It’s time for an intelligent debate…

By intelligent I mean let’s put aside far left and far right ideals and debate instead what works for the very stakeholder all of this is meant to be about.  The client: a stakeholder that should be at the front of the queue in our thinking!

The Corporations Law already applies a Best Interests Duty to a Financial Planner, and the Royal Commission’s recommendation is that Mortgage Brokers will move under an AFSL structure and will also be subject to a Best Interest Duty. Other than the need to define some “safe harbour” provisions for Mortgage Brokers there is little debate or argument about the need for this Duty to apply.

Commission systems for the insurance industry and the mortgage industry have been the subject of inquiries, reviews and recommendations for years now, the most recent being the Hayne Royal Commission. 

The far “left” side of the debate will argue that commissions are the root of all evil and should be abolished and the far “right” will argue that the market should determine the remuneration structures and there should be no intervention at all.

The new Scott Morrison Government is both determined to implement the Hayne Royal Commission recommendations but prepared to listen to logical debates so neither the far left or the far right are likely to win their extreme positions in this time of necessary reform.

Personally I believe the early and positive support the Mortgage Broking commission structure received showed that commonsense prevailed. This particular Hayne Royal Commission recommendation was not well thought-through, as the likely outcome of the recommendation if implemented was that banks would increase margins and consumers would pay extra for advice which is currently free. A perverse outcome indeed!

Meanwhile, the Hayne Royal Commission recommendation of adding Best Interest Duty into Mortgage Broking was accepted and the Government, via Treasury, is now in the process of seeking industry input before preparing the bill for parliament. 

Given this direction we will have a Best Interest Duty that applies to Financial Planners and Mortgage Brokers, with a commission system that applies to mortgages and life insurance products. How we look at the sustainability of a commission system for mortgages and life insurance should in fact be consistent applying “first principles” as opposed to looking at them in isolation..

So the question is: How can a Best Interests Duty work in concert with a commission system?

Let’s be clear about the frame of reference here, we are focussing on life insurance products and mortgage products which are traditionally bundled and more difficult to deconstruct unlike superannuation and investment products which are unbundled. (The horse has bolted on commissions in superannuation and investments so there is no point in discussing that.) The focus needs to be on insurance and mortgage products because this debate is in front of us right now!

Despite many commentators suggesting otherwise, there is a cost of Best Interest advice and while the left extremists will argue the client should pay a fee, a commission structure remains a convenient, efficient and affordable way for the client to pay for their advice. To their advantage, commissions can be amortised in products like insurance and mortgages which allows an upfront fee today to be spread over several years easing the immediate cashflow impact. This is particularly important for everyday Australians who unlike the very wealthy do not have large amounts of readily available cashflow surpluses to pay fees to professional advisers. 

Margins in products that are allocated to the cost of acquisition is common in goods and services provision all over the world. The challenge is to design the commission system for life insurance and mortgage products to adequately remunerate those advising the clients without creating latitude for poor advice or mis-selling so that the client still gets advice that is in their best interest.

So let’s look at the characteristics that are required for a commission system and a Best Interests Duty to operate in concert:

A Best Interests Duty works well as a counterbalance to poor advice

The application of a Best Interests Duty alone will have legal “teeth” to hold the adviser accountable for the recommendations that have been made to clients they advise. It is often argued that because commission is percentage-based on either the premium amount for insurance or the drawn-down loan amount for a mortgage that advisers will be recommending more than what is required. A Best Interests Duty acts as a counterbalance to any concerns that clients will be subject to miss-selling because there will be a legal obligation under the Corporations Law for an advisers to satisfy that there recommendations are in the client’s best interest.

This environment creates real consequences for those that deliberately circumvent this Best Interest Duty. The vast majority of advisers who are also business owners with branded office premises, staff and longstanding reputations in their communities are not going to jeopardise what they’ve worked hard to build by breaching this Duty.

Importantly those advisers that show a flagrant disregard for the client’s best interest duty will be answerable by law and this change will likely see them exit the industry.

A standardised commission structure

A standardised commission structure is critical to ensuring the adviser acts without conflict when selecting products thereby removing any bias, perceived or real, of selecting one product over another. This neutralises the influence of commissions and leaves the product to compete on price, features and benefits to the consumer.

Large variances in what a product provider is prepared to pay for “acquisition costs” has been the cause of problems in the past and whilst in mortgages, for example, there is a relatively small variance across product providers, removing this perception is important. This is something life insurance has recently implemented with good effect albeit determining the correct benchmark is a challenge. So let’s discuss. 

Regulating a standardised commission structure

Commission amounts should be regulated by a central body after discussions with key stakeholders. It is important these discussions are arbitrated by a central body to balance out arguments and potential misuse of market power by larger institutions when dealing with smaller businesses like independent or franchised Financial Planners and Mortgage Brokers; the ACCC would be a welcomed participant here. The decision on the prescribed amounts should take into account margins in the product, the work required by the adviser (including profit margin and business overheads) and the value to the consumer.

As mentioned in the previous section selecting the right benchmark is critical to ensure the system is balanced for all stakeholders ie the client, the adviser and the product provider. Arguably the Life Insurance Framework Reforms (LIFR) got the structure right but the benchmark which progressively has moved from circa 120 per cent and will settle at 60 per cent from 1 January 2020 has swung the pendulum too far!

The ASIC review of life insurance commission needs to urgently address the mismatch of the upfront payment at 60 per cent with the costs of the work required by the adviser to meet the ever-increasing compliance costs whilst still making it affordable to the consumer. More science needs to be used in determining such a benchmark and it can’t be bullied by larger institutions, some of whom are mega global players with deep pockets to fund legal advice.

If removing commissions for Mortgage Brokers would play into the hands of the major banks and reduce competition, then this would also be the fate of the life insurance industry where the adviser has previously felt the brunt of a power imbalance at the hands of insurance giants, many of whom who are not even Australian-based companies.

Our analysis tells us that 80 per cent upfront commission for life insurance is in fact the right benchmark to be using.

A balanced distribution of the payment between upfront, ongoing and “clawbacks”

The commission structure needs to account for the work required upfront as well as ongoing to ensure there is a balance between initial advice and the need to support a client after the product is up and running. This balance needs to be struck between initial or upfront payments, deferred payments and clawbacks for short dated contracts where the client leaves dissatisfied in a short period of time (less than two years). This balance is critical for all stakeholders: clients, advisers and the product providers. 

The unintended consequence of not getting this structure right is that it creates an imbalance which will inevitably lead to broad market behaviour. For example if all remuneration is skewed to upfront then the longevity of products may be shortened due to frequent switching or at an extreme level, wide-scale churn. A shorter product-life leads to lower profitability which leads to higher prices for clients.

The Trowbridge Report recognised the importance of this balance in its review of Life Insurance remuneration and the first principles it proposed were refined, agreed and then legislated. The outcome was to reduce the upfront payment (on average from 110 per cent progressively to 60 per cent) and increase the ongoing payments (on average 5-10 per cent to 20 per cent).  Clawbacks were also standardised within the first two years. This was deemed the right balance. 

The result of these changes anecdotally is that “churn” has been significantly reduced however the Financial Planning community will be rightly arguing, as I stated previously, that the reduction to 60 per cent as an upfront payment may be too far a reduction given the legislative cost of providing best interest advice to everyday Australians. A review by ASIC is scheduled for 2021 and let’s hope this review brings about refinements that restore this balance.

Ironically the debate around a commission systems has some parallels with legislation released just on 12 months ago! The first principles of paying bonuses to executives in the Banking Executive Accounting Regime (BEAR), introduced on 1 July 2018, legislated as a central theme that the payment of incentives over a longer period of time (for example, paying a percentage of the incentive in year one and the remainder over a longer period, say four years). When you think about it, this sounds not dissimilar to the upfront and deferral payment system in place for insurance and mortgage products today. A sensible outcome would be to apply these same principles to the agreed commission margin which would see us get closer to getting the balance right.

Final thoughts

My conclusion is that a commission system and a Best Interests Duty can work in concert so long as the commission system is built on well thought through “first principles” that have been spoken about here.

It’s time for an intelligent debate, what do you think?

P.S

Our AFSL at Wealth Market has been built without reliance on payments from product providers. This means we are product agnostic so our Approved Products List is broad and the revenue we receive from clients via fees or commissions is the same no matter which products form part of our recommendations.  This means that structurally we are set up to focus on the Best Interests of the client from the outset!