteria, experience and qualifications required of investors who are wanting to maintain or establish Self-Managed Superannuation Funds (SMSFs). Will this result in the rise and evolution of Small APRA Funds (SAFs) if there is further regulation and SMSF trustees decide that it too complex, costly (including penalties) and time consuming to fulfil trustee duties? For this to eventuate we believe SAFs will need to be more flexible and accommodating in what and how investors can invest.
More to come
The impact of the Royal Commission will be far reaching and will play out over the next decade. Pitcher Partners is already held to higher Accounting Professional and Ethical Standards across all services and the changes proposed above are not expected to have a significant direct impact on the business itself over the short term.
It has been heartening to witness the Royal Commission’s emphasis on client care, something that has been a core value to Pitcher Partners since we were established in November 1991. The Commission exposed how banks, financial service firms, superannuation funds and lenders put profit and personal interest ahead of the client. In contrast, our commitment since our foundation has been to prioritise the client: it is the reason we were established. We have always invested heavily in our staff as part of our client-centric model, through training, mentoring, and international exchange. We know that the best people give the best service to our clients.