FFP 1209 supplementary materials

Foundations of Financial Planning

Supplementary materials


© Kaplan Education Pty Limited. All rights reserved.


Supplementary materials

December 2009

© 2009 Kaplan Education Pty Ltd. All Rights Reserved.

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June 2008

Advising in volatile markets

OverviewInvestment markets are volatile, the only thing for certain is that markets go up and they come down. For investors who are happy to take on a level of risk, a long term, diversified investment portfolio will allow them to ride out the bumps along the road. Needless to say, volatility such as that experienced in early 2008, is a concern for investors, especially people in, or close to, retirement. The purpose of this Ontrack training is to examine volatility and how getting back to investment basics and other strategies can be used to deal with such situations.

Did you know?

The Chicago Board Options Exchange Volatility Index (VIX), a measure of market volatility, has fallen by half from its highs early in 2008 – but predictions are that the VIX will be pushed higher due to the escalating oil price and economic weakness in the US, undermining this new found stability.

Learning objectives After reading this article you should be able to:

> Outline the current and projected level of volatility in investment markets

> Revisit the principles of investing that allow investors to better manage the negative impacts of market volatility

> Outline some successful investment strategies for younger people, those close to retirement and anyone in retirement, to minimise the impact of volatile markets.

To give advice on the product(s) referred to in this article you must be licensed or accredited by your licensee and operating in accordance with the terms of your/their licence.

Knowledge areas This article is relevant to the following knowledge areas:

> Financial planning (45 minutes)

> Skills (30 minutes)


Current volatility in investment markets By the end of the March 2008 quarter, the Australian share market had suffered its worst quarter since December 1987, falling around 26% in value. The volatility experienced in 2008 has mainly been in equities and equity-related investments, and in credit markets. Government bonds, cash, unlisted property, and unlisted infrastructure investments have been somewhat protected from the volatility.

So what is driving instability in equity markets worldwide? Subprime debt in the US, artificially constructed financial products like CDOs, and massive bank losses, are the root causes of the problems in financial markets. Investors are concerned that the resulting credit squeeze is likely to continue to impact negatively on companies with a significant debt exposure that may need re-financing in the near future.

Another important factor driving current instability in Australian equity markets is the impact that the credit squeeze is having on financial stocks. Financials (including A- REITS) make up 35% of the S&P/ASX 200. The fall-out from the subprime crisis and resulting credit squeeze combined with exposure to derivative products, has wiped off significant value across this sector. As a result, this has affected the value of many individual investor portfolios.

What does history tell us? Historical data suggests that traditional, diversified portfolios of assets (cash, bonds, property and equities) deliver negative returns every six years or so and that the current pattern of volatility is not that unusual.

So while the outcome is much the same, the story is slightly different. Even more disconcerting for investors, is that the period from 2003 to 2007 saw stable and positive returns from Australian equities; perhaps lulling investors into a false sense of security that this could continue indefinitely.

Where there is similarity between this time and previous periods of volatility, is in investor behaviour and psychology. Typically, prior to a collapse in financial markets, there is a bubble of some sort – in this case, the bubble was in credit markets. Investors placed their money in high risk credit investments, which flowed through the US housing market, and once the bubble burst, investors panicked and effectively ‘ran to the other side of the boat’, causing sharp falls in both credit investments and equities. It is this investor behaviour which actually caused the volatility we have seen recently in the market.

Share prices are affected by any number of factors – company profits, dividends, economic growth, interest rate and currency fluctuations, political events and major catastrophes. All these factors make it difficult to predict stock prices over the short term. As Burton G. Malkiel, the author of ‘A Random Walk Down Wall Street’, reminds us, investing is for the long term and the best strategy is to ‘stay the course’ (Vanguard Investments, 2007). Markets do recover and equity markets do deliver the best return over time of any of the key asset classes.

June 2008 Page 2 of 15


For example…

Data from AMP Capital Investors shows that despite setbacks such as this, the share market has always recovered and continued to rise, delivering capital growth of 6.1% per annum, or a total return of 12.4% per annum including dividends.

Outlook for equity markets Some industry experts are predicting that the worst of the volatility is probably over, and that there will be more stability in the market by the end of 2008.

When assessing the level of market volatility, the Chicago Board Options Exchange Volatility index (VIX) is a key measure of near-term volatility in the S&P500 stock index. Since the VIX was as introduced in 2003, it is viewed as a leading indicator of investor sentiment and market volatility. Interestingly, it reached its highest point on 22 January 2008 at 37.57 and has now almost halved as at 19 May 2008.

Quicklink

For more information on the VIX, go to http://www.cboe.com/micro/vix/historical.aspx

> Under the ‘Historical data’ heading, select ‘VIX data 2004 to present’ (updated daily).

That said, volatility is unpredictable, and to a certain extent, irrational – so it is impossible to pick whether we are now at the bottom of the market or how long it will take for the market to recover. Because economic conditions are generally better this time than they were when compared with the 1987 stock market crash, inflation is relatively low, and shares were nowhere near as overvalued, it is predicted that the market will not take as long to recover from this event.

For example…

In a similar historical example from 1987, Australian and global share values doubled in the space of 12 months prior to the October 1987 crash and Australian shares reached a level where they were significantly overvalued. The crash caused the market to fall by 50% and returned stocks to a level of fair value, then it took the next five or six years for those stocks to reach their previous highs.


http://www.cboe.com/micro/vix/historical.aspx


Back to investment basics In times of volatility, it is worth revisiting some of the principles that underpin sound investing especially in equity markets such as diversification, time in the market and the risk /return equation.

Diversification Diversification is a key factor in reducing the impact of market volatility – it essentially smooths out returns. History shows that a sector that is the standout performer one year may lag behind others the next, making it difficult to pick which sector will lead the market. Consequently, the best approach is to diversify a portfolio across asset classes, geography, and within asset classes such as Australian and global equities, and hold a diversified portfolio of stocks.

Some industry experts recommend increasing the number of stocks held in a portfolio, as well as ensuring proper diversification across all sectors. A portfolio with approximately 15 stocks is considered the minimum to obtain sufficient security without undermining the benefits of diversification.

Investors in managed funds should be careful of too much diversification when it comes to the number of fund managers in a portfolio – while four or five will give a well diversified mix across different styles, more than this could offset the benefits provided by accessing various management styles.

To illustrate the benefits of diversification in stabilising an overall portfolio, if a client had held all their money in the Australian share market in the last year, their investments would have suffered a 25% fall from the high in November 2007 to the low in March 2008. Some exposure across fixed interest, unlisted property, global shares and cash as well as Australian shares, the portfolio would not have lost so much value.

With a live example currently in play, now is a good time to be discussing diversification with clients both at the fund manager level and within the client’s own portfolio to reinforce the benefits. Discussions about diversification may be useful to help an investor focus on a more balanced portfolio, rather than to ‘dash for cash’ if they are feeling nervous about the current climate.

Time in the market, not timing the market Investing for the long term allows an investor to ride the ups and downs of the market. It is generally accepted that more than five years and closer to ten years in the market is considered investing for the long term.

Market timing should be avoided as it is almost impossible to pick the top or bottom of the market and, at any point in time, most market information is already factored into the stock price before investors have had a chance to buy or sell a stock. Being in the market allows investors in companies with strong balance sheets, sound management and strategy to benefit from dividend yields and earnings growth. It is also costly to move in and out of the market, whether it be the transaction costs, tax or missed opportunity.

The annual Russell/ASX Long-Term Investing Report details returns by asset class over a ten and twenty year period. It demonstrates the value of getting the asset allocation right, staying invested, avoiding timing the market and diversifying to iron out returns. The Report is available from www.asx.com.au.


www.asx.com.au


Risk return equation Understanding a client’s attitude to risk and return is important when selecting asset classes.

Clients are exposed to risk in any situation where there is uncertainty about the possible returns on their investment. Risk tolerance is the extent to which a client chooses to risk a lower return in the pursuit of a higher return.

Investment products can be ranked according to their underlying level of risk. Generally, growth assets (such as shares and property) have a higher risk than defensive assets (such as government bonds and cash).

The higher the level of risk, the higher the potential return. The higher the potential return, the higher the potential loss might be.

The following gives a broad sense of the risk/return characteristics of various asset classes.

Figure 1: Risk/return characteristics of various asset classes

Investment Risk Projected real annual long-term returns (p.a.)

Cash Very low 0% - 1%

Term deposits (1 – 3 years) Low 0% - 2%

Long-term fixed interest and bonds (3 – 10 years)

Medium 0% – 3%

Residential property Medium 1% – 3%

Commercial property Medium – High 3% – 5%

Australian shares High 5% – 8%

International shares High 6% – 9%

Emerging markets Extremely high 10% – 20%

These have been widely accepted as the likely returns for each asset class. A global downturn in financial markets may mean such figures of projected long-term returns need to be revised. Past performance is no guarantee of future performance.

Another way to assess risk by fund or via directly investing in a specific asset class, is the likely frequency a negative return over time.



Figure 2: Negative return frequency

Asset classes A negative annual return is not expected more frequently than

Shares Once in every 4 years

Property Once in every 6 years

Fixed interest Once in every 8 years

Cash Negligible risk

Source: ASIC 2008, ‘Money Tips: Negative returns: the dark side of investments’ [online]. Available from <http://www.fido.gov.au> [cited 20 May 2008].

What fund managers do to minimise impact of volatility As a result of the downturn in shares, a typical balanced fund with 70% of fund assets invested in growth investments and 30% invested in defensive assets, will be in negative territory for the financial year to date, and if share markets do not start to rise, those types of funds will deliver negative results for the financial year.

Perhaps a legitimate question clients may ask their advisers would be: what are fund managers doing to protect my money?

In investment terms, volatility is not regarded as all negative, as it creates buying opportunities for fund managers. So in times of volatility, a fund manager will be much more active in monitoring their portfolio and looking for value and opportunities to buy into certain good-quality asset classes and stocks.

For example…

Investment grade debt has been sold down quite dramatically through the credit crunch, particularly relative to government bonds, and so there is an opportunity to find good-quality investment grade debt or to reweight it in the portfolio.

Hedge fund managers in particular are very active in trying to time the markets, whereas traditional fund managers in Australia may or may not consider timing as part of their strategy. However, they will try to manage risk through changes to asset allocations for diversified funds.

For example…

Fund managers may run stock loss positions, if they have a large exposure to shares, and the market starts to drop. An order will automatically be put through to a broker to reduce weight to shares and remove some of the risk.



Lessons for investors This period of market volatility demonstrates some fundamental lessons for investors. It provides a good opportunity to reinforce what should be discussed with clients.

> It is a dramatic illustration of the fact that markets go down as well as up.

> Investors need to be sceptical of any investments they don’t understand, particularly those which have a great deal of financial engineering. Many investors were caught out by taking investments that appeared to be securities with triple ‘A’ ratings but were in fact rated ‘B’ or less.

> Investors need to be sceptical of excessive gearing – while it can play a great role in enhancing returns over time if undertaken correctly, clients can run into trouble if they have a large amount of margin debt and end up having to sell out of the market at the exact point when they should be investing.

> As always, diversification is key – investors who have been well diversified have been insulated to some degree from the shocks in the market and have not seen their portfolios come down nearly as much.

> Perhaps most importantly, investors should not get blown off course by volatility in investment markets, but instead stick with their long-term strategy. The psychology of investment comes into play here, with investors feeling despondent at the fall in markets, and excited during rising markets. Investors need to overcome this psychology, as buying during down times and selling or holding during the good times, rather than following the crowd on investor sentiment, will create the greatest value in the portfolio.

For investors who stick to their strategy and maintain their exposure to shares through thick and thin, they will find that their patience is rewarded in terms of growth to their portfolio over the long term.

Working with clients though volatile markets People do panic and feel nervous when the market falls. This is often reinforced by negative media commentary and discussions with friends and family. How clients respond to a crisis, is often a measure of how well an adviser communicated the risks and returns involved in investing at the beginning of their relationship. The following should be covered:

> the likelihood of experiencing a period where market volatility is high

> the potential for capital loss

> the corresponding benefits of investing

Gerry Power, Lakeside Financial Planners, believes that the negative response to this crisis has been more muted than in previous years. He put this down to one thing - communicating proactively and often. Clients need to feel like they are being taken care of, and by being proactive, rather than reactive when markets are down, clients are generally more comfortable.



Consider…

Advisers might consider taking a more proactive approach to dealing with clients who have been upset by any significant market downturn.

Being proactive may include:

> sending out a communication if there has been a particularly significant event in the market

> If clients are new to the investment process and have not experienced market corrections before, they may require more reassurance that this is par for the course.

> Using historical examples to show how markets move over time can help to reassure clients that these ups and downs are all part of the cycle. Tools such as graphs showing historic data can be an important part of this communication, particularly if they are from independent sources.

All this can help build trust in the adviser-client relationship and is likely to secure that relationship over the longer term.

Quicklink

Useful tools and graphs could be accessed at the Australian Securities and Investments Commission’s FIDO website, covering ‘Negative returns’ and ‘Rates of return: what history shows’. These provide explanations of historic trends and levels of risk for consumers, as well as a risk and return calculator. Go to www.fido.gov.au select ‘Publications and resources’.


http://www.fido.gov.au/


It is human nature for clients to be upset if they have sustained a significant loss, and showing empathy will ensure they understand that their adviser cares about their situation. It is also important to distinguish between the client being unhappy with the negative returns, or being unhappy with the advice given. If the client understands the basis for advice and their investment, even though they might not be happy about losing money, then the adviser’s job has been done correctly.

Consider…

If the client is feeling particularly uncertain about their strategy, it may be a good idea to:

> get another opinion from another expert in the field – and if the necessary work around risk profiling and investment time horizon has been done correctly at the outset, it is more than likely that this second opinion will confirm for the client that they are on the right track.

> It may also be worthwhile for the client to speak to the person who referred them – particularly if that is another professional like an accountant or lawyer who understands the ‘swings and roundabouts’ of the markets and can provide a level of comfort around that (although they cannot give advice).

Clients may ask if the consequences of this volatility could have been avoided through some quick action. The answer to this is it is very difficult to time the market, particularly if there are unfamiliar factors at play, and that these types of moves do not have a place if you are taking a long-term view of your investments.

For younger advisers just building up their practice, it is extremely important to ensure that they have appropriate back office staff to free them up to do the face-to-face work around reassuring and educating clients during times of volatility. If these advisers haven’t personally experienced market falls and volatility before, it may also be worthwhile seeking the advice of more experienced advisers on how they tackled these issues with their clients from a personal perspective.

Risk profiling While clients’ risk profiles shouldn’t change during volatile markets, advisers suggest that their perception of risk does, and there may be pressure from clients to move towards more conservative investments. It may prove to be a good opportunity to revisit and confirm the overall strategy with the client.



Those who made a large contribution into superannuation prior to the end of June 2007 to take advantage of the new rules may perhaps be lamenting their timing, as they had to watch the value of their plumped-up portfolio fall. However by coming back to the risk profile, it can provide the client with some comfort. If their profile is to invest in growth assets over the long term, then trying to time the market is irrelevant. So rather than focus on short-term gains or losses, it is important to make sure their risk profile and long-term goals are set, and that clients know exactly what they need to achieve from that investment.

Bear markets create buying opportunities It may be difficult to look on the bright side at the moment, but despite the recent losses, the fact is that bear markets create buying opportunities. With volatility high and the market and PE ratios perceived to be low, clients who invest more funds into the share market now stand to make additional returns when the trend turns upwards.

There is an argument that as long as people are investing in good quality stocks with strong balance sheets and focus more on dividend yields, movements in share prices are irrelevant. Shares have historically shown growth over the long-term. When compared with conservative investments such as term deposits, companies paying healthy dividends will continue to add value to an investor’s share portfolio, without requiring any further investment on the part of the investor.

Strategies for advisers to employ with younger clients As discussed above, it is best (and perhaps easiest) for young people to view periods of volatility such as this as a buying opportunity. They generally have a long time horizon and can be as aggressive as they wish in their portfolio, to get the maximum return over time through investing in good quality assets as early as possible, regardless of the point in the market cycle. The advantage of investing in shares now when the market is down, is that they will get more from their money.

Dollar cost averaging Dollar cost averaging allows the client to invest via a regular savings plan or a gearing strategy, without having to try to time the market to get the greatest value. When the market is low and stocks are considered good value, they can buy more for less. Conversely, when the market is high and valuations are stretched they will get less stock. This applies whether directly investing in equities or via a managed fund.

For example…

If a client has $100,000 to put into a managed fund or the share market, the best approach may be to break it up into five or 10 tranches of $10,000 - $20,000 spread over five to 10 months. Particularly for young people, it can also provide a discipline of regularly saving and adding to the investment.



Gearing Given that it is not yet clear whether we are at the bottom of the cycle, gearing into the market at this time may be regarded as a high risk strategy. If the client has a longer term view, gearing as an option may be considered, depending on their overall financial circumstances, needs and investment objectives and risk profile. Again dependent on a client’s risk profile, their stomach for gearing and a given a long investment timeframe, when markets are low could be precisely the time to gear to maximise returns in the long run.

If market volatility is likely to continue, an alternative might be that gearing should only be done through protected funds or structured products, rather than margin lending, because these products provide an extra level of capital security and protection. Some of these types of investments can be expensive and an investor’s individual financial circumstances, needs and objectives must be taken into account before progressing.

Gearing through dollar cost averaging over a period of 12 months or longer could also be a safer option than gearing a full amount at once. In any case, gearing should be approached with caution, and should only be an option for someone without cash flow issues and some financial backing in place, so they could absorb another fall in the markets, if that was to eventuate.

Strategies for people close to, or in retirement Those near to, or in retirement will generally have fewer opportunities to use the market conditions to top up their funds and invest more into the share market, and so would generally view the current climate as more of a negative situation than a positive.

While younger people can focus on the bear market as an opportunity, for those who are close to, or in retirement and are watching their portfolio shrink, it can be a worrying time and they may take the worst possible option - panic and pull out of the markets, lock in losses and invest in cash.



For example…

Calculations by AMP Capital Investors going back to the 1920s, shows the results for two scenarios:

> in the first, the investor has maintained a constant portfolio with a mix of equities, bonds and cash

> in the second, the investors has a similar portfolio, but each time the market or strategy has delivered negative returns for a financial year, they have switched to cash for a period, before returning the funds to the market.

Over the long term, the investor that maintains their strategy even after a negative return tends to do far better than the other, delivering an average return of 10.7% per annum compared with a result after ‘switching’ of 9.4% per annum. This is because in the second scenario, the investor generally does not return to the market until it has risen significantly – thereby destroying value. These returns compare with the 5.4% per annum for cash, 6.9% per annum for bonds and 12.1% per annum for equities.

Figure 3: Constant strategy versus switching to cash after bad times

Comparison of constant strategy versus switching to cash after bad times

$10

$100

$1,000

$10,000

$100,000

$1,000,000

1928 1938 1948 1958 1968 1978 1988 1998

Value of $100 invested in July 1928

$339,438

Fixed 70/25/5% mix of Aust equities/bonds/cash

Switching portfolio

$131,062

Source: Oliver’s Insights ‘Putting negative investment returns in context’ Edition#11, 2 April 2008. AMP Capital Investors

Sticking with an investment strategy This is where communication from an adviser to their client is of crucial importance; their job is to reassure the client, encourage them to go back to their original strategy, and if the strategy was to take on a certain amount of risk with the pay-off of higher returns over the long term, the investor should stick with it.



Retirees on account based pensions For a retired client with an account based pension, who is seeing significant erosion of their capital base because of the current volatility, there are certain techniques that can be employed to guard against having to draw down income from growth assets.

With account based pensions, investors should have some flexibility to change the amount they draw on the fund. If this is the case, then ideally they should perhaps be drawing the most when markets are strong, but during periods of market weakness, they can try to cut back on the money they draw out of the fund. This can help to preserve the capital in the fund.

Another strategy designed to preserve capital, particularly during times when growth assets are suffering, is that there should be an amount of money held within an income-producing asset or investment, such as a high yield or cash fund. This will allow the client to draw on these funds for their income – ideally for a period of between six months to three years, leaving growth assets intact for when the market recovers.

Having this money ready for times of volatility does require some preparation. Some advisers suggest that during regular quarterly or half-yearly reviews, particularly when the markets are strong and delivering good profits on the portfolio, it is a good idea to draw some of the profits from the investment and place in the yield or cash fund. These extra funds can also then be re-invested in growth assets during times of volatility, as prices will be lower and the investor will then hold a greater number of units in the investment. When making changes such as this to the investment, ensuring the necessary documentation is completed for compliance purposes is essential.

Practical considerations

Discuss the difference between an investment plan and a financial plan. > An investment plan is a subsection of a financial plan; they are not

interchangeable terms. In fact, a financial plan may not even contain an investment plan, for example when only dealing with insurance matters.

> Financial planning considers the full scope of a client’s goals and examines their tolerance to risk. This results in a recommended asset allocation to achieve the client’s goals which drives key aspects of the investment plan.

> If the client’s goals, as part of the financial plan, do not require higher risk investments then during periods of market upheaval the client may be cushioned from volatility by having a well diversified and perhaps more conservative investment plan.

> A financial plan is also a lot more than just an investment plan. Matters such as risk management, estate planning business, tax and investment structures including discretionary trusts and self managed superannuation funds, can be considered in a financial plan.

> Poor estate planning may result in 100% of investment funds directed to inappropriate ‘beneficiaries’. Poor tax planning may result in up to 46.5% of investment funds being paid to the Australian Tax Office (ATO) or a tax of 93% being incurred on contributions to super. These circumstances could be avoided if considered thoroughly at plan preparation time.



> Whereas outcomes as a result of an investment correction are often less than the percentages mentioned above i.e. 46.5%, 93% and 100%, and based on historical data, the loss from the result of an investment correction will generally be recovered over time.

Can dollar cost averaging out of an investment be as effective as dollar cost averaging into an investment?

> In periods of market volatility or downward corrections, dollar cost averaging is a very effective strategy for investing funds into investment markets.

> With dollar cost averaging, investments are eased into the market over a period of time in small increments. If the market is falling then investments are being purchased at lower prices for the latter investments thus reducing the average price paid for the investment overall.

> In periods when the markets are appreciating, dollar cost averaging into the market will not be as effective as investing all available funds as early as possible to gain all the appreciation in value of the market.

> Dollar cost averaging may reduce risk in investing but it doesn’t necessarily result in the best investment return.

> Dollar cost averaging also works just as effectively when withdrawing from the markets for similar reasons. However, it is most effective during periods of market volatility in periods of appreciation and less effective in periods of downward correction.

> Dollar cost averaging in and out of investment markets is a very effective risk management tool that is recommended to clients by many advisers.

> Dollar cost averaging is ‘automatically’ used by many superannuation investors when they make regular investments (contributions) in accumulation mode to their funds usually on the same day of the month or quarter over their working lives.

> When they retire and commence a regular income stream or pension, they are withdrawing on a regular basis from their fund and the underlying investments, thus effectively utilising the principles of dollar cost averaging out of these investments.

> Just as dollar cost averaging into investments doesn’t guarantee the best investment return or outcome, neither does dollar cost averaging out of investments. However, it does help manage the risk of unit price volatility when withdrawing funds.



Wrap up Markets are volatile, a fact that may have been forgotten after a period of stable and increasing returns experienced by equity investors from 2002 to 2007. History also shows that over time, equity markets do deliver the best return of any of the key assets classes and staying the course is often the best strategy. Remembering the important principles of investing – well diversified investment portfolios to iron out volatility in returns, time in the market rather than timing the market and understanding the risk return equation for investments - will most likely deliver the most consistent returns over time.

Depending on the age of the investor, different strategies can be used to mitigate risk and maximise returns. For all investors, reviewing market activity and its effect on investments should always be done through the filter of that particular client’s financial circumstances, needs and goals.

References Russell/ ASX (2008), Russell/ ASX Long Term Investing Report, May.

Vanguard investments (2007) Realistic Sharemarket Expectations.

Acknowledgement & thanks We thank the following people for their contribution to this article:

> Gerry Power, Managing Director, Lakeside Financial Planners Pty Ltd

> Dr Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital Investors

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This document was prepared by and for Kaplan Education Pty Limited ABN 54 089 002 371. It contains information of a general nature only and is not intended to be used as advice on specific issues. Opinions expressed are subject to change. The information contained in this document is gathered from sources deemed reliable, and we have taken every care in preparing the document. We do not guarantee the document’s accuracy or completeness and Kaplan Education Pty Limited disclaims respons bility for any errors or omissions. Information contained in this document may not be used or reproduced without the written consent of Kaplan Education Pty Limited.


A history of financial planning in Australia The financial planning industry as we know it today - sitting down and planning people’s affairs in a professional and meaningful way - is little more than a decade old. It is based on historical developments that may be categorised as:

• Attitudes to personal wealth accumulation and investment.

• Service and product developments.

• Evolution of distribution channels.

• Responses to consumerism and legislation.

• The evolution towards professionalism.

Attitudes to personal wealth accumulation and investment In 1909, Australia became one of the first countries in the world to provide government pensions - a low, flat rate, means-tested pension for ‘the deserving poor’. The benefit was intended as a lifestyle supplement, not adequate in itself to support life with any degree of dignity.

This period also saw the beginning of restricted and private superannuation pension schemes, mainly for senior management and public servants, but the level of participation remained relatively low. These funds generally provided pensions rather than lump sums and so for that reason the beneficiaries at retirement rarely became ‘investors’.

Australians needing investment advice generally sought specialist advice in particular investment areas, e.g. stockbrokers, accountants, solicitors, real estate agents, banks, trustee companies and life insurance companies. These groups continue to provide particular forms of financial planning advice.

The post World War II economic boom saw a rapid growth in industrialisation and national prosperity matched with an even greater growth in public expectations. Superannuation became more popular as a form of wealth accumulation. The major life offices marketed superannuation actively on the basis of the availability of tax deductions for both member and employer contributions.

By the mid-1960s defined benefit schemes, where benefits were expressed as a multiple of salary, were introduced. Previously, the funds had been structured as accumulation funds, where the benefit was the total of contributions and earnings. Also during this period, trustees began to actively manage funds within asset classes, and unit linked investments began to be used.

Very high inflation in the early 1970s led to rapid increases in wages and salaries. The effect on superannuation pay-outs from defined benefit schemes was significant. An employee retiring from a government pension fund, might receive as much as 75 per cent of salary as a pension or five times annual salary as a lump sum. Either way, the effect of rapid inflation on the pay-outs was considerable.

In 1973, Prime Minister Gough Whitlam declared that the age pension entitlement was a fundamental right for all Australians. He introduced a policy providing a universal (non-means tested) pension pegged at 25 per cent of average weekly earnings.

The 1980s saw the first wave of ‘industry restructuring’ (i.e. the dismantling of the Australian manufacturing industry.) Large numbers of Australians retired or retired early under voluntary redundancy schemes, continuing to receive significant lump sums for investment.

These Australians began to consider themselves investors. During a period when interest rates had peaked at 19 per cent, many banks were still paying only 3 per cent on savings accounts. Investors in fixed interest investments realised they had a problem. The

income they received from their investments meant that in many cases they were missing out on age pension or part age pension under the income test - a benefit they had begun to believe was their entitlement after ‘a lifetime of paying taxes’.

Social attitudes to wealth accumulation have continued to evolve since the 1980s, the main change being a changed view of the need for self-provision for retirement.

The old view was that a home (and, if possible, a new car) by retirement was sufficient provision for old age as the pension would provide an income stream. These days the majority of Australians are aware that the ‘baby boomers’ will face a shrinking tax base by the time they retire - making it difficult for the pensions to maintain the age pension. The trend is clearly to replace unfunded social security pension benefits by funded compulsory superannuation supplemented by private savings.

Service and product evolution Australian Fixed Trusts (AFT) were established in 1936. During the post-war period and going through the 1950s, AFT actively marketed unit trusts on the basis of ‘earn double bank interest’.

In July 1959, the first unlisted property trust was set up by Australian Land Trusts (subsequently acquired by the Hooker Group), AFT launched their first unlisted property trust in October 1959 and their first mortgage trust in 1960.

During the 1960s, AFT expanded their property trusts, launching a new property trust every three years. In 1973, they closed property trust number five and launched the real estate trust.

By 1960, AFT was taking in excess of £1,000,000 a day into unit trusts. Hookers were also heavily involved in unit trusts. Three things changed all that. The first was the Companies Act of 1961, which basically outlawed ‘share-hawking’. Under the Companies Act, unit trusts were deemed to be securities and came under the same legislation as shares.

The second factor was the mini-budget of 1961, which caused a fairly dramatic drop in the share market. AFT had marketed a number of fixed trusts. Under the deeds of these trusts, certain shares were held in set proportions for the life of the trust. There was no ability to go liquid. As a result of the budget, the value of those trusts went down dramatically.

The third factor was the credit squeeze of 1961. AFT had introduced a series of balanced funds in the 1950s and 60s, so that when debenture companies like Reed Murray, Stan Hill, A.G. Heeling, and H.G. Palmer got into trouble as a result of the credit squeeze, AFT’s balanced trusts debentures become if not worthless, dramatically reduced in value.

Interest in unit trusts was not rekindled until 1976, when Robert Morrison and Paul Terry started running full-page advertisements quoting the returns on unit trusts. Paul Terry, who went on to form Monitor Money and John Blewett who founded RetireInvest were Morrison’s main competitors. They were followed by Darlington Commodities, which began selling unit trusts in the late 70s. This was an important move out of life insurance, which had been one of the main forms of investment until this time.

However, unit trusts were not really popular again until Prime Minister Malcolm Fraser changed the basis of calculating pension entitlement from a means test to an income test. The change created a great opportunity for geared property trusts which produced no income so retirees could still get the pension even if they had substantial assets. So, in 1981, AFT introduced the Real Property Growth Plus Series, which generated no income.

Other entrepreneurs followed the lead of AFT and started setting up property trusts. These were the halcyon days until the assets test was introduced in 1983.

The late 1970s were also years of stockmarket buoyancy. Many investors accessed the stock market using equity trusts that provided fairly consistent positive returns between 1975 and 1982.

In 1981, Hill Samuel (now Macquarie Bank) applied the unit trust structure to savings accounts, by introducing the first Cash Management Trust (CMT) into Australia. The early CMTs offered 24 hour liquidity, and later began to offer cheque account type facilities. CMTs, by investing in 90 day bank bills, were able to offer Australians an attractive alternative to the 3 per cent bank savings accounts. Australian banks, being still regulated, were unable to vary their home loan lending and savings account rates.

In the early 1980s, the split (property) trust was introduced by Growth Equities Mutual (GEM). The split trust offered separate income and growth units and overcame many of the problems of gearing but the structure did not survive the property crash of 1990.

In 1983, the Federal Government began to deregulate investment markets, thereby giving Australians access to international investments for the first time. Again, unit trusts were well positioned to offer offshore exposure.

Meanwhile, Australia’s life offices had also been actively developing innovative products and marketing concepts within the insurance context.

The first insurance bonds were essentially a single-premium savings vehicle (available in minimum contributions of $1,000) which could provide tax-free bonuses.

Interest rates were high between 1974/75 – the result being that some early insurance bonds (effectively single-premium endowment policies) offered tax-free returns of around 17 per cent. The Australian Tax Office (ATO), in response to what they no doubt regarded as a ‘contrived scheme’, introduced the 10-year rule soon after. The 10-year rule required the investment to be held for 10 years before the investment could be withdrawn tax-free. An internal tax on earnings, equivalent to the company tax rate, was introduced.

Unit-linked insurance bonds were introduced by Australian Eagle and Sun-Alliance. These bonds were not capital guaranteed but unit/market linked, i.e. the value was related to market movements.

Norwich Union was the first Australian life office to actively adopt a financial planning emphasis by widely distributing a booklet and video under the title ‘The Secret of Wealth’.

Friendly societies provided an interesting variation on the insurance bond theme. The history of ‘friendlies’ dates back well into the last century in England where groups of workers banded together to provide syndicated benefits, particularly in the health area. By the early 1980s, the friendly societies were regulated by state statute and was strongest in Victoria, where friendly society bonds were developed and actively marketed by two larger groups - the Independent Order of Odd Fellows (IOOF) and the Australian Retired Persons Association (ARPA). Friendly Society bonds offered irregular, tax-free draw-downs which did not affect pension entitlements under the income test (and, for a time, under the asset test).

Rollover funds began around the time the assets test was introduced in 1983. It had been feared that the asset test would be the death of the financial planning industry. But one of the strengths of the industry was, and is, its ability to adapt to and use changes in the regulation of superannuation and the social security system. In 1983, changes in both these areas were used to move into the superannuation area and work with the rollover system.

The next major changes occurred in 1985 and 1987. In 1985, the financial planning industry faced a revolution in the taxation system: the advent of Capital Gains Tax (CGT). Then, in 1987, the introduction of dividend imputation further altered the balance between the tax-efficiency of capital growth and income. This was a dramatic change yet the industry adapted quite quickly.

There were many retrenchments following the stock market crash of 1987. By 1990, the recession meant more retrenchments. The financial planning industry did extremely well during this period, not only in terms of business but, as more people approached for technical advice, the industry also gained credibility and enhanced professionalism.

After the stock market crash, and through to about 1992, many life offices went back to their basic business - building up regular premium risk products. Some life offices had been badly affected by the property crash of 1990. The excessive marketing of capital guaranteed products during the 1988-91 period also meant that reserves had been severely depleted. This combination and increased competition meant returns were much lower. Consequently, it was very difficult for these companies to build up reserves.

In 1988, (former) Treasurer Paul Keating outlawed the variable income annuity, a kind of predecessor of the allocated pension. The cash back or allocated pension began to appear in 1989/90 and was officially endorsed in 1992. Annuities - lifetime annuities, and even more significantly term annuities with 100 per cent residual capital values or nil residual capital values - became a very important part of financial planning for retirement.

The balanced (diversified) trust Balanced trusts really started to emerge following the property trust debacle of 1990. Clients no longer saw property trusts as appropriate vehicles for accessing property markets. Balanced trusts became popular because they introduced diversified investment (allowing exposure to different asset classes) through one fund manager. Westpac’s Personal Investment Fund was the first to introduce balanced trusts, followed closely by Bankers Trust (BT) which introduced its lifetime trust. Rothschild and Barclays followed suit soon after.

Balanced trusts have become increasingly popular. The balanced trust is a useful financial planning tool because it can provide the client with:

• a monthly income

• a savings plan

• access to diversified sectors, and (with the trend towards ‘master funds’)

• access to diversified managers.

Direct equity investment In 1990, a number of unlisted property trusts suspended redemptions. By 1992, most of the former unlisted property trusts which had survived were listed or prepared for listing. The withdrawal of the unlisted property option put pressure on investment advisers to diversify into direct equities. The pressure also came from an increasing perception among investors that direct investment in equities offered better value. The fees and costs of managed funds were under attack.

In 1992, the ‘cash back’ or allocated pension was officially endorsed and over $3 billion was placed in allocated pension investments in the month of June 1994, only partly because of the pressure of changing tax rules.

Evolution of distribution channels As the number of trusts outside the institutional sector increased during the 1980s, the need became apparent for ‘independent’ advisers to represent the various trusts alongside other types of investments.

By 1983, a number of ‘independent’ advisory networks had developed and began marketing trust, bond and friendly society products, mainly to retirees. However, independence was limited. For example, such was the relationship between the advisory firms and the fund managers that it was not uncommon for advertising bills to be met directly by fund managers, and the practice of fund managers sponsoring some financial planning network annual conventions and training sessions continues to this day.

In addition, many of the original ‘independent’ networks have now been taken over wholly or partially by institutions.

Networks have increasingly moved towards charging fees for service in the form of rebated commissions (i.e. not hourly fees). This is significant because the planner becomes more clearly the agent of the client, not the agent of the fund manager.

While unit trusts were developing in the 1980s, the larger financial institutions (banks, life offices and trustee companies) expanded their financial planning operations offering advice mainly on in-house products.

Many banks, life offices and large stockbrokers established licensed advisory divisions and subsidiaries.

• Westpac established ‘Personal Investment Centres’ (PICs).

• Australian Fixed Trusts was fully absorbed by ANZ Funds Management. (NAFM).

• The Commonwealth Bank established ‘Commonwealth Bank Financial Services’.

• Norwich purchased ‘FPI’.

• ANZ set up its financial advisory service ‘ANZ Funds Management’.

• Bain & Co founded a financial planning subsidiary.

Master trusts: 1989-1994 A significant development in the financial planning industry was the establishment of master trusts, which allowed financial planning organisations to protect their client’s identity. Some master trusts run a full investment service, including several products with a particular asset mix. Others have developed ‘discretionary master trusts’, where clients can choose a variety of investments from a recommended list.

Some master trusts specialise in superannuation, rollovers and allocated pensions, others also run non-superannuation master trusts. Eventually, some fund managers have developed similar master trusts in conjunction with other fund managers.

Direct marketing by funds manager Funds managers began to use direct marketing (advertising, direct mail) to sell products to clients. A significant part of this was cross-selling, i.e. approaching clients holding an investment in one product, with other products and/or services.

Electronic trading A very significant development in the industry in 1994 was the beginning of electronic trading. Several information delivery systems have been developed and advisers have access to information on such matters as client prices and trailing commissions via the internet.

Responses to consumerism and legislation The National Companies and Securities Commission (NCSC) The NCSC was established in 1979 and became fully operational from 1 July 1981. The NCSC’s major role was to coordinate the activities of the various state based Corporate Affairs Commissions, each of which provided various categories of licences:

• Dealer’s licences.

• Investment adviser’s licences.

• Dealer’s representative’s licences.

The NCSC introduced the process of issuing proper authorities that were to replace dealer’s representative’s licences.

NCSC had insufficient resources to actively monitor the activities of securities advisers, and so became discredited as a regulator.

The Australian Securities Commission (ASC) In 1991 the NCSC was disbanded and the ASC was formed.

ASC more closely coordinated the activities of the different states and had a national rather than a state focus. Under the ASC, advisers were the holders of proper authorities, and as such became responsible to the dealer.

The ASC was formed to administer new securities legislation in the form of the Corporations Law. The entire administration became a federal function, thus making a nationally coordinated approach to auditing and surveillance feasible.

Dealer’s representatives were no longer licensed by the regulator, but became the responsibility of the dealer, to whom a licence was issued.

The Insurance & Superannuation Commission (ISC) The ISC, which was established in 1987, also affected financial planners in relation to superannuation and insurance products. The Industry Code of Practice (1995) placed the onus for responsibility for the conduct of agents with the life company (as well as the agent) where they are agents or multi-agents and with the broker where they work under a broker’s licence.

A new regulatory environment The Australian Securities and Investments Commission (ASIC) From 1 July 1998 the regulation of financial services in Australia has undergone some important changes.

The Australian Securities Commission has been renamed the Australian Securities and Investments Commission (ASIC).

ASIC has jurisdiction to deal with certain matters under various insurance, superannuation and banking legislation. Jurisdiction over other parts of this legislation passed to Australian Prudential Regulatory Authority (APRA).

ASIC has the role to “promote the informed and confident participation of investors and consumers in the financial system and to strive to improve the performance of the financial system”.

In dealing with ASIC you will need to be aware that the words ‘financial system’ highlight the much wider range of financial services and products that ASIC will regulate compared with the ASC’s previous role in securities and futures.

If you deal with superannuation, life insurance and some banking products, your consumer protection functions are no longer covered by the ISC or the Reserve Bank; these functions are the responsibility of ASIC. ASIC is responsible for all investment products offered under the life insurance banner, as well as the market-based investments. The re-badged organisation also covers a whole new class of products through which consumers protect themselves against risks, such as general and traditional life insurance.

The Australian Prudential Regulation Authority (APRA) The Australian Prudential Regulatory Authority (APRA) has the job of making sure that the institutions that people deal with are able to honour their commitments when they fall due. For life insurance and superannuation, these commitments will often arise many years into the future. It is likely that APRA will focus mostly on the overall viability of the institutions, while ASIC focuses on the relationship between the institution and the consumers. However, the dividing lines will not always be absolutely clear-cut and ASIC and APRA will have to work closely together.

The Financial Services Reform Act 2001 The Financial Services Reform Act 2001 (FSRA) changed the regulatory framework of the Australian Financial Services industry. The FSRA states that any person or company providing financial product advice needs to apply for an Australian financial service licence (AFSL) from ASIC, who have the right to ban any person from giving financial advice if they find there has been false or misleading conduct.

The FSRA also sets out uniform disclosure guidelines for a financial service provider, stating that a product disclosure statement (PDS) must be provided for every offer of superannuation, life insurance, general insurance, managed investment schemes, derivatives and banking products. It also advises that a financial services guide be provided to the client explaining the adviser’s capacity and background. Specific rules are also set out for the advice process, including the provision of a Statement of Advice (SOA) when advice is given, and the ‘know your client’ and ‘know your product’ rules.

Federal government super simplification reforms As the post-war baby-boomers reach retirement age, the Australian government is attempting to cope with the ageing population by introducing huge reforms to the superannuation system, with the majority effective from 1 July 2007. The main changes include:

• for people aged 60 or over, benefits paid from a taxed fund will be generally tax-free • Reasonable Benefits Limits (RBLs) are abolished • Employment Termination Payments can no longer be rolled over to superannuation,

and • the 50% assets test for complying income streams is no longer available.

July 2008

Ethics in financial services

Overview Ethics can be defined as the principles, values and ways of thinking that guide a person to make moral choices, which are reflected in the way they behave. The challenge for businesses is to determine limits and boundaries around what is acceptable in terms of decision making, conduct and behaviour. This Ontrack training explores the meaning of ethics, particularly in a financial services context, focusing on specific issues, such as managing conflicts of interest from an ethical perspective.

Did you know?

According to the 2005 Sweeny Research ‘Eye on Australia’ survey, nearly two-thirds of Australians believe that business leaders are untrustworthy. (Lloyd, 2006)


> Outline some considerations in defining the nature of ethics

> Identify the role of ethics in the current environment

> Identify the regulatory influences in determining ethics in financial services

> Identify the importance of industry codes of practice.



> Generic knowledge (75 minutes)


Ethical conduct Ethical conduct is widely debated in the financial services industry, as it should be, because ethics is of particular importance in this industry:

Financial planners deal with a range of ethical dilemmas in their daily practice, which often arise in circumstances where there are multiple stakeholders, interests and values in conflict and where the law may be uncertain. (Smith, 2007)

What do we mean by ethical conduct in a financial services context? How is ethics different from laws and regulation and is there a link between the law and ethics? How difficult is it to develop an ethical framework that is commonly shared by employees within an organisation, when Australia is so culturally and ethnically diverse?

This article explores the meaning of ethics, particularly in a financial services context. It reviews specific issues, such as managing conflicts of interest from an ethical perspective. The following questions are discussed:

> Do ethics inform the law and regulation?

> Of what value are codes of ethics, developed by professional bodies and organisations, in the financial services industry?

> How effectively are they owned by individuals and applied in their everyday work with clients?

> Is it possible for an organisation to develop a meaningful ethical decision-making framework, or should individuals be relied upon to do the right thing at the end of the day?

Defining ethics Ethics can be defined as the principles, values and ways of thinking that guide a person to make moral choices, which are reflected in the way they behave. Often it is the struggle to distinguish right from wrong when faced with a choice between competing outcomes or courses of action. To enter that struggle is to venture into the area of ethics.

The challenge for businesses is to determine limits and boundaries around what is acceptable in terms of decision making, conduct and behaviour. Determination of those limits is shaped by the motivations and aims of business, the personal and corporate values of business, and the principles that form the basis of the relational nature of all business and its dealings.

What ought one do? A 2005 KPMG survey on business ethics reported that, in the public’s mind, business ethics are linked to notions of honesty, integrity, trust, accountability, transparency and social responsibility. (KPMG, 2005)

Dr Simon Longstaff, Executive Director, St James Ethics Centre, repeats Socrates’ view on ethics when he asks what he believes is the central question about ethics – ‘what ought one do?’. Dr Longstaff explains that Socrates did not begin by asking questions about right or wrong, good or bad. Rather, by asking ‘what ought one do’, a person is placed in the position of having to make an ethical decision. (Longstaff, 2001)

July 2008 Page 2 of 14


Faced with a choice and being conscious of the competition for a particular response, the individual tries to determine what is the good or right thing to do in the circumstances. That struggle, and a person’s recourse to values and principles, is a search for what a person ought to do. But, importantly, it also requires a practical response in terms of what a person would do in that situation. That process of thinking and responding is both reflective and practical.

Consider…

A study of the S&P/ASX200 companies has shown that, in the period 2004-07, directors in 23 of those companies traded shares during the period following books-close until the day results were released. In 8 of those 23 companies, directors traded on the same day results were released. This is not illegal in itself. However, is it ethical – why?

[The study was the Regnan Position Paper – ‘Director and executive security trading’ (10 March 2008)]

Are organisational values universal? Underpinning an ethical approach is a set of individual or organisational values and principles. However, often these are not shared. Dr Lagan, Director Corporate Citizenship and Business Ethics, KPMG, believes that one of the biggest mistakes that organisations make in implementing values-based decision making is assuming that everyone applies the same meaning to the values promoted by the company. Other commentators believe there are different sets of values operating in many organisations:

> the values that the organisation wants people to believe

> the values actually in use. (Walters, 2005)

Suzanne Ross, Director of Consulting, Training and Counselling at St James Ethics Centre, says that from time to time the St James Ethics Centre is asked whether there is a universal set of values that can be drawn upon to develop a code appropriate for an organisation. This is difficult as there is significant debate about universal values, with some believing that the following could be called ‘universal values’:

> trustworthiness

> respect

> responsibility

> fairness

> caring

> citizenship.

Others believe that there is no universal set of values and that any agreement about values can only be reached after there has been much debate and consultation.



Consider…

Does your organisation have a set of commonly agreed values and principles? If so, what was the consultation process conducted during their development? Was everyone in the organisation involved or were the decisions made by management and then imposed on the staff?

Cultural differences In Australia, which has a diversity of cultures, the approach to ethical decision making and the values that underpin it could be challenged as being too classically liberal democratic and too ‘Western’. With the increasing internationalisation of business and financial markets, a cross-cultural ethical perspective may be required. The problem with this approach is that what is morally right or wrong varies from society to society – that is, everything is relative, so that there is no overarching moral principle to guide behaviour.

The current environment and ethics Ethical conduct has been under the spotlight since media coverage of the collapse of HIH, of huge payouts to CEOs and more recent examples of poor corporate behaviour, including:

> Opes Prime and other firms involved in the margin call difficulties

> Westpoint with its mezzanine funds and high commissions paid to advisers to encourage them to place retail investors in a product that was not appropriate to their needs

> The collapse of Fincorp

> ASIC proceedings against certain James Hardie directors in respect of the funding of the Medical Research and Compensation Foundation.

Even though some illegality may be involved in such cases, there has also been a focus on the standard of ethical behaviour in some organisations and questions raised about the apparent absence or downgrading of some key values and principles in the decision-making process.

The ‘Eye on Australia’ survey found that the impact of poor corporate behaviour has resulted in Australians having a general lack of confidence about corporations and their leaders. (Lloyd, 2006)



For example…

KPMG’s Forensic Fraud Survey (2006) found that:

> 32% of employees witnessed unethical or improper conduct at work during the previous two years

> 38% of employees blamed senior management for its lack of commitment to the organisation’s ethical code

> 32% of employees believed a poor ethical culture contributed to unethical behaviour

> 88% of employees felt that the CEO function within an organisation was responsible for promoting the culture of integrity in the organisation.

Investors’ concerns Restoring investor confidence in the capital markets has occupied the minds of the regulators and government in recent years. The fallout from the sub-prime disaster in the US on Australian companies and the stockmarket, has only put increasing pressure on the regulators as they consider a new round of regulation to restore confidence in the capital markets. Without confidence in the integrity of the markets, investors, both institutional and retail, will go elsewhere.

In a study by BT Governance Advisory Service, the superannuation funds that participated in the survey want listed companies to ensure that:

> corporate boards oversee areas of business ethics practices that are a potential risk to the company

> management processes are in place to review, monitor and manage business ethics issues

> company codes of conduct guide employees in their ethical decision making

> governance measures such as whistle blowing policies and compliance training are available for all staff

> there is public reporting on the company’s performance on business ethics issues and other policies to increase transparency. (Lawrence, 2005)

Corporate and regulatory response to ethical decision making What has been the response to poor ethical decision making? In many financial services organisations, ethical accountability has been taken up in the implementation of general compliance measures. At a government level, the response has been a focus on more legislation, regulation and compliance requirements.



Responses such as the following demonstrate how ethical considerations underpin much of our legal and regulatory framework.:

> financial services reform and the introduction of licensing and disclosure obligations

> the Australian Prudential Regulation Authority’s (APRA) ‘fit and proper’ test for directors and senior managers

> ASX Corporate Governance Principles and Recommendations (Revised Edition, 2007) – Principle 3: ‘Promote ethical and responsible decision-making’

> Federal Government’s ‘Green Paper on Financial Services and Credit Reform’ (June 2008)

> the Federal Government’s introduction of criminal penalties for serious cartel conduct in the trade practices area

> the management of conflicts of interest, particularly in financial services organisations,

At the same time, professional bodies have introduced their own codes of ethics and conduct, partly as a response to managing conflicts of interest and other conduct.

For example…

A number of codes have been developed that relate to:

> the remuneration system paid to advisers by product issuers to promote their products to retail clients

> research report providers in the wholesale market

> communications between corporates and analysts

Individuals’ response to ethical decision making At the other end of the spectrum is the individual’s response to ethical decision making. It is important to remember that decisions are taken by people, often with a capacity for discretion in the decisions they make, but who ultimately need to come to a decision.

A reflective yet practical strategy would be to proceed by trying to identify the following:

> What are the facts?

> What assumptions am I relying on?

> Who are the people affected?

> Which of my values are significant?

> Are there alternative perspectives for resolving the issues?

> What alternative options are available?

> How do I justify my decision?

This process provides a framework for an individual’s course of action, being mindful of the alternatives and the motive for the action chosen.



Consider…

Simon Longstaff, St James Ethics Centre, borrows from US Supreme Court Judge, Justice Brandeis, when he refers to the ‘sunlight test’. The ‘sunlight test’ asks a person to imagine how they might feel if a decision they make is subjected to full public scrutiny. Consider this in your own decision making — would you have made a particular decision if it were subject to public scrutiny? (Longstaff, 2001)

Business ethics and financial services law The importance of ethical principles to the development and transformation of law cannot be underestimated. The Corporations Act 2001 and the body of common law principles that constitutes the law of contract are good examples of how values and principles are incorporated into law.

It should be remembered that the law can be a blunt and inadequate instrument in responding to ethical expectations. At best, the law, including those areas of legislation that have an impact on the financial services industry, will only set minimum standards from the ethical perspective. Ethics will frequently require more of an individual. Being ethical could require the sacrifice of individual self-interest for the good of another or the community as a whole.

Responding to conflicts of interest A conflict of interest is probably one of the most common examples giving rise to an ethical dilemma in business. But what is it that gives rise to such a conflict?

A conflict of interest is really a tension between competing obligations or responsibilities. As business involves people, the conflict will frequently involve a competition between different relationships such as:

> commitments to an employer organisation and loyalty to a friend

> developing an investment portfolio for a client that will appropriately balance risk on the one hand and the social implications of financial investments on the other.

Often there will also be a conflict of values.



Consider…

When presented with information that has been acquired dubiously, though not strictly in breach of the Corporations Act requirements on insider trading, should you be absolutely honest about the sources and risk losing a potential client to a competitor?

If you are conscious of the conflict that is present, how should you resolve it? By ignoring the conflict and hoping it will go away or by asking the key question ‘what ought one do?’.

The legislative obligation to ‘have in place adequate arrangements for the management of conflicts of interest’ (s912A(1)(aa) of the Corporations Act) is a good example of where the law stops short of dictating particular conduct and relies on general principles of ethical dealings.

The Australian Securities and Investments Commission (ASIC) puts it as follows in its Regulatory Guide 181 [RG 181] Licensing: Managing conflicts of interest:

What constitute adequate conflicts management arrangements will depend on the nature, scale and complexity of the licensee’s business. In many cases, a licensee may be able to comply with the law’s requirements in a number of different ways. (para. 181.10)

and goes on to suggest (para. 181.20) that there are three mechanisms that licensees would generally use to manage conflicts of interest, namely:

1. controlling conflicts of interest

2. avoiding conflicts of interest

3. disclosing conflicts of interest.

Despite the legislative requirement under s 912A(1)(aa) of the Corporations Act and ASIC’s guidance on the mechanisms to deal with conflict management, it will ultimately be up to the individual adviser to determine to what extent they can continue to act in a transaction for a client.

An adviser is prevented from making adequate conflict of interest disclosure because the information to be disclosed is commercially sensitive or is protected by confidentiality agreements. Such situations are difficult to manage adequately and it may be that the adviser will need to avoid providing the advice altogether. (RG 181)



Ethical principles and licensing Ethical principles are fundamental to many of the rules embodied in the Corporations Act and applicable to holders of financial services licences. A wide range of people involved in giving investment advice or dealing in financial products are required to hold licences. These specific requirements include that:

> there is disclosure about interests or associations the financial services provider has that might reasonably be expected to be capable of influencing the financial services provider in giving advice to clients (ss 942B and 947B)

> competent advice is given to those clients (s 945A)

> the holder of an Australian financial services licence is obliged to act efficiently, honestly and fairly (s 912A).

These obligations, although now embodied in legislation, clearly arise out of substantive ethical principles. They also reflect a similar development of the common law that imposed obligations called ‘fiduciary obligations’ on persons holding trusted positions, such as financial services providers.

Ethics of disclosure obligations At common law, an agent has a duty to inform its principal of any circumstance which may interfere with the provision of impartial advice. In the financial services industry, this obligation is reinforced by the Corporations Act for the purpose of providing a level playing field for all investors.

The duty of disclosure by financial services providers is based on the long-standing professional ethical standard that to help inform a client’s decision-making process, a client is entitled to know if their adviser will derive a personal advantage if the client accepts the adviser’s advice.

Price-sensitive information Market rules originating from ethical considerations are not only imposed purely from a desire for fairness, but also to address a more basic concern; that is, the fear that unless the financial markets are seen to be behaving with integrity, would-be participants will be scared off, leading to the prospect of the markets ultimately failing. Equal access to price-sensitive and other important information is fundamental to the success of financial markets.



For example…

Insider trading It is illegal (not only unethical) for a person who is in possession of non-public price sensitive information to deal in the relevant financial products of the entity to which the inside information relates. This goes beyond the requirement that anyone who represents the corporate issuer of the relevant financial products should not betray a duty of confidence owed to that issuer. The insider trading rules affect persons who may have access to inside information not only as a result of such a connection, but also through independent means.

Continuous disclosure The same considerations underlie the rules on continuous disclosure.

Misleading or deceptive conduct There is a prohibition on engaging in misleading or deceptive conduct in dealings in the financial services industry (Corporations Act, s 1041H), so that consumers are able to make informed decisions based on accurate information.

All these examples are concerned with the overriding principle that all participants should have equal access to important information.

Industry imposed non-law codes There is a trend in industries and organisations to develop written codes of conduct and, to a lesser extent, codes of ethics. Both are forms of self-imposed non-law regulation.

Figure 1: Different types of codes used

Code of conduct

A code of conduct tends to be prescriptive as to certain unacceptable conduct and behaviour.

Code of ethics

A code of ethics is a positive and affirming set of broad principles to guide decisions and behaviour and will often articulate specific values.



Ethics play an important role in generating confidence that our financial markets are operating fairly and justly in a competitive market. Against these standards and expectations, laws establish a minimum framework and a set of benchmarks for lawful conduct and behaviour. Values such as honesty, integrity and trust are the overarching ethical values and principles, and are the cornerstones of ethical governance of financial markets.

These can be usefully represented in the nature of the following duties:

> honesty and truthfulness

> keeping promises and agreements

> loyalty to those who have placed faith in you

> fairness and justice

> doing no harm through negligent or intentional conduct.

In the past, financial market ethics was a matter of personal responsibility, integrity and conscience. Responding to unethical practice was largely a matter of personal conscience.

For example…

Ethics in the financial markets can be traced back to the phrase ‘my word is my bond’, the motto of the London Stock Exchange. London brokers zealously adhere to their motto, which allows enormous quantities of shares to be exchanged between brokers and ‘jobbers’ on the London Stock Exchange without so much as a signature.

Notwithstanding the existence of laws, stockmarket rules and professional codes of conduct, financial market participants the world over operate on the basis of their ‘word’ and the assumption of ethical practice and conduct in their financial transactions and dealings.

Codification of ethical conduct More recently, attempts have been made to ‘codify’ values and principles to assist financial services providers to understand and comply with their ethical responsibilities. These have evolved in various guises from voluntary industry non-law codes of conduct or ethics to mandatory and binding codes such as ASX Market Rules.

The Corporations Act recognises the importance of codes and s 1101A provides for the approval of codes of conduct by ASIC. In ASIC’s Regulatory Guide [RG 183] Approval of financial services sector codes of conduct, the importance of non-law codes is summed up:

Industry codes of conduct play an important part in how financial products and services are regulated in Australia. Where they enjoy the support and commitment of the sponsoring industries, codes can deliver real benefits to both consumers and subscribers. (para 183.3)

The effectiveness of these codes will depend on how they are lived out in participants’ day-to-day conduct.



Examples of industry codes include:

> Financial Planning Association (FPA) – Principles for Managing Conflicts of Interest

> Securities and Derivatives Industry Association (SDIA) – Code of Ethics and Code of Conduct

Codes of ethics and advisers For the vast majority of financial advisers, personal ethics and integrity govern behaviour, as do rules and regulations set by government and the regulators. June Smith, Argyle Partnership, questions whether many organisations have an ethical framework to provide guidance or whether it is mostly left up to the individual to respond. She believes that financial advisers mostly rely on their judgement to make ethical decisions every day in their adviser/client relationships, much of which is done in the absence of any formal ethical framework.

KPMG endorses this view when it reported in its 2005 survey on business ethics and leadership that most Australian company boards believe that ethical issues remain an individual rather than a collective issue. (Fielding, 2005)

Case studies The following case studies have been taken from ASIC’s discussion paper Managing Conflicts of Interest, April 2006. While they relate to disclosure and other compliance issues, it is also important to be able to identify the ethical considerations involved.

Case study 1: Financial advisers (wholesale) and research report providers Salamander Securities Ltd, a stockbroker, discloses at the end of one of its research reports on Lizard Industries Ltd, that it might have a range of relationships with Lizard from time to time. The disclosure is a lengthy attachment to the report, is non-specific, written in legalese and in a smaller font than the rest of document.

Source: A5 Poor disclosure of interests.

Consider…

Aside from issues as to whether this form of disclosure meets compliance with RG 181, there are ethical issues that arise.

Consider what they may be and ask the question ‘What ought Salamander Securities do?’.

Should Salamander disclose this upfront to their clients and detail what the relationship is? Why would this be the right thing to do?

The duty of disclosure by financial services providers is based on the long standing professional ethical standard that to help inform a client’s decision-making process, a client is entitled to know if their adviser will derive a personal advantage if the client accepts the adviser’s advice.



Case study 2: Licensees/financial advice (retail) Jan, an adviser at Finco Super Pty Ltd, recommends to clients to switch to a wrap account provided by Leopard Financial Ltd. Finco is a wholly-owned subsidiary of Leopard. Leopard’s wrap account offers similar functions to the client’s current platform, however it makes administration of the client’s portfolio easier for Jane, the adviser. Jane also gets upfront and trailing commissions when clients switch to Leopard’s platform. Both the relationship and the commission payments are disclosed to the client. Here Jane is receiving a financial benefit for switching her clients to the new platform in circumstances where there is no discernable benefit to the client in making the move. Generally, just because the platforms make it easier for the adviser to manage her clients is not sufficient reason to justify the switch. Source: B5 Advice on platforms.

Consider…

Should Jane rebate the commissions she earns from Leopard to her clients? Would this be the right thing to do?

To assist in making an ethical decision, Jane might ask herself, ‘How do I justify my decision to switch clients to a platform that will potentially cost them more and for which I will be rewarded?’.

Asking this question might influence her course of action, being mindful of the alternatives and the motive of the action chosen. Ethical conduct can require the sacrifice of individual self-interest for the good of another.

Wrap up Ethics can be defined as the principles, values and ways of thinking that guide a person to make moral choices, which are reflected in the way they behave. The challenge for businesses is to determine limits and boundaries around what is acceptable in terms of decision making, conduct and behaviour. For this reason, and because of examples of poor corporate behaviour, major corporate collapses and conflicted financial advice, many organisations have developed codes of ethics and codes of conduct to assist employees to make a choice about what is the good or right thing to do in the circumstances, while at the same time being conscious of competing aims of the organisation and the client.

Whether or not codes of conduct and ethics are effective often comes down to whether an individual’s values and principles are aligned with those of the organisation and how effectively an organisation integrates ethical values into its operations and the way its staff do their jobs.

Governments have focused on more legislation, regulation and compliance requirements as a response to inappropriate corporate behaviour. In many financial services organisations, ethical accountability has been taken up in the implementation of regulation and compliance measures.



The final words on ethics in financial services should be those of Mr Justice Owen from the Report of the HIH Royal Commission (2003):

‘From time to time as I listened to the evidence about specific transactions or decisions, I found myself asking rhetorically: did anyone stand back and ask themselves the simple question—is this right? This was by no means the first time I have been prone to similar musings. But I think the question gives rise to serious thoughts…

In an ideal world the protagonists would begin the process by asking: is this right? That would be the first question, rather than: how far can the prescriptive dictates be stretched? The end of the process must, of course, be in accord with the prescriptive dictates, but it will have been informed by a consideration of whether it is morally right. In corporate decision making, as elsewhere, we should at least aim for an ideal world.’

References Australian Securities and Investments Commission (2006), Managing conflicts of interest in the financial services industry: an ASIC Discussion Paper, Sydney, April.

Fielding, Z. (2005), ‘Creating an ethical climate’, Money Management, 16 March.

Ghillyer, A (2006), ‘Business ethics: a real world approach’, McGraw-Hill Education Australia

KPMG (2005), A view from the top, KPMG, October.

Lawrence, M. (2005), ‘Business ethics as risk management’, Keeping Good Companies, August.

Lloyd, S. (2006), ‘Future shock, Eye on Australia’, Business Review Weekly, 4 May.

Longstaff, S. What is ethics?, Available from <www.ethics.org.au>. [cited June 2008]

Ross, S. Universal values: do they exist? Can one code fit all? Available from <www.ethics.org.au>. [cited June 2008]

Smith J, Armstrong A and Francis R, (2007), Professionalism and ethics in financial planning, Journal of Business Systems, Governance and Ethics, April

Walters, K. (2005), ‘Defining your values’, Business Review Weekly, 21 April.

DISCLAIMER



September 2008

Building trust in trying times

OverviewThe client-adviser relationship is highly reliant on the level of trust that the client places in their adviser. To add value to these relationships, advisers need to be able to offer more than superior financial products and services — they also need to develop and maintain a high level of client trust throughout the relationship. While this is simply common sense, the level of trust between adviser and client is easily eroded if the client perceives that communication, reliability and quality advice is lacking.

Did you know?

In a report conducted by State Street Global Advisers in the United States, a survey of advisers and clients found that advisers tend to overestimate a client’s level of overall satisfaction with them. The survey found that 56% of advisers responded that their clients were ‘very satisfied’ with the level of service, while only 24% of clients responded that they were, indeed, ‘very satisfied’.


> Explain the importance of trust in the client-adviser relationship. > Identify the factors affecting trust in client-adviser relationships.

> Describe how advisers can build and maintain trust, especially when markets are volatile.





The importance of trust Trust is at the heart of the relationship between a client and their adviser. Although it is a business relationship, the client relies on the adviser, and the adviser owes a duty of care to the client. Sue Viskovic from Elixir Consulting explains, ‘I think it’s really important to develop trust with a client in order to be a good financial adviser because people need to be able to trust you in order to be able to disclose all of their financial information’.

In Bridging the trust divide: the financial advisor-client relationship, a report conducted by State Street Global Advisers in the United States, 74% of advisers and 69% of clients surveyed rated trustworthiness as the most important factor in selecting an adviser.

Quicklink

To read the entire Bridging the trust divide report, visit http://knowledge.wharton.upenn.edu

> select ‘special sections’ from the top menu

> select the ‘Bridging the trust divide: the advisor-client relationship’ report.

Recent research by the Financial Planning Association (FPA) found that one in five Australians use the services of a financial adviser. The following elements were listed as the most important to a client when visiting an adviser:

> that the planner is knowledgeable about a range of issues

> that they can trust their planner

> that they can reach their planner when they need something

> that their planner puts their interests first.

In The Trusted Adviser, Maister provides a useful list of the benefits that an adviser would gain if their clients trusted them more — the more a client trusts an adviser the more they will:

> seek out an adviser’s advice

> be inclined to accept and act on their adviser’s recommendations

> respect their adviser

> share more information that helps an adviser to help them

> refer their adviser to their friends and business acquaintances

> lower the level of stress in client/adviser interactions

> give their adviser the benefit of the doubt

> involve the adviser earlier rather than later in the process

> trust their adviser’s instincts and judgements. Source: Maister, 2000

September 2008 Page 2 of 8


Consider…

The state of a client’s personal finances and the real state of their health, (sometimes driving a requirement to confront health issues through tests etc, that are otherwise being avoided), are especially sensitive areas for most people. Given that information related to income and health are the two key pieces of information financial, investment and insurance advisers need from clients to do their job well, it is no surprise that building trust is particularly important in the business of financial planning.

Building trust-based relationships It takes time to build trust in any relationship and first impressions are crucial. The initial meeting with a client should be based on listening and trying to understand, rather than ‘winning’ the client. This includes understanding their motivations, concerns and aspirations, as well as their financial affairs. ‘I see great success with advisers who structure their process so that their first meeting is actually designed to be the client speaking for 80% of the meeting. Some people say “How can that be? How can I tell them about my experience and how am I going to tell them about our portfolio management?”. I don’t think any of that needs to come into the first meeting — it really should be a chance for you to be asking lots of questions of the client and getting them to open up and tell you all about their financial affairs’, Viskovic said.

Aside from maintaining eye contact and appropriate body language, Viskovic offers the following strategies to help advisers build trust with clients:

> Avoid talking about mutual items of interest in an effort to show a new client you’re like them, and don’t interject with stories of your own experiences. If you have areas of mutual interest, allow these to surface later on in your relationship.

> Don’t paraphrase — if the client has stated they want to send their children to a particular school, don’t convert this to ‘You want to send your children to a private school’. Better yet, if they already know which school they want, use the name of it.

> Be there for the whole meeting — don’t zone out and think of something other than what the client is saying.

> Never finish a client’s sentences. Regardless of how long they take to make their point, be respectful and wait for them to use their own words.

Asking the right questions with new clients is a vital skill to understanding and building trust. Open-ended and straightforward questions should be asked to allow the conversation to flow in the direction that suits the client. Encourage clients to talk more and to help the adviser understand their position.



Beyond first impressions The second meeting with a new client is where a strategy discussion, which may also cover administration issues, might begin. With new and ongoing clients it is important to ensure that the adviser is always upfront and transparent about the fee structure. In the initial meeting it is especially important that the client leaves with an understanding of the fee they will be charged, or at least the basis on which fees and charges are calculated.

An adviser also needs to take the time to develop a well thought out statement of advice (SOA), ensuring that the strategies have been discussed in depth with the client before presenting them with the final document. This will lay the foundation for an ongoing and trusting relationship. Clients are much more likely to accept the recommendations of the SOA if they feel that they played a part in producing it.

Servicing ongoing client relationships Once an adviser has signed a new client, it is imperative that they continue to communicate and deliver exceptional service to their client. By creating systems such as a client service model, advisers and dealer groups can ensure that they have the processes and staff in place to continue to deliver a quality service to their clients.

‘If you’re going to get a statement of advice out to somebody or any documentation within a period of time, make sure that your admin staff are able to do that. Also, if a client is coming in for a review meeting, make sure that you’ve got your portfolio snapshot or your reports. Make sure it’s ready and it’s there. If you’re saying that you are going to return calls to a client, make sure that you do it within a certain period of time,’ Viskovic said.

Jim Taggart from Taggart Nominees says clients can lose faith in their advisers when the service is poor and there is a clear lack of respect. ‘When people say I’ll ring you back this afternoon and they don’t ring back … I’ll get that information for you tomorrow and they never do it …so, over time, the relationship falls apart.’

For many advisers, the highest praise that can be achieved with a client is to be regarded as their ‘trusted adviser’. One of the keys to professional success is the ability to work with clients in such a way that maintains their confidence. Clients must feel that their adviser has integrity, and a high level of skills and knowledge. The quality of advice also needs to always be high and the client needs to feel that the adviser is genuine, ‘I have a great passion for what I do … there is a genuineness in caring about people. So when I’m talking to advisers or to others, I feel I have the ability to be able see whether they’re genuine or not and I think most people can see that. So if that’s not the basis of talking with people, then I don’t think you’re going to go to the next stage — the higher level of trust’, Taggart said.

Continuing to service and maintain a high level of trust with a client can also provide a competitive advantage. A client is likely to stay with an adviser if they have a high level of trust, irrespective of fees, location or other factors. ‘The client has opened up all of their affairs to you, so you can provide better advice … so rather than perhaps only having a small portion of their total affairs, you look after everything’, Viskovic said.



Maintaining trust when times get tough An important factor in maintaining trust is that clients need to feel that an adviser genuinely cares about their needs, wants and concerns. This is especially important when financial markets retract. In recent times, the significant financial losses that have resulted from a number of major corporate failures have led to questions about whether or not investors can rely on advisers to provide high quality and accurate advice. Of course, financial markets will not always be positive, but if clients are well informed and feel that their adviser understands their risk tolerance and is doing all they can to protect their investments, they will have a greater level of trust, despite the market’s fluctuations.

It is also important for advisers to have conversations with new clients about what the financial markets can and can’t do. While advisers cannot guarantee a return, they can structure and diversify a client’s portfolio to reduce risk. If it gets to a point where the client feels that their portfolio is not performing in the way that they believe it should, then that could be an opportunity for an adviser to communicate and remind them of their initial discussions and objectives.

‘It’s about making sure, in the initial interviews and the implementation phase, that clients are reasonably clear about the rise and falls of market conditions. Since 2000 to 2005/06 most of the funds have gone up at a much greater rate in terms of dollars in their superannuation fund; it’s only been the last 15-18 months that it’s fallen and it’s fallen nowhere near the rise that’s taken place over that time, but the media and other commentators want to dwell on that aspect. In fact, clients who have been in particular growth assets have done much better, even with this short-term market volatility, so it’s about educating them at every point in time’, Taggart said.

Regular contact is an important step in gaining a client’s trust. Making contact about 10 to 12 times a year is recommended. This can vary in form, with an emphasis on more personal contact for higher-value clients and those clients who may have just experienced a negative return. ‘Pick up the phone, and have a chat with them. You might dread that phone call … but it doesn’t matter what the client says at first — it’s how they feel when you get off the telephone. You are allowing them to vent, allowing them to tell you about their fears and respect their fears because it is a scary time, especially if you listen to the news — but then allay their fears’, Viskovic said.

Managing the relationship during periods of volatility is particularly important for clients who are about to retire. In this case, it is important to remind clients that the day they retire is not the day that they withdraw all their money out of their investments; rather, it is the day that their employment income stops. While they’ll be drawing down a portion of their investments to provide an income from this time, the majority of their wealth will still be invested during their retirement, and with people living longer this could potentially be 20 to 30 years. Advisers need to make sure they are educated about the relevant issues and keep their skills up-to-date so that they can maintain the confidence of older clients.

Remuneration and conflicts of interest One of the factors that can undermine trust in adviser-client relationships is the remuneration structure under which advisers operate. All advisers are aware of the debate and the argument against commission-based remuneration, i.e. that the advice they provide can never be truly independent. While opinions on this point differ, a shift is taking place toward fee-based remuneration and, with it, an improvement in the quality of advice.



For example …

For every client who invested in Westpoint, advisers received 10% commission. In 2006, the Westpoint Group collapsed, leaving around 4000 investors out of pocket — some had lost their life savings. Some of the advisers involved have been banned by ASIC, with legal proceedings still underway. The chief criticism was this: investors trusted the advisers with their money; and instead of acting with integrity, advisers were seduced by the possibility of their own personal gain.

Regardless of the type of structure used by advisers, it is vital that the adviser promotes transparency concerning the costs involved and that the client feels they are getting value from the relationship.

Quicklink

For guidance on managing conflicts of interest, visit www.asic.gov.au.

> select ‘Publications’ from the main menu:

> select ‘regulatory documents’

> select ‘regulatory guides’

> select RG 181: Licensing: managing conflicts of interest.

Rebuilding trust Once eroded, trust isn’t easily rebuilt. A key ingredient of rebuilding trust is to be reliable. Inevitably, things can happen that might cause a client to lose faith in their adviser. The best thing an adviser can do is to:

> be honest with the client — if it was a mistake or oversight on the adviser’s part, trying to hide it from the client will only make the trust relationship worse

> take immediate steps to correct the mistakes, letting clients know that their adviser cares about what has happened

> tell the client about any further actions or decisions to ensure that the situation will not happen again. (Stenner, 2005)

For an adviser to demonstrate that their behaviour is consistent, and that they can be relied upon, goes a long way to re-establishing trustworthiness in the eyes of clients, should that trust have been eroded. ‘With trust you have two elements: trust can come about in good times, but is also when things are tough, but you can stand beside someone in those hard times’, Taggart said. Similarly, it is vital for advisers to be clear on the value proposition they offer and to be able to clearly communicate and demonstrate the reasons that the services on offer are worth the fee.


http://www.asic.gov.au/asic/asic.nsf


Consider…

The following ‘trust equation’, based on one by Collie & Associates Management and Marketing Consultants, shows the factors that make up trust:

Trust = (Credibility + Reliability + Intimacy)

Self Interest

The bigger the ‘figure’ that is the outcome of this equation, the better; i.e., the higher the level of self-interest, the lower the trust, according to the theory of this trust equation.

Quality advice One of the most important and influential aspects of building and maintaining trust with clients is to provide quality advice over the entire course of the relationship. When providing advice, successful advisers:

> are very careful about the way in which they communicate

> ensure that they don’t come across to the client as patronising or superior

> avoid jargon and use language that their clients will understand

> give their clients reasons for decisions made, not just instructions.

Another important issue to consider is when a client doesn’t listen to the advice or doesn’t implement the recommended advice. This is where an adviser needs to ensure that they have a good review process in place — meeting with the client on a regular basis to revisit their financial goals.

When building trust with a client, it’s not advisable for an adviser to simply tell their clients what they want to hear. It might also be necessary to discuss their lifestyle decisions and this can be a difficult conversation to have. For example, a client might say they want to live on $80,000 per year in retirement, but it might be necessary to be honest and direct with the client about how realistic, or unrealistic, their expectations are, and what will need to be done to achieve them.

Wrap up Clients place great trust in their advisers to guide them in the achievement of their financial goals. They rely on the knowledge and ability of advisers to manage their life savings and, if that trust is broken, the outcome can be very detrimental to both the client and the adviser.

With the recent volatility in the market, many advisers may find that their clients are beginning to lose confidence in them. However, with honesty and genuineness, as well as good communication, an adviser can have a much more meaningful and profitable relationship with their clients.



References Financial Planning Association (2007), Consumer attitudes to financial planning, May. Available from www.fpa.asn.au [cited 22 August 2008].

Maister, D, Green C and Galford, R (2000), The Trusted Advisor, New York, The Free

Press.

State Street Global Advisers (2008), Bridging the trust divide: the financial advisor-client relationship, University of Pennsylvania. Available from http://knowledge.wharton. upenn.edu [cited 13 August 2008].

Stenner, T (2005), ‘Just trust me’, Advisor practice. Available from www.advisor.ca [cited 2 August 2008].

Viskovic, S (2008), ‘Cultivating client trust’ Money Management Technical Adviser, 19 June.


> Jim Taggart, CEO, Taggart Nominees

> Sue Viskovic, Managing Director, Elixir Consulting

DISCLAIMER



http://www.fpa.asn.au/

http://knowledge.wharton/

http://www.advisor.ca/

April 2009

Skills to cope in turbulent times

Overview The year 2008 was an ‘annus horribilis’ for investment markets, with 2009 looking to be the same. Many financial advisers are facing a difficult time with their clients and their businesses.

For experienced advisers, the downturn may be similar to, though more severe than, those they have faced in the past. For them, this article provides reminders of useful strategies for communicating with clients, managing themselves and their staff, and positioning their businesses.

For newer advisers, the downturn might be the first they have confronted. This article identifies strategies and initiatives that will help them to build a more sustainable client base and operation.

Did you know?

‘Clients will continually need to be reassured about the future and kept informed of what is happening; sometimes twice a week’, said Conscious Money principal, Wayne Lear, at Kaplan’s Financial Adviser Roadshow in February 2009.


> Explain when an adviser might rework a client’s financial plan. > List the ways in which an adviser and their staff can be more effective during

difficult economic times. > Detail how a financial advising business model could be made more sustainable.





April 2009 Page 2 of 12

Developing and reviewing a financial plan Working with a client to develop a financial plan requires a certain amount of looking into the future. There is no certainty about what the future will hold, so assumptions must be made. These assumptions might be about:

> the client’s situation (e.g. health, income, dependants) and goals (e.g. retirement date, income needs)

> the economic environment, including interest rates, inflation and exchange rates

> legislation, including tax, superannuation and social security

> investment returns.

An adviser will need to understand the client’s attitude to investment risk as well as the uncertainty of future returns.

Once a plan is put into place, it is imperative that the client attends periodic reviews so as to provide the opportunity to assess its progress and make changes where relevant.

Consider …

Who would have thought when compulsory superannuation was introduced in 1992 that now:

> super after age 60 is generally tax-free

> reasonable benefit limits (RBLs) have been abolished

> assets test-exempt income streams can no longer be commenced

> official interest rates would rise to 7.0% in February 2008 and fall to 3.25% a year later

> the exchange rate of the Australian dollar in terms of US currency would be 97.86c in July 2008 and then fall to 68.84c as at 20 March 2009.

A good adviser will use a client review to evaluate the financial plan and identify any areas where it is failing to meet the client’s goals. A plan might be revised to:

> meet the client’s new situation or new goals

> take advantage of new opportunities presented through legislative change or economic circumstances

> avoid threats caused by adverse economic circumstances or legislative change

> cater for a change in the client’s attitude to investment risk.

The end of the long bull run in investment markets is an extreme example of a situation where the assumptions made in a financial plan might not come to fruition (at least in the short term).



Educating clients While the adviser may recommend a course of action involving various strategies and products, the client must make an informed decision to accept the recommendations and ‘own’ their financial plan.

At the start of the relationship with the client, the adviser will generally know more about the legislation, products and possible strategies. The client will know more about their own situation — their fears, goals and attitudes.

Over time, the adviser will start to understand the client and will expect the client to have a better understanding of financial issues, strategies and products.

A client may say they understand that share markets rise and fall in value. However, it is something different to see the value of their own investments rise and fall. This is real ‘in your face’ education. One of the adviser’s roles is to ensure that the client is coached through these ‘lessons’ and has a better understanding of financial returns from a long-term perspective.

What to do when things don’t work out as planned The assumptions underpinning financial plans may have been wrong since the first financial plan was written — this is the nature of planning for an unknown future. Understandably, clients might be angry or disappointed when their plan does not work out as they had expected.

For example …

In January 2006, at age 65, Charles retired with $2 million in superannuation. He had an RBL problem and his adviser advised him to use a non-commutable complying pension to maximise the tax effectiveness of his retirement income.

On Budget night in May 2006, [then] Treasurer Peter Costello announced that RBLs would be abolished and superannuation would be tax-free after age 60.

How do you think Charles may have felt?

Interpersonal skills are vitally important when dealing with a client who is angry or disappointed. The adviser needs to listen and focus on the client’s needs first rather than have graphs, explanations, handouts and reasons to explain what has happened.

A client is not alone in being angry or disappointed. The adviser may feel the same way because they recommended the strategies and products to the client in the first place.

Acknowledge The first step is to acknowledge the anger or disappointment that the client feels. It is important to be open and accept what has happened. Often, the event that has caused the client’s concern cannot be ‘undone’.



Listen Let the client get the concerns off their chest. The adviser should explore the client’s feelings by asking open questions to bring out underlying issues. For example:

> What news has caused you the biggest concern?

> When did you start to be worried?

> What were your expectations?

> What are your fears?

The adviser should avoid the temptation to provide answers or reasons at this stage. They just need to listen.

Demonstrate empathy The adviser needs to demonstrate that they understand what the client is saying by:

> nodding their head

> smiling in agreement (where appropriate)

> using short phrases (such as ‘I see’, f course’) to acknowledge the client’s statements

> sharing their experiences with the client, though keeping the reflections short to maintain the focus on the client.

An adviser cannot ‘fake’ caring. Their aim must be to put themself in the client’s shoes to understand how the client feels.

Put things in perspective Current media headlines are almost universally negative, so it is not surprising that reading these will probably add to the client’s feelings. An adviser can demonstrate that the news may not be as bleak as the client thinks. For example:

> In November 2008 the headlines said ‘Australia sheds 15,600 jobs’. This was based on the Australian Bureau of Statistics Labour Force report. Behind the headline is the fact that 24,400 part-time jobs were lost, but 8,800 new full-time jobs were created. (Australian Bureau of Statistics, 2008) Full-time work and the prospect of steady income lead to increased consumption.

> Unemployment was at 5.2% in February 2009 (Australian Bureau of Statistics, 2009), whereas just a year ago the jobless rate stood at 3.9%, its lowest in more than 30 years. However, economists have traditionally considered that 5% unemployment is a realistic long-term full employment figure.

> Australia is better off than the rest of the world in that our banks are strongly regulated and at low risk of failing. While the Australian economy may dip into negative growth, there is no expectation that it will retract as significantly as those of the United States, United Kingdom and Europe.

An adviser should look for positive stories to tell their clients and so help restore their confidence.

Reassure While an adviser cannot predict the future, for example, when the market will bottom out, an adviser can draw on comparisons to the past and show the client that these types of events have happened before. In the long-term scheme of things, the share



market crashes of the past fade into insignificance compared to the long-term growth following such an event.

In uncertain times, most people (clients, staff and other advisers) look for signs that the future may be more predictable and certain. While no one knows the future, retaining a positive outlook and encouraging people to manage what they can control is a valuable role.

Economies and markets are cyclical and we can expect them to self-correct over time with the help of government and renewed confidence.

General tips for the adviser > Be confident — body language and attitude will reflect it.

> Look for positives — explain how the media negatives may not reflect the entire picture.

> Recognise that not all problems can be easily fixed.

> Remember the value of silence when listening to clients.

> Summarise the outcomes and stress the positives at the end of a client meeting.

Focusing on communication Communication is always important, but even more so when the client is likely to be concerned or worried. Education and knowledge help dispel fears. A well-informed client is better able to evaluate other information they hear and read and thus separate the half-truths from facts.

There is no magic formula for client communications and the adviser’s choice will depend on the client’s needs and resources and the adviser’s business style. The following are guidelines to help an adviser check the effectiveness of their communication.

Targeting Whatever medium is chosen to communicate with clients, an adviser needs to pay close attention to the message they want to deliver. In an ideal world, an adviser would write or speak individually to each client and address their personal needs.

Word processing, email and other technology allows for the communication of the same message to many people, saving time and effort.

The adviser might consider the following before developing the communication:

> Do all the clients need the same message?

> Can clients be segmented to tailor the message?

For example …

If a client has invested in cash and term deposits, would an adviser send them the same letter as those clients who invested 100% in shares?



Style Communications should always be open and honest — this is absolutely critical in difficult times. It is better for an adviser to acknowledge that they have no answer than to pretend they have an answer.

Medium There are practical limits to the way an adviser can communicate:

> personally — one-to-one or over the phone

> in a group, where the adviser does the presentation or engages an ‘expert’ with more knowledge than the adviser has

> written, one-to-one communications or the same communication to a group of clients

> by letter or email.

An adviser should choose which medium (or more likely what combination of media) will best suit both their client and the adviser’s resources.

Frequency The frequency of communication needs to match the needs of the client. In difficult times, the number of communications may need to be increased to keep the client informed of what is happening.

For example …

Many advisers have a communications program that sets out a plan for the year. This may be:

> an annual or six-monthly seminar for all clients on topics of interest

> a quarterly newsletter

> an irregular e-newsletter to clients focused on issues relevant to them. For example, changes in deeming rates for pension clients and changes in official interest rates for clients with mortgages.

> a scheduled annual review in a face-to-face meeting with the client.

On top of this planned program, an adviser can build special communications in for times of need.

Before deciding on frequency, the adviser needs to consider:

> Does communicating too often create a short-term focus and encourage panic?

> Does communicating too infrequently imply that the adviser does not care or has something to hide?



Content Financial advisers are immersed in the daily news of investment markets, legislative changes and product innovations. It is easy to assume clients are aware of the same news, though perhaps in less detail.

One way for an adviser to find out what clients need is to ask them. Rather than rushing out a newsletter with an update of the financial markets, the adviser could call a few clients to ask them how they feel and what they need. Apart from showing that the adviser cares, it provides a basis to write to all clients in a similar situation.

An adviser might focus on issues clients can do something about, such as debt management, cash flow, access to liquid assets and spending patterns.

When looking for content, an adviser ought to look for positive news, particularly from their local area and make sure their clients know about it. When attending a fund manager seminar, an adviser could ask the speaker for some positive news to tell clients.

For example …

The mortgage fund recommended to a client has frozen redemptions. The media headlines say ‘Fund frozen, investors panic’.

The positive view of this situation is that the fund has continued to pay good distributions based on mortgage interest rates much higher than current term deposits.

The redemption freeze is a temporary action because the government guarantee of bank deposits has encouraged conservative investors to transfer money to low yielding bank accounts.

Responsiveness The best communication comes in two ways:

> promptly to a client when they have asked a question or expressed a concern

> pre-emptively to a client when they are concerned, but have not yet asked a question.

Lack of responsiveness is a sure way to breed disquiet and increase worry in the client’s mind. It is worth contacting the client (or arranging someone else to call) even if there is no answer. For an adviser to honestly say, ‘I have no answer but I am working on it’, is far better than no response at all.

Making positives out of negatives In this economic environment, it is easy to get into a negative state of mind. However, remaining positive is a trait of all successful business people — advisers included.



Gaining new clients At face value, it may not seem a likely time to be winning new clients. On the other hand, it may be a time to attract people who are dissatisfied with their current adviser.

Good communications and responsive service are things an adviser can control. An advertisement saying ‘Have you heard from your adviser lately?’ might be a good way to attract new clients.

Building long-term relationships There are many advisers and many different business models. In difficult times, one of the most effective approaches is a full service model where an adviser advises on and reviews all of a client’s needs. The adviser creates a network of associates — accountants, tax advisers, lawyers, insurance brokers and so on. This way all of the client’s needs are looked after.

One of the benefits of such a model is that the client is more likely to rely on the adviser for advice on a full range of topics. For example, the adviser may be advising on insurance and estate planning issues successfully even if investment markets are causing worry for the client.

Creating good memories for clients It is a fact of life that clients will remember what happened in the ‘bad’ times for far longer than they remember what happened in the ‘good’ times. They will also tell their friends about the service in the difficult periods.

Looking after yourself and the team Giving good service and dealing with difficult times is not just about the client. It is also about the adviser and their team.

Staying fit and positive An adviser may be tempted to throw themselves into dealing with problems, but the danger is burning out and subsequently not doing a good job with clients.

To stay effective, an adviser ought to:

> maintain a healthy lifestyle

> take time to exercise and rest

> spend time with family and friends

> look for the positives in everything and share them with others; spread a positive message and others will respect that attitude

> take time to talk to other advisers and team members, including asking for feedback

> remember that people look to their leaders for signals of how things are going and what the future holds.

Planning client interactions Advisers should take time to prepare for interactions with clients, whether it is on the phone, one-to-one or in a group. The adviser might:



> get themselves into a positive frame of mind by visualising good outcomes and satisfied clients

> put aside negative preconceptions. Imagine the client as if ‘nothing is wrong’. Unconscious behaviour will follow the way of visualisation and the client will respond in a positive way

> agree on an agenda with the client before starting discussions — let the client’s needs drive the meeting

> at the end of the meeting, review decisions made and ask, ‘What was the best thing to come out of this meeting?’ Any commitments made should be reaffirmed and promised actions followed up.

Supporting the team The other people in the adviser’s business will bear some of the stresses and strains that the adviser feels. Team members need support too, including:

> encouraging them to look after themselves physically and ensuring they take time off to exercise and rest to prevent burnout

> educating the team in the same way that clients are educated. If they understand what is happening, they will communicate more effectively between themselves and to clients

> taking care with the language used in the work environment to ensure it remains positive and focused

> encouraging the team to support each other

> looking for opportunities to praise and acknowledge the team.

Evaluate the financial planning business model Difficult times can be a good time to reflect on the way the adviser currently does business. Following the dot.com crash and the events of 11 September 2001, Warren Buffett wrote: ‘You only find out who is swimming naked when the tide goes out’. (Berkshire Hathaway, 2001) By this he meant that it was easy to run a business in good times. In difficult times, the strong, sustainable businesses survive and weak businesses fail.

Rather than just thinking about it, an adviser needs to write down what they currently do for their clients. It is often hard to work out a sustainable and deliverable business model working alone. Help from business coaches or talking to other advisers can be of assistance. An adviser could also ask what their clients want.

Managing a client’s attitude to investment risk The first step in managing a client’s attitude to investment risk is to ensure that the client’s risk tolerance is appropriately assessed. Risk tolerance assessment is an important part of meeting legislative and common law obligations. Advisers must have a reasonable basis for advice under the Corporations Act 2001, and ASIC Regulatory Guide 175 (RG 175) expressly specifies that where advice is related to financial products with an investment component, financial advisers should determine their client’s tolerance to risk in regard to their potential capital loss and also their general tolerance to the fact that the investment strategy might not produce the expected returns.



However, assessing risk tolerance is not the same as risk profiling. Risk profiling, which often places clients on a spectrum typically from ‘conservative’ to ‘aggressive’, is an inexact science. In its Policy Position on Risk Tolerance, the Financial Planning Association (FPA) concluded that risk profiling is not a proven technique and that client attitudes are likely to be strongly influenced by short-term market performance and the current political and economic environment. (Financial Planning Association of Australia, 2005)

This is one reason that advisers sometimes mistakenly equate risk tolerance with risk behaviour and misinterpret changed risk behaviour as changed risk tolerance. Numerous studies suggest that risk tolerance is stable, even through a bear market, but behaviour may change, particularly where the perceptions of risk have changed. Behaviour in risky situations is not a function of risk tolerance alone, and just because a client’s behaviour has changed doesn’t mean their risk tolerance has.

For example …

An adviser interviews a client, assesses them as being a conservative investor and recommends a predominantly fixed interest portfolio. The share market is in a bull run and the client complains ‘I’m missing out’.

The client decides to switch to share-based investments but when share prices fall, he complains ‘I’d do better in the bank’.

Of course, attitudes and behaviour can change even though the underlying risk tolerance might remain constant.

The broader principle of risk tolerance in RG 175 includes both the risk of capital loss and the risk that the expected benefits will not be achieved.

The FPA Policy Position on Risk Tolerance confirms that financial advisers have a legal responsibility to assess a client’s investment risk tolerance, and apply that assessment when formulating advice. This assessment is an integral component of explaining the risks of the recommended strategy and educating clients about investment risks. Further, the FPA Rules of Professional Conduct require members to consider a client’s tolerance to risk as an essential factor of formulating appropriate financial strategies and product recommendations. (Financial Planning Association of Australia, 2005)

Among other things, the ability of a client to tolerate investment risk depends on:

> their financial capacity to tolerate poor investment performance over various periods compared to a risk-free (cash) return

> their attitude to periods of poor performance.

A client’s actual circumstances and objectives may be in conflict with their expressed attitudes and preferences. A financial adviser’s role is not to ensure that clients avoid risk, but to educate and help clients embrace and manage reasonable investment risks in achieving desired financial goals over realistic time frames.

An adviser might ask:

> How well was the client’s attitude to risk assessed?



> Can it be done better?

> What are the weaknesses of what is currently done?

Assessment of a client’s tolerance to investment risk also needs to consider the client’s tolerance of volatility in relation to income and capital fluctuations over the short and longer terms.

Goals-based planning Rather than focusing on risk and returns, an alternative approach is to focus on a client’s goals. Some advisers spend a lot of time with a client to understand their life goals and then build plans to achieve them. For instance:

> What income does the client need today?

> What will the client need to support their lifestyle when they are retired?

> What is the client’s bigger purpose, and why?

When an adviser knows the answers to these questions, the strategies they recommend to a client will start to fall into place.

Business diversification Most advisers recommend that their clients diversify their investment portfolios, but might not follow their own advice when running their business. For example, a financial adviser who only provides investment advice will be finding things more difficult in the current environment than an adviser who also specialises in risk insurance.

The adviser might ask:

> How can the business be diversified?

> Would the business be robust and sustainable in all (or a wider range of) circumstances?

Communicating with clients about risk Many clients (and advisers) have been surprised by the volatility of investment markets. An adviser may say they understood that volatility was to be expected, but not as dramatically as we have seen recently.

Advisers have three obligations in respect of investment risk. They need to:

> ensure clients are aware of risk

> educate clients about the consequences of the different investment choices a client may make

> explain risk to clients in a way the client is likely to understand.


> How well does the Statement of Advice (SOA) explain risk?

> In the SOA, are the warnings about market volatility close to where investments are discussed or are they tucked away ‘in the small print’?



Income generation An adviser needs to be remunerated for the service they provide. Ideally, business income would remain steady and not fluctuate excessively through all market cycles.


> Is their charging system fair to clients?

> Is the charging system defendable when markets are falling?

> Is the charging system over reliant on new business or are there rewards for ongoing service?

Wrap up This article has looked at how an adviser might approach communications with clients, get the best from themselves and their team and evaluate and improve their business. While the article focuses on how these are effective in the current challenging financial environment, most of these ideas are valuable and appropriate at all times.

A period of adversity can actually provide the stimulus to hone skills, improve the client’s service experience and build a more sustainable business.

References Australian Bureau of Statistics (2008), Labour Force, Australia, Nov 2008, Catalogue Number 6202.0, ABS, Canberra. Available from www.abs.gov.au [cited 16 March 2009]

Australian Bureau of Statistics (2009), Labour Force, Australia, Jan 2009, Catalogue Number 6202.0, ABS, Canberra. Available from www.abs.gov.au [cited 16 March 2009]

Berkshire Hathaway Inc (2001), Annual Report 2001, Berkshire Hathaway Inc, Nebraska. Available from www.berkshirehathaway.com [cited 16 March 2009]

Financial Planning Association of Australia (2005), FPA Policy Position on Risk Tolerance. Available from www.fpa.asn.au/members [cited 22 March 2009]


> Peter Grace, Independent consultant

DISCLAIMER


August 2008

Debt dilemmas

OverviewIn Australia, debt levels have risen substantially over the past 15 years. Treasury reports that household debt reached around $5 trillion by June 2007, representing an average of $600,000 of debt per household. So how did Australians become so indebted? And is all debt bad? This article answers those questions and looks at strategies that advisers can use to manage a client’s debt, while also accelerating their wealth.

Did you know?

According to the 2008 AMP/NATSEM Income and Wealth report, between 1985 and 2004, the average Australian income doubled, while the average house price increased by 400%.


> Outline the current picture of Australian household debt.

> Identify the factors that have contributed to a rise in debt, and the impact of this on the economy.

> Identify strategies that a financial adviser could use to help clients manage their debt.





Debt dilemmas

A snapshot of debt Australia’s household debt has been growing rapidly over the past decade with the help of a low interest rate and low inflation environment. This has been caused mainly by increased borrowing for housing through financial deregulation, and innovations such as home equity loans and redraw facilities. Household debt has expanded so rapidly over this period that some commentators argue that Australians are now worse off than most other households in the developed world.

According to Demographia’s 2008 International Housing Affordability Survey, Australia has one of the least affordable housing markets among developed countries. MLC’s Brian Parker explains, ‘If you look at Australians’ behaviour over the past 15-20 years, you’ve seen debt to income and debt to GDP ratios pretty much rise consistently over that period. We’re now in a situation where household debt is about 160% of income; that’s probably the worst of the Western world … Most of that debt is mortgage debt so about 85% of our outstanding debt is home mortgages and the rest is credit cards’.

Quicklink

To read Demographia’s full 2008 International Housing Affordability Survey, visit www.demographia.com

> select ‘4th Annual Demographia International Housing Affordability Survey’.

Over the past decade, the gap between the growth of credit and that of gross domestic product (GDP) has been substantial in countries such as Ireland, Spain, the United Kingdom, the Netherlands, New Zealand and Australia. In these countries, credit has grown, on average, about 5% faster than nominal GDP per year. According to the Reserve Bank of Australia (RBA), if credit is growing faster than GDP, then the ratio of credit outstanding to GDP will rise further. (Battellino, 2007)

Unlike periods of credit expansion during the last century, today’s debt is largely being driven by households rather than businesses. This is in contrast to the 1990s, when Australia experienced its last major debt bubble and businessmen such as Alan Bond and Christopher Skase contributed to much of the borrowing in the corporate sector. During that time, the debt to GDP ratio peaked at close to 100% of GDP, with three quarters of that debt representing business debt. Businesses then reduced their debt dramatically from 1990 onwards, while household debt started to increase. Economics Professor Steve Keen, University of Western Sydney, says ‘there was an exponential rate of growth of debt from back in the mid-60s when the ratio of debt to national income GDP was about 25%. We are now well on the way to hitting 175%. So we have seven times the level of debt burden on the economy as we had back in the 1960s and most of that debt recently has been taken on by households’.

August 2008 Page 2 of 10

http://www.demographia.com/

Debt dilemmas

Lower interest rates over the past 10-15 years (compared with those in 1989/90), together with an increase in the number of dual-income families, have encouraged the average household to be more willing to take on higher levels of debt. However, during the last three to five years, it appears that many households have borrowed too much and are now finding it difficult to manage. Households are now paying more out of their income in interest repayments than they did in 1989, when interest rates were more than twice their current level. According to MLC’s Brian Parker, ‘People are quite happy to do this as long as their income is growing, as long as they’re secure in their jobs and as long as the assets they’ve invested in are doing well and prices are going up. Increasingly I think you’ve seen some pretty bad returns from share markets recently, you’ve seen parts of the property market under stress and I think you’re going to see an increasing percentage of the residential property market in Australia under stress over the next few years.’

Causes of debt In many ways the low interest rate environment after the September 11 terrorist attacks in the United States in 2001 contributed to the current debt crisis. The central banks around the world flooded the world with liquidity in a move to make sure there was enough money in the financial system to keep the economy going. As a result, a lot of this money filtered into property markets in the United States, the United Kingdom and Australia.

However, the Australian property market was already experiencing a boom with many investors taking advantage of lower inflation and interest rates and generally rising property prices. ‘It just encouraged more people to borrow more money to get into property and an increasing percentage of the mortgage debt outstanding is from investment property and you’ve seen the share of that mortgage debt accounted for by investment property pretty much consistently increased over the past decade’, Parker said.

Problems can arise when people buy over-valued assets; but people don’t really have debt problems until the labour market starts to weaken. So far Australia has experienced a very strong labour market. The unemployment rate has been close to multi-decade lows and so people who might otherwise find it difficult to repay their debts are currently managing well because the labour market has been so strong, and they feel more secure in their jobs. ‘That strong labour market has tended to hide a multitude of sins. The banks are reasonably well provisioned at this point. Default rates and problem loan rates are still very low, but if the economy were to slow substantially and if the unemployment rate were to rise significantly then frankly you would see almost inevitably higher default rates and higher rates of non-performing loans’, Parker said.

Deregulation and financial innovation over the past 15 years has also played a role in greatly increasing household access to credit. Many banks refocused their lending towards this sector and non-bank lenders also moved into the market.

According to the March 2008 AMP/NATSEM Income and Wealth Report, almost a quarter of households spent more than 30% of their disposable income on housing in 2005/06, compared with 19% in 1995/96. This means that the average person nowadays has less money to spend on necessary items of consumption such as food and oil.

The growing availability and use of credit cards has also seen the amount of debt increase. According to the RBA, the total value of credit card transactions, including advances, rose by 3% in April 2008, and Australians spend over $17 billion on their credit cards.


Debt dilemmas

Total credit and charge card balances outstanding increased by 1.4% to $43.64 billion and the balances accruing interest rose by 1.3% to $31.65 billion in April from $31.24 billion in March. Interestingly, credit card repayments fell by 0.8% to $17.53 billion in April from $17.67 billion in March.

Types of debt Not all debt is bad. Where debt is used efficiently, it can be beneficial for clients.

Efficient debt is used to acquire assets that have the potential to grow in value or generate assessable income. A tax deduction can generally be claimed on the interest.

For example…

Borrowing to invest in portfolio of shares, or an investment property is considered ‘efficient’ debt.

Inefficient debt is used to buy goods, services and assets that don’t generate income, will depreciate in value, or have no value once they are used. A tax deduction cannot be claimed on the interest incurred, so no extra income is available to help repay the debt. It is wise to reduce inefficient debt as quickly as possible.

For example…

Examples of inefficient debt are personal loans to buy a car, a principal residence, or a holiday.

Managing debt Sometimes when people get themselves into debt it can be difficult for them to find their way out. Once an adviser has completed a detailed cash flow analysis for their client and suggested appropriate ways to reduce expenses, there are a number of standard strategies that can be used use to help clients manage their debt.

Consider…

A practical strategy, before a client gets into debt, is for an adviser to ask the client to begin saving an amount equal to their potential loan repayments, or the difference between their rent and home loan repayments, including the extra transactions such as levies involved with home ownership. This should give clients a good idea of what is realistic in terms of repayments and how much debt they feel comfortable with.


Debt dilemmas

Making efficient use of cash Clients should be encouraged to use extra funds to reduce their inefficient debt, if appropriate. Many people receive surplus income such as bonuses, inheritances or gifts; although it can be tempting to spend these windfalls, using the extra cash (or even half of it) to pay off a loan will help a client to reduce their debt sooner. For example, according to AMP, if an extra $25 is paid into a mortgage every month, then it is better than paying $300 once a year. (AMP, 2008)

Alternatively, the windfall could be paid into an existing home loan, creating extra equity that can then be drawn upon when using a gearing strategy (see below for more details about gearing).

Additionally, keeping cash in a home loan, either through a redraw facility or a 100% offset account, can reduce the principal owing and the interest payable on the loan. The funds can be usually withdrawn within 24 hours if necessary.

Another way of reducing inefficient debt is for a client to use their credit card to pay the majority of their living expenses, and then the client uses their income to pay off their daily loan balance. However, this will only be beneficial if the credit card is repaid within the interest-free period.

Consolidation By consolidating debt into a loan that has lower interest rates, debt is reduced sooner and interest costs are minimised. Having all debt ‘in one place’ can also make it easier to monitor a client’s finances. A common approach is to ‘bundle’ debts, such as car loans or credit cards, into a home loan. Home loans usually have lower interest rates than personal loans and credit cards, although it is necessary to have equity built up in a home to combine other debts into a mortgage.

However, additional fees could apply when consolidating or refinancing a client’s home loan, although the existing loan provider may negotiate to waive any such fees to keep the loan business. Another thing to bear in mind when using this strategy is that debt consolidation often results in short-term debt converting into long-term debt, which has the potential to cost more over that time frame. For example, while personal loans carry higher interest rates, they are generally paid off within a few years, whereas home loans commonly have terms of between 25 and 30 years. It is important to be disciplined when using this strategy to ensure that the total debt is reduced sooner and real savings are made.


Debt dilemmas

Case Study: Consolidating Steve (aged 37) and Karen (aged 35) are married with a young family. Their home is currently worth $450,000 and their debts are summarised in the figure below.

Figure 1: Case study debts

Debts Outstanding balance

Interest rate Current repayments (monthly)

Home loan (20-year term)

$200,000 7.5% $1,611

Personal loan (5-year term)

$25,000 12% $556

Credit cards $5,000 17% $66

Total $230,00 $2,233

To minimise their total interest bill and improve the manageability of their finances, they approach their lender about consolidating their debts. They want to increase the size of their home loan from $200,000 to $230,000 and use the additional funds to eliminate their personal loan and credit card debts.

Assuming the lender approves the application, the entire loan balance of $230,000 will be subject to a 7.5% p.a. interest rate. This will result in a new minimum monthly payment of $1,853 and a cash flow saving of $380 in the first month alone.

The key to this strategy is to use the cash flow saving to pay off extra capital each month. For this reason, Steve and Karen decide to maintain the existing $2,233 monthly repayments on their consolidated loan – not just for the five years the personal loan would have lasted, but for the entire term of the consolidated loan. This will enable them to pay off the consolidated loan earlier and save $13,170 in interest.

Figure 2: Case study results

Separate loans* Consolidated loans*

Outstanding loan(s) $230,000 $230,000

Monthly repayments $2,233 $2,233

Remaining term 14.3 years 13.8 years

Total interest repayments $153,064 $139,894

Interest saving $13,170

* It is assumed in both options that repayments of $2,233 per month are made for the life of the home loan. With the separate loans, once the personal loan is repaid these payments are re-directed to the home loan.

Source: MLC 2008.


Debt dilemmas

Gearing Once inefficient debt is under control, an adviser might recommend a gearing strategy. To gear, it is possible to borrow against equity in a client’s home (which offers a lower interest rate); take out a margin loan with a lending institution or invest in an internally geared fund. However, when using a margin loan, if the assets don’t produce enough income or capital growth over the long term, this could outweigh any tax reduction, and multiply losses considerably. Such a strategy should be undertaken for the potential to create wealth rather than for the sole purpose of achieving a tax deduction.

Through a strategy known as instalment gearing, it is possible to set up an investment loan which can be drawn upon periodically to generate an investment portfolio. Establishing a margin loan is usually the most efficient way to implement this. There is always a risk with margin loans that if the value of the managed funds falls, the investor may be required to meet a margin call. Another way to use instalment gearing is to draw money from a line of credit secured by the client’s home. A couple could split geared and ungeared investments. Generally, ungeared investments should be placed in the lower income earner’s name to minimise tax on the investment income, while the geared investments should be held by the higher income earner so they can take greater advantage of the gearing related tax deductions.

Putting a client in an internally geared fund means that they will not receive the tax benefits of negative gearing, but if the fund does not perform as expected, the client is not required to repay the shortfall.

Recycling debt Debt recycling is effective in reducing inefficient debt, such as a home loan on a principal place of residence, while using efficient debt to create wealth. It can be used when equity has been built up in the home, i.e. the value of the home is greater than any home loan attached to it. Debt recycling has three steps:

1. The equity in the client’s home is used to borrow for investment. To make the strategy work from a tax perspective, this amount must be segregated from any other home loan amount, as a tax deduction will generally be available for the interest attached to these borrowings.

2. The investment income and tax savings arising from the geared investment, as well as any surplus cash flow, is then used to reduce any outstanding home loan balance for which a tax deduction is not available (i.e. inefficient debt).

3. At the end of each year, any further amount of equity in the home is then borrowed which is equivalent to what was paid off the home loan during the year.

The additional borrowings are used to purchase additional investments. The process is continued until the home loan is repaid, allowing the client then to buy additional investments with your surplus income.

In this current period of interest rate uncertainty it appears that fixed rate loans can provide protection in a rising interest rate environment; but there is the risk that if interest rates fall, the client will end up paying more. Some people prefer fixed rate loans because the size of their loan repayments is predictable; however, some fixed rate packages don’t offer unlimited redraw facilities, or offset accounts, which allow borrowers to use their savings to reduce the size of their loan. The most appropriate type of loan will depend on what is needed by the client.


Debt dilemmas


How can an adviser help a client who has a high level of personal debt? > The very first step is to do a detailed cash flow analysis identifying the amount of

debt the client has and how much their capital and interest payments are each month.

> This analysis will also illustrate whether the client is spending more than they are earning. Where this is the case the client is either eating into existing capital or taking on more debt to fund the difference.

> The debt should also be categorised as deductible and non-deductible as the non-deductible debt is the least efficient and should usually be eliminated first.

> Where a client is spending more than they are earning, it may only be a short-term situation due to unforseen circumstances. The adviser needs to determine whether this is actually the case before proceeding with constructing a financial plan for the client.

> One of the main priorities for clients in this situation will be to gain control of their financial situation which usually means to reduce, if not eliminate the debt. At the very least it needs to be controlled and an analysis of the client’s spending habits may be required.

> At this point it is important for the client to acknowledge and understand their situation. Without this acknowledgement, understanding and acceptance, the best laid out budget and financial plan may be useless as the client may not recognise the need for it. A frank and open discussion about the client’s situation and their expenditure may need to take place.

> When this acknowledgment is achieved, the next step is to start the client on a budget. This is crucial to the process. If the client is unable to stick to a budget and control their spending it may, again, be futile to commence a savings or wealth creation program if they are unable to commit to it for the long term. It may cost them more in the long term due to fees, dishonoured payments, etc.

> Provide the client with clear illustrations demonstrating what can be achieved by reducing their expenditure in non-essential areas and instead, directing these funds into debt repayments. This is best done by providing the client with a series of cash flow analyses (and projections) which indicate to the client how their financial situation will be impacted by the changes in saving and spending patterns proposed.

> Even saving as little as $20 a week and paying this to a home loan monthly with an interest rate of 9.5% can reduce the loan by approximately:

» $17,000 over 10 years

» $34,000 over 15 years

» $62,000 over 20 years.

> An extra payment of $50 a week would save approximately:

» $43,000 over 10 years

» $86,000 over 15 years

» $155,000 over 20 years.

> This is a simple example of the power of compounding interest or, in this case, reducing one’s exposure to it.


Debt dilemmas

> At the end of the day it will be those who lived within their means throughout their working life who will be able to lead a comfortable retirement, not having spent their hard earned cash on any unnecessary interest payments.

> It is also important to ensure that the client’s cash is being utilised efficiently and not lying idle in low or non-interesting bearing accounts. Make use of higher yielding cash management accounts and cash management trusts to optimise returns.

> A client should understand their own spending and transaction habits to enable them to select appropriate accounts and minimise fees.

> Where the client has both deductible and non-deductible debt, it is worth investigating the benefits of converting the loan on the deductible debt/s to interest only payments and directing the extra cash into paying off the non-deductible loans.

> It may be hard work for both the adviser and the client in the beginning but very satisfying for both when the client is ultimately able to gain control of their financial affairs.

Wrap up In the aftermath of the subprime crisis, the lending behaviours of many financial institutions have been criticised as being too aggressive. However, it is widely agreed that investors need to take responsibility for their own finances. Given the current debt levels, it seems that many people are willing to make huge sacrifices in other aspects of their lives to own a home. Brian Parker argues that too many people are treating their house as an asset rather than a consumable good, ‘A house is not so much an asset, because you use the services it provides, and so I think people have been too willing to treat their house as an asset that they can draw down on, and the analogy is that we don’t actually live in a house, we live in an ATM without the buttons.’

In June, Senator Nick Sherry, as Minister for Superannuation and Corporate Law, released a Green Paper, Financial Services and Credit Reform: Improving, Simplifying and Standardising Financial Services and Credit Regulation. Steve Keen put forward the submission that the greatest hole in financial regulation is that non-bank lenders are not regulated. ‘The Green Paper considers regulating all lenders rather than just deposit-takers, and this would be a sensible change. It could be a first step away from the fetish for deregulation, a fetish that has resulted in the subprime crisis.’

As at July 2008, following the Council of Australian Government’s (COAG) meeting, it has been announced that the Federal Government will be taking over all forms of consumer credit regulation from the States, providing a national regulatory framework. Senator Sherry said: ‘National consumer credit regulation will close loopholes that have existed in various State and Territory jurisdictions and have allowed unscrupulous credit providers at the fringe end of the market to take advantage of people in desperate circumstances.’ (Sherry, 2008)


Debt dilemmas

References AMP (2008), NATSEM Income and Wealth Report: Wherever I lay my debt, that’s my home. Issue 19, March 2008. Available from www.amp.com.au [cited 25 June 2008].

Battellino, R. (2007), Some Observations on Financial Trends, RBA Deputy Governor’s address to Finsia, Melbourne Centre for Financial Studies, 12th Banking and Finance Conference, Melbourne, 25 September. Available from www.rba.gov.au [cited 25 June 2008]. MLC (2008), Debt Smart: Strategies for debt management 2007/08, MLC Nominees Pty Limited, Sydney.

Pavletich Properties Limited (2008), 4th Annual Demographia International Housing Affordability Survey, Chicago:Demographia. Available from www.demographia.com [cited 8 July 2008]

Sherry, N. (2008), COAG Agree to Transfer Responsibility for All Consumer Credit to the Commonwealth, Press Release, Canberra, 3 July.


> Steve Keen, Economics Professor, University of Western Sydney

> Brian Parker, Investment Strategies, MLC

DISCLAIMER



http://www.demographia.com/

August 2008

Impact of inflation on investment markets

Overview

It is widely agreed that inflation is rising, both domestically and globally. In Australia, the inflation rate is currently 4.5%; in the United States, 4.2%; in the Euro region, 3.9%; and in China, 7.7%. These rates of inflation are the highest that we have seen for many years. The rise in inflation is being fuelled by developing countries such as China and India via their increased demand for commodities, which has driven up the price of food and oil. So, are we seeing a return to the higher rates of inflation? If so, what will be the ramifications for investment markets?

Did you know?

Surging food and energy prices are the common factors behind rising inflation worldwide. For example, in the G7 economies, average headline inflation is above 3%, but core inflation (ex food and energy) is still around 2%. (Oliver 2008)


> Describe the historical impact of inflation on investment markets.

> Outline factors that are contributing to both core and headline inflation globally and in Australia.

> Identify defensive investment strategies for a high-inflation environment considering the effect that inflation has on different asset classes.





Domestic and global inflation Australia’s annual headline inflation rate for the year ending June 2008 stands at 4.5%, the highest level it has been since June 2001 when it briefly spiked above 6%. But the figure is still low compared with the 20-year period from 1971 to 1990, when inflation was consistently above 5%. Brett Taggart from Bell Advisors explains, ‘If we go back to the 1970s, inflation was significant when we had oil price shocks, and even through the early 1990s here in Australia when we did have tough economic times, interest rates on bank deposits were paying 17-18%, which is telling us that inflation was running at 10% plus, so compared to where we are today versus 15-20 years ago, our inflation rate is still very, very modest’.

Figure 1 provides on overview of inflation rates in Australia since 1949.

Figure 1: CPI Australia September 1949 – March 2008

CPI Australia Sep 1949 - Mar 2008

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Source: Based on data from Australian Bureau of Statistics, 2008.

According to TD Securities, the Melbourne Institute’s monthly inflation gauge, Australia’s headline inflation climbed 4.5% in the year to May 2008, after increasing by 0.3% during May 2008. Since the survey began in August 2002, this has been the fastest annual increase. The main contributors to the overall increase in the gauge in May were price rises for rental accommodation, fuel and financial services.

Excluding those volatile items such as fuel, fruit and vegetables, the Reserve Bank of Australia’s (RBA) core inflation figure rose to 3.6% in the year to March, its fastest rate of growth since 2001, according to ABS data. The survey by TD Securities also found underlying inflation rose 0.3% in May and was higher than the RBA’s figure at 4.3% in the same year.



Quicklink

For more information on inflation rates, visit the Reserve Bank of Australia’s website at www.rba.gov.au/, and select ‘inflation rate’ on the home page.

Inflationary pressures are quickly rising, both domestically and globally, as a result of surging oil and food prices. The Economist's dollar-based commodity-price index is up by more than 34% from a year ago; the food index is up by more than 66%; and the price of oil has risen almost 100%. These jumps are the main cause of higher inflation across the globe. They are also related to, at least in part, structural changes in the global economy.

The world economy is increasingly powered by countries such as China and India, whose growth is far more energy and commodity-intensive than that of rich countries. Since 2001, China has accounted for approximately half of the increase in the world's demand for metals and almost 40% of the increase in oil demand.

Morgan Stanley estimates that food accounts for 30-40% of the consumer price index in most emerging economies. In particular, food prices in China have risen by 22% in the past year in comparison with only 15% in the G7 economies.

While China’s inflation rate slowed in May, it still remains high at 7.7% year on year. Chinese economic activity data remains strong. Dr Shane Oliver from AMP Capital says that this is all consistent with ongoing efforts by the authorities to slow the economy down, with the People’s Bank of China increasing the banks’ required reserve ratio yet again, but with non-food inflation remaining low at just 1.7% and, given the rebuilding required after China’s earthquake in May 2008, it is hard to see the brakes being applied too hard.

According to recent figures by Morgan Stanley, India's wholesale-price inflation rate is 7.8%, a four-year high, and Indonesia’s inflation is already 11%.

But, as many media commentators warn, these official global figures may be slightly skewed in some emerging economies. For example, China's true inflation rate may be higher because the consumer price index does not properly cover private services. Delays in data collection in India can also mean big revisions to inflation – the final number for March was almost two percentage points higher than the original.

The United States, on the other hand, continues to flirt with recession. Recent figures showed that consumer prices were 0.6% higher in May, while the annual headline CPI measure was 4.2% for the year to May 2008, as shown in Figure 2.


http://www.rba.gov.au/


Figure 2: CPI USA 1914 to 2008

CPI USA 1914 to 2008

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Source: Based on data from the United States Department of Labor, 2008.

In the European region, inflation is running at 3.9% (May 2008), the fastest pace since the euro notes and coins began circulating.

According to Goldman Sachs, global inflation was 4.8% in the year to November, two percentage points higher that the previous year. Of the countries tracked by Goldman Sachs, 80% exhibited price rises. (Economist, 2008)

Current inflation drivers Current global inflation is being driven by demand for essential commodities such as oil and food. The rapid industrialisation of developing nations such as China and India has resulted in high demand for raw materials. Over the 12 months to the end of June 2008, the Economist’s commodity price index rose more than 34%; the food index rose more than 66%; and the price of oil doubled.

Current inflationary pressure is occurring despite a slowing of growth in the major OECD economies, including the United States, Europe and Australia. According to Peter Pontikis, Group Treasury Strategist, Suncorp Banking:

‘The problem we have in Australia is that the overall economy is running against its supply capacity, which is triggering these inflationary pressures that arguably come from internally-based momentum; which is why the RBA is trying to address that in the short term. Longer term, the only way you can stop people spending or bidding prices high is to take money out of their pocket and that’s done through the fiscal policy. The trouble is, as we know, raising taxes is a very unpopular mechanism and unfortunately we’re at that part of the cycle where the social acceptance of higher taxes is a very unpopular phenomenon.’



Increases in oil and food prices can lead to higher inflation and adding to this pressure is a very tight labour market. Brett Taggart, Bell Advisors, says:

‘When there is a limit on the number of people in the workplace, wages will automatically increase. If there are fewer staff but people want better employees, they’re going to have to pay more for them so combine those factors together, then it leads to an increase in core or headline CPI.’ Peter Pontikis shares this view and admits challenging times lie ahead. ‘The issue we have now is to try to maintain full employment without igniting inflationary behaviors, which actually destroys growth. It forces people into speculation rather than actual productive economic activity, and the problem with inflation too is it actually eats into your real returns, so while you may get great nominal returns, it really means nothing; it has dissipated into nothing through inflation.’

Quicklink

For more information on current global economics and inflation rates, visit the International Monetary Fund’s (IMF) website at www.imf.org and select ‘World Economic Update July 2008’ on the home page.

Some notable points made in the IMF’s report include:

> Regardless of global growth slowing, inflation continues to be a pressure in both advanced and emerging economies.

> Higher food and fuel prices are the driving forces behind the higher inflation.

> In advanced economies, headline rose to 3.5% in May 2008 while in emerging and developing economies, it rose to 8.6%.

> Core inflation for advanced and emerging economies were 1.8% and 4.2% respectively.

> The inflation rates for emerging and developing economies are the highest rates since around the beginning of the decade.

> Inflationary pressures in advanced economies is projected to be countered by slowing demand with the expected increase in 2008 to be reversed in 2009 thanks to stabilising commodity prices.

> For emerging and developing countries, inflationary pressures are mounting faster, driven by souring commodity prices, above-trend growth, and accommodative macroeconomic policies. As a result, inflation forecasts for these economies have been raised by 1.5% in 2008 and 2009 to 9.1% and 7.4% respectively.


www.imf.org


A lesson from history Australia has certainly seen its fair share of high inflationary periods. As discussed earlier, the 1970s experienced close to double-digit inflation rates. Figure 3 plots the price of oil relative to the personal consumptions expenditures price index (PCEPI), together with the core PCEPI inflation rate for the United States.

Figure 3: Inflation and the relative price of oil

Source: Federal Reserve Bank of San Francisco, 2008.

The price of oil jumped sharply twice in the 1970s, as did inflation. While it is argued that oil price shocks fuelled higher inflation during this period, this graph also shows that the correlation between oil prices and inflation appears to have deteriorated over the latter part of the sample; when oil prices fell sharply in the mid to late-1980s, core inflation appears to have been unaffected. Similarly, the last part of the sample shows a sustained increase in the relative price of oil that does not appear to be reflected in inflation.

There are some who believe that adjustment to monetary policy during the 1970s, which also included the Vietnam War, was the real driver behind the high inflation, rather than oil prices. Suncorp’s Peter Pontikis explains, ‘At that time most of the major currencies of the world and Australia were fixed against the US … through the Vietnam War, US dollars landed in other people’s hands and there came a point at which they had too many dollars relative to what they were comfortable with and we had this significant US dollar devaluation in 1972, when actually we broke the peg, both for the US dollar against gold and for the US dollar against a lot of the major currencies, so the US dollar actually fell about 50% in value in that period 1972–74. In that period, the Aussie dollar itself went to about US$1.49, which is our highest level, a very significantly high level and functionally a global phenomenon which I think is the same situation here’.




Some commentators believe a little bit of extra inflation can be a good thing. However, as history has shown, high inflation, such as in the late-1960s, can be disastrous. This is because inflation leads to higher nominal growth, particularly faster wages growth, which may seem good at first, but ultimately is destructive because it reduces the value of cash. High inflation is also an incentive to spend and hoard rather than save and produce. It also leads to higher interest rates as savers demand a higher return to compensate for inflation.

In fact, the 1980s highlighted that average interest rates increased more than the rise in inflation because, in a high inflation world, savers and lenders require compensation for the extra uncertainty caused by high inflation. AMP Capital estimates, ‘A sustained 2% average rise in Australia’s rate of inflation above the 2.5% average of the last 15 years would mean a sustained average standard variable mortgage rate of 10.25%. This would wreak havoc on home borrowers, given current debt levels. It would add to downward pressure on house prices. High inflation leads to a focus on investments which protect against inflation’. (Oliver’s Insights, 2008)

Inflationary impacts on asset classes History has shown that a relationship exists between the performances of asset classes at various stages of the inflation cycle. Commodities generally benefit from a high inflation environment while most other asset classes suffer.

Commodities During times of inflation, commodity markets are generally the strongest performing asset class. Gold prices have risen by approximately 40% to US$900 an ounce in the year to June 2008, while oil has risen 100% to US$140 a barrel. Commodities are traditionally seen as a store of wealth that will maintain their value through a high inflationary period. ‘People are looking at oil as a protection against rising food costs. They’re providing it as protection against rising inflation and speculators and oil traders or investors are out there looking at the momentum in oil,’ Taggart said.

Equities Sustained high inflation has a negative impact on share market investors. The 1970s, a high inflation period, is considered the worst decade for shares in the last century, because of rising interest rates, poor productivity growth, spiralling wages and the poor quality of company profits. High inflation lowers the quality of reported company profits as firms underestimate the cost of replacing assets, so they don’t allow for depreciation adequately.

Equities are likely to underperform due to the adverse effect of rising prices on both the economy and interest rate policy. High inflation pushes up interest rates and thus the cost of funds, which in turn will eat into profit margins. Rising interest rates also force bond yields higher and drive down price to earnings multiples for equities.

Stocks that are involved in discretionary consumer spending are particularly hard hit by high inflation. In contrast, resource stocks may experience a positive effect as rising demand for commodities leads to higher prices for the materials that they produce.


Bonds Inflation will punish fixed interest investments. Central banks may look to raise interest rates to combat rising inflation and ensure price stability. However, if rates do increase, fixed income investments will generally underperform other asset classes. This is because the value of fixed return bonds falls as interest rates rise.

Cash While people will invest in cash as a defensive play, it is not considered to be a good strategy in a high inflationary environment. Evidence of this can be seen historically, for instance in the 1980s, when interest rates were high but so too was inflation. This meant that the actual rate of return was worse than it is today. In essence, high inflation destroys the value of savings and actually encourages consumption rather than savings, which is exactly what the RBA is trying to avoid by raising interest rates.

Figure 4: Inflation since 1900

Inflation since 1900

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Source: Global Financial Data, AMP Capital Investors, 2008.

The negative impact of inflation on investment markets is demonstrated in the reverse by the positive impact of declining inflation. As can be seen in Figure 4, the high inflation environment of the 1970s and 1980s shifted to a low inflation environment in the 1990s. This shift pushed yields lower, which provided a huge boost to bond and equity returns and more recently to unlisted commercial property returns. For equities it was evident in the sharp decline in the earnings yield on shares (or rise in the PE) since the early 1980s. The adjustment from high inflation to low inflation is also evident in the fall in unlisted commercial property yields from 8-9% in the 1980s to nearer 6% today.

As at mid-2008, assets such as equities, bonds and property are being priced on the basis that inflation will be 2-3% over the long term. AMP Capital predicts that if inflation moves up by 2% on a sustained basis, it would mean that ten-year bond yields should be averaging approximately 8%, the PE ratio on the share market should be approximately 12.5 times and commercial property yields should be approximately 7%. This would translate to capital losses of approximately 6% on bonds, 16% on shares and 14% on property. (Oliver’s Insights, 2008)




Defensive strategies Looking at an adviser’s client base, those investors who are asset rich will be least affected by rising inflation because values and yields will probably rise on their investments. However those on fixed incomes are more likely to feel the pinch, particularly wage earners in slow growth industries and people drawing an income stream to fund retirement. A good defensive portfolio should be simple, well balanced and well diversified. ‘This is going to see clients through a range of economic cycles. It’s going to see them through booms and busts; it’s going to help protect their capital by simply not having all their eggs in one basket. That philosophy and that strategy will see people through any economic times and that being said, we’ve had periods of high inflation before. We’ve had periods of booms. We’ve had periods of busts. We’ve had recessions and we’ve had depressions. It’s all happened,’ Taggart said.

While a simple, well balanced and diversified portfolio is the best long-term defensive strategy, advisers who are particularly concerned about inflation may want to consider making a small increase in their portfolio allocation to assets that are considered traditional hedges against inflation. These include property, inflation-linked bonds, commodities and precious metals.

Gold Gold is the most often cited hedge against inflation because it’s portable, considered valuable and as inflation increases, so does the price of gold. As well as buying the metal itself, investors could also look to shares in gold mining companies or units in a managed fund that invests in gold. ‘Clearly when we see the reserve pricing unit in the world (which is the US dollar) very much devalued, then basically commodities, gold for instance and the oils and all the other hosts of commodities, are the ones that normally bounce in value; they are a reservoir of saving and that’s where the more savvy investors tend to park their funds,’ Pontikis said.

In a world where energy resources are stretched, it is also a good defensive strategy to park your funds in commodity-rich currencies, such as the Gulf Arab States, Russia, Australia, New Zealand, Norway, South Africa and Canada.

Bonds Other inflation defensive assets include government bonds such as:

> treasury inflation-protected securities (TIPS), which are inflation-adjusted bonds issued by the US Treasury

> treasury indexed bonds issued by the Commonwealth Government.

Inflation-linked bonds are bonds where the principal is indexed to inflation and are designed to cut out the inflation risk of an investment. While they can be used by retail investors, the base price of a bond is expensive and generally considered out of reach for the average investor. Another way to access inflation-linked bonds is through a managed fund, which may have them included in their portfolio.

‘Inflation-linked bonds are a fantastic tool in inflationary environments because their coupon rate, or their interest rate is adjusted for inflation. That allows investors to be able to maintain their purchasing power. Whereas in a non-inflationary bond, their coupon rate may be set at 5% so if you go through an inflationary period, it’s going to erode the real value that you’re receiving out of that interest payment whereas an inflationary bond is going to keep providing you with a protection mechanism from rising living costs,’ Taggart said.



Property Property has also typically been viewed as a hedge against inflation. It operates like a CPI-linked bond because the rent price is normally adjusted up to CPI, unlike a fixed interest security. However, in the current inflationary environment, property may not necessarily produce good returns.

‘At the moment if you look at the cash rate, the official cash rate is 7.25%; they are offering to us officially a 3% real rate return and so that’s an attractive real return, even if the inflation rate is 4.25%, we are still getting a real return. I’m not certain that that’s necessarily going to be the case in some segmented property markets because a lot of that expectation of inflationary gains arguably are embedded in some price already, in which case you may buy a property; you won’t necessarily go back in nominal terms but in fact will actually go back in real terms and as an asset class relative to cash, it may in fact be an under performer, at least in the short term,’ Pontikis said.

Defensive strategies are an important consideration, but making adjustments to portfolios now based on future economic events, which may or may not happen, can be dangerous. If decisions made are wrong, then clients can face a significant loss. Once again the general view is that when constructing clients’ portfolios, keep it very simple and constantly review those investments. Brett Taggart sums it up in saying:

‘We’re all human, so we do face psychological issues when the value of our investments is going down. However, those who stick to their long-term strategy will be far in advance and have far more wealth than those who look at past events and make their decisions accordingly; then try and predict the future and make further decisions accordingly. To chase last year’s winner or try and chase this year’s winner is a very, very tough game and if anybody can do it on a consistent basis, they’re an absolute genius and if they’re in financial planning, they will probably have another career carved out for them sitting on an island, making their own money.’


Discuss whether the published rate of CPI is an accurate reflection of the spending experience of all Australians.

> For many Australians this is a definite ‘no’.

> CPI is measured by tracking the prices of various items in a specific ‘basket of goods’. The government regards these items as those that would be consumed by an average household. This ‘average’ Australian household is also assumed to be living in an Australian capital city.

> This basket of goods includes items such as food, clothing, footwear, alcohol and tobacco, housing, household contents and services, health, transportation, communication, recreation, education and financial and insurance services.

> All of these items are inflating at different rates while some may even depreciate. Technology items in particular fit into this latter category. These depreciating items often ‘skew’ what is really happening to the prices of essential goods and services.

> The ‘average’ family, who is struggling with a high level of personal debt and the high cost of goods, would tend to decrease spending on luxury items and other discretionary items such as technology/communications goods and services, as more of their income is being used for necessities, which are the items that are increasing in cost. They are not concerned with an average inflation figure represented by CPI but what it actually costs to feed, clothe and shelter the family each week.



> If a client is not a member of an average household living in an Australian capital city, their experience with inflation may also be quite different to that which appears in the published CPI figures.

> Farmers are an example of this variation from the average household. Many of the goods and services they purchase and utilise are not included in the CPI measurement (e.g. farming equipment, feed, veterinarian services), or their expenditure to various goods included in the CPI measurement as a proportion of their income, is different to the household average.

> The elderly are another example. Elderly people tend to purchase less new clothing and footwear, less household contents and services such as cable TV, new technology etc., and spend less on recreational pursuits.

> The elderly do, however, tend to spend a higher proportion of their income on medical goods and services, thus their spending patterns do not reflect those represented by the CPI measurement. These medical goods and services have been increasing at a rate higher than the CPI average.

> Thus CPI, while being a good overall indicator for the politicians, economists etc., seems unrealistic to many Australian consumers compared to what they are actually experiencing.

Why is it important for advisers to understand the issue discussed in the previous question?

> Advisers are required to factor CPI into projections, whether this is achieved through including inflation in client goals, expectations etc. and showing future inflated values, or whether they exclude it by using real rates of return and expressing everything in today’s dollar values.

> The issue is: what value should be used? Should it be the current rate of CPI or an adjusted figure to allow for movements in CPI and the kinds of issues discussed in the previous question above?

> Factoring an accurate CPI amount into client recommendations/projections is difficult but the message is that caution should be exercised when assuming a figure. Erring on the side of caution is probably wise and will mean these inconsistencies will potentially have less of an impact on clients.

> Licensees may have specific guidelines on this issue that advisers should understand and be familiar with. For example, different inflation rate assumptions may be used for different expenditures (e.g. with private school fees) when presenting cash flow analyses.



Wrap up The current rise in inflation being felt globally is being fuelled by developing countries such as China and India via their increased demand for commodities, which has driven up the price of food and oil. Current inflation rates are the highest that have been seen for some time, and while they are expected to increase for emerging and developing economies during 2008 and 2009, there is relief projected during 2009 for advanced economies.

Current inflationary pressure is occurring despite a slowing of growth in the major OECD economies, including the United States, Europe and Australia.

It was suggested that in Australia, the overall economy is running against its supply capacity, which is triggering inflationary pressures that arguably come from internally-based momentum. There is an attempt by the RBA to manage this in the short-term by the use of monetary policy, with a view taken that the longer term solution can be found in the effective use of fiscal policy.

History has shown that a relationship exists between the performances of asset classes at various stages of the inflation cycle. Commodities generally benefit from a high inflation environment while most other asset classes suffer. The general view is that in times such as these when constructing a client’s portfolio, keep it simple and regularly review portfolios so that managing economic volatility, such as high inflation, can be combated where possible, before disaster strikes.



References Economist.com (2008), Inflation in emerging economies: An old enemy rears its head, 22 May. Available from www.economist.com [citied 11 June 2008].

Federal Reserve Bank of San Francisco (2008), FRBSF Economic Letter 2005-28; October 28, 2005, Oil Price Shocks and Inflation. Available from www.frbsf.org [cited 20 June 2008].

International Monetary Fund (2008), Recent Inflation Trends in World Commodity Markets. May 2008. Available from www.imf.org [cited 13 June 2008].

International Monetary Fund (2008), World economic update July 2008. July 2008. Available from www.imf.org [cited 21 July 2008].

Morgan Stanley (2008), available from www.morganstanley.com.

Oliver, S. (2008), ‘Why relaxing inflation targets would be bad for investors’, Oliver’s Insights, Edition 17, 27 May.

Oliver, S. (2008), Weekly market and economic update, AMP Capital, 13 June.

Oliver, S. (2008), ‘How big a threat is inflation’, Oliver’s Insights, Edition 19, 18 June.

SBS News (2008), Inflation gauge rising 'at fastest rate', 2 June. Available from news.sbs.com.au [citied 11 June 2008].

The Economist (2008), ‘A delicate condition’, 17 January. Available from www.economist.com. [cited 9 July 2008]


> Peter Pontikis, Group Treasure Strategies, Suncorp Banking

> Brett Taggart, Managing Director, Bell Partners Wealth Creation

DISCLAIMER


http://www.economist.com/

http://www.frbsf.org/

http://www.imf.org/

http://www.imf.org/

http://www.morganstanley.com/

http://news.sbs.com.au/worldnewsaustralia/inflation_gauge_rising_39at_fastest_rate39_548265

http://www.economist.com/

April 2009

Investment outlook

Overview The global financial crisis, or ‘GFC’, as it is now commonly called, is proving to be an unprecedented disaster, no matter where you are invested in the world. Early in 2009, key economic data has presented financial services representatives and companies with little reassurance to put investors at ease. In Australia, there is consensus among leading economists that a recession is imminent, but there is also the view that a recovery could happen towards the end of the year and into 2010 … after all, markets always rebound, don’t they? In the meantime, it’s crucial to be aware of the economic trends around the world and the impact on asset classes, as well as the key risks that could delay that elusive rebound.

Did you know?

During the Great Depression, the United States economy contracted by about 30% over a four-year period. Although the current recession is obviously severe, its output cost so far has been much smaller than that of the Great Depression.

(Claessens and Kose, 2009)


> Identify the impact of major economic trends on investment markets.

> Describe the outlook for specific asset classes.

> Outline the key risks for investment markets over the next six months.


> Generic Knowledge (75 minutes)

Investment outlook


State of the Australian economy Australia is considered to be a lot more robust than many of its trading partners and there have been a number of positive points that have helped to support the domestic economy. Since September 2008, the Reserve Bank of Australia (RBA) has been doing its part to ease monetary policy by cutting interest rates fairly aggressively. The Federal Government has also announced a number of fiscal stimulus packages with the latest being a $42 billion Nation Building and Jobs Plan to support jobs and invest in future long-term economic growth. On top of that, the Australian banking system is in relatively good shape with the top banks still reporting good profits and providing lending to credit-worthy borrowers.

Both monetary and fiscal policy are expected to play a large part in helping Australia to weather the unfolding credit crisis and soften the impact of the collapse in commodities’ earnings. However, all the evidence thus far in 2009 is indicating that the weakening global economy is bound to take a heavy toll. The word ‘recession’ is being used by leading economists and, even though (as we write in March) we might not be technically in a recession, all the indicators suggest that we are close to it. Figure 1 below from Access Economics shows that the current economic outlook for Australia points to a recession in 2009 with output growing by 0.9% in 2009. However, it’s expected to recover moderately in the later part of 2009 and rise to 3% in 2010. Figure 1: Economic outlook for Australia

Helen Kevans from JP Morgan believes that the Australian economy has already fallen into a recession, ‘We do think that growth contracted in the fourth quarter of 2008 and will contract again in the first quarter of 2009, so that will be the first technical recession since the early 1990s. Households, in particular, will face considerable head winds in 2009. Unemployment is going to rise significantly, credit availability is being reduced and asset prices are falling, so they’ll really struggle in 2009. At the same time,

Investment outlook


business investment is being pulled back significantly and exports will really drag on the economy, given that global demand has weakened so much.’

Inflation Inflationary pressures are easing due to the economic slowdown and that’s despite the impact of a weaker Australian dollar on import prices. Inflation is tipped to fall back to within the RBA’s target band of 2%–3% before the end of 2009. Headline inflation dipped by 0.3% in the December 2008 quarter and that was largely due to a large drop in oil prices. Underlying inflation, which excludes ‘volatile’ items, rose by 0.5% in the quarter to be 4.1% higher over the year. JP Morgan is forecasting that inflation will average at about 1.7% in 2009, below the RBA’s target range. ‘That will give the RBA plenty of scope to continue cutting interest rates if it needs be, but inflation will become so subdued because we’re seeing petrol prices falling; we’re seeing a lot of discounting among major retailers in a bid to get rid of stock off their shelves and inflation will really weaken throughout the year’, Kevans said.

Quicklink

For the latest inflation rate statistics, visit the Reserve Bank of Australia at www.rba.gov.au:

> select ‘Inflation Rate’ under ‘Rates & Statistics’.

Employment The unemployment situation in Australia hasn’t been as negative as that seen overseas. Employment fell 1,200 in December, rather less than expected, although there was a notable shift towards part-time work. However, forward indicators show that the job market continued to slide, with the ANZ job ads series down 9.7% in December, which was the lowest growth rate since the ANZ series began in 1975. Newspaper job advertisements also halved through the course of 2008 and it’s been widely reported in the media that more large-scale job losses are on the cards.

Quicklink

For the latest Australian employment statistics, visit the Australian Bureau of Statistics at www.abs.gov.au

> select ‘Labour Force’ under ‘National Statistics’.

Ongoing risks There remain a number of key risks to the local economy — the first that a sustained lack of confidence in the market might keep investors away from investment markets. Secondly, there still hasn’t been enough policy assistance, at sufficient speed, to avert

Investment outlook


disaster. And lastly, there’s the risk that there has been too much fiscal and monetary stimulus, which might cause a rebound to be much stronger and many investors might miss the recovery. Nicki Hutley of Access Economics says, ‘I certainly think that the downside risks are larger than the upside risks and if we do see this prolonged recession, and things don’t turn around as expected by the end of this year, then that’s obviously going to continue to keep confidence knocked on the head. Even if expectations of recovery feed through into equity markets, if we then get more adverse surprises on the economic front later in the year, then we could see further shocks to the downside, and if confidence is sufficiently undermined, then there is no telling how much further you could go’.

Outlook for global economies Many of the world’s major economies are undoubtedly in serious recessions and JP Morgan is forecasting that in 2009, 85% of the global economy will be in recession with the United States and the United Kingdom expected to deliver four quarters of negative gross domestic product (GDP) growth.

The Group of Twenty (G-20) Finance Ministers and Central Bank Governors will meet in London on 2 April 2009. Their communique released on 14 March indicated that their focus for this year’s forum will be: ‘Restoring Global Growth’ and ‘Strengthening the Financial System’. (G-20, 2009) The International Monetary Fund’s (IMF) forecasts for global growth in 2009 were lowered from 0.8% to 0.5% at the end of January. The initial figure was already indicating the weakest growth since 1982. Figure 2: IMF economic growth forecast

Economic data out of the United States continues to show considerable weakness, with GDP falling at an annual rate of 6.2% in the fourth quarter, adjusted for inflation, according to a preliminary report from the Bureau of Economic Analysis. Employment also fell 524,000 in December, with the largest job losses in the month seen in manufacturing, construction, retail and business services. The unemployment rate rose

Investment outlook


to a 16-year high of 7.2%. Factory orders fell 4.6% in November and wholesale sales fell by a record 7.1%, with unsold inventories rising to a five-year high. Industrial production also fell 2.0% in December, while vehicle production fell another 7.2% in December to a 25-year low.

Quicklink

For the latest economic data from the United States, visit the Bureau of Economic Analysis at www.bea.gov.

Data out of the United Kingdom showed that economy contracted by 1.5% in the December quarter of 2008. The result represents the greatest contraction since 1980 and follows a 0.6% contraction in the September quarter and zero growth in the June quarter. JP Morgan also expects that Europe will see five quarters of negative GDP growth. The fallout in credit markets in Eastern Europe is also of particular concern. ‘Eastern Europe at the moment has about one third of GDP in debt that it needs to be rolled over this year or repaid this year and unfortunately the IMF can’t even help bail it out after bailing out the likes of Hungary and other nations throughout the globe,’ Kevans said.

Japan appears to be faring the worst, with JP Morgan predicting it will see six quarters of negative GDP growth. This is expected to present a big challenge for the Australian economic outlook because Japan imports about a fifth of our exports. In response to falling global demand for its cars and electronics, Japanese exports declined by a massive 45.7% in January 2009, since the same time last year, resulting in a record trade deficit. Data also showed that machinery orders were down 16.2% in November compared with the previous month, following a 4.4% fall in October.

Growth has also stalled in China, which obviously has significant implications for Australia, given that since 2007 it’s been our largest trading partner. China’s growth rates have halved from their peak at around 13% and the economy grew by 6.8% in the year to the December quarter 2008, the slowest pace in seven years. Exports in December were down 2.8% from the same time last year, while imports fell more sharply, down 21.3% in the past year. The end result was that December produced China’s second highest trade surplus ever, just short of November’s US$40.1 billion. There have also been signs that China’s strong fiscal stimulus and the cuts in short-term cash rates have had some impact. Retail sales were up 19% compared to a year ago, while industrial output was 5.7% higher over the past year. Consumer prices rose 1.2% in the year to December, while producer prices were down 1.1%.

Nicki Hutley says, ‘China is a very large emerging market with a very large population that is chasing after a higher standard of living and you would expect to see well above average growth rates that you’d see in the developed world for many years to come yet. So I believe the fact that there’s lots of infrastructure spending planned, that you’ll start to see China emerge from its 6%–7% growth rates at the moment by the end of the year and start to head back up again’.

Investment outlook


The outlook for key asset classes

Interest rate markets The board of the Reserve Bank of Australia (RBA) cut the official cash rate by 100 basis points in early February. Subsequently, in the February Statement on Monetary Policy, the RBA indicated that further large rate cuts were unlikely in 2009. This statement was verified in March when the RBA left rates on hold at 3.25%. However, many economists still expect further rate cuts this year and the view is that rates might end 2009 sitting between 1% to 2%. One difference between Australia and the rest of the world is that the RBA’s reductions in official interest rates have been passed on by the banks, in their lending rates. This has provided a big stimulus to the economy because it’s helped struggling home owners and businesses to reduce their debt service levels.

Quicklink

For the latest interest rate statistics, visit the RBA’s website at www.rba.gov.au

> under ‘Rates & Statistics’

> select ‘Policy Interest Rate’.

Bond markets Global bond yields reached record lows in many OECD countries in early January 2009 and fell below 2.2% in the United States and less than 3.9% in Australia. The cause of this appears to be two-fold. Firstly, official cash rates and inflation expectations fell as recession fears rose through 2008. Secondly, the fall in bond yields was partly due to the impact of investors and companies buying bonds as a safe haven to more risky and less liquid securities. However, a third factor is likely to play a key role in 2009 and that is the excess savings in emerging countries, notably China.

Perhaps the biggest risk associated with bonds in 2009 is the significant increase in bond issuance by the United States. The Obama Administration’s $1.2 trillion stimulus package, passed by the US Congress in January, will require a huge capital raising via bond issuance. The Australian Government also forecast a deficit for this year, which many believe will be around 3% of GDP in 2009 and around 5% of GDP in 2010. As a result, bond issuance is expected to increase significantly. The capacity for countries such as China, which has to fund its surplus, to keep placing their excess funds in bonds will determine how much the additional supply weighs on bond prices.

In 2009, bond yields are expected to remain low, especially in light of lower inflation, with many commentators tipping they will end the year around 3% in the United States and 4% to 5% in Australia, depending on interest rates. After that, bond yields are likely to come under upward pressure as markets anticipate a recovery taking hold and official interest rates rise and the appetite for riskier, higher-yielding assets recovers.

Equities

Investment outlook


Perhaps the two biggest factors that will determine what happens with local share prices over the next 6 to 12 months are what happens in overseas equity markets and the outlook for company earnings. Some financial commentators in Australia believe that substantial falls in company earnings have already been priced in, so the market won’t fall much further.

However there are others who argue the opposite, such as Paul Brennan from Citigroup who says, ‘As the economy slows, it means that companies aren’t going to have the earnings that they previously had. Looking at what analysts are forecasting, they’re probably not fully capturing what we’re seeing in terms of the downward pressure on earnings, so I suspect that the equity markets are going to be finding things quite difficult, even though we’ve already seen a huge correction in the equity market’.

Generally speaking, lower inflation is a positive for the equities market; however, the risk is that if inflation falls too fast deflationary pressures may emerge, which will make it harder for some companies to pass on the price increases that they’re experiencing. ‘Inflation is now down to around 4% and it’s going to head lower and by the end of 2009 could be down to around 3%. It’s a big drop in inflation and if it stayed around those levels, it probably wouldn’t be a negative for the sharemarket, but if it was to keep falling and was to drop below 2% and go to 1% or even less, and then the markets started to worry about deflation here, then that would be a clear negative for the equity market,’ Brennan said. The economists interviewed for this article believe that stockmarkets will commence their recoveries towards the end of 2009 and, at that time, a meaningful rise in equity markets is expected to occur. That said, the speed of recovery may be slower than is usually the case, reflecting the more muted improvement in earnings growth and the unemployment figures. In Australia, valuations are looking attractive based on long-term fundamentals such as P/E ratios. The current P/E ratio for the Australian market is at the low end of its post-1986 range. Based on this, it is expected to take a much bigger slump in earnings than seen to date, extending over a number of years to alter this picture significantly. Confidence will determine when investors will start buying stocks again and if there is another blow to confidence, the market is at risk of overshooting by a long way to the downside, even if P/E ratios on any reasonable assessment are giving a strong buy signal. Share prices in emerging markets fell considerably in 2008, posting a 47% decline for the year. According to Access Economics, emerging markets are likely to turn earlier than developed markets. However, investors are likely to be discerning if, for example, commodity prices lag behind a general upturn in emerging stockmarkets, then commodity exporting emerging markets such as Brazil and Russia may lag behind commodity consumers such as China. Similarly, emerging markets that are dependent on foreign capital may be left behind.

Stock pickings Currently, the recommendation for particular stocks from Citigroup is to stick with defensive companies. However, as the recovery begins to take hold, assuming it is towards the end of calendar 2009, then consider cyclical stocks and those companies that will benefit from the lower interest rates and the pick-up in consumer demand and housing demand.

Investment outlook


Commodity prices may start to gradually rise later in the year, and when demand begins to pick up, resource stocks will benefit and that will help them gain ground again. However, the recent moves by the likes of BHP and OPEC to put on hold indefinitely some large investments in new capacity indicates that producers will retain varying degrees of influence over market prices.

Commercial property Commercial property in metropolitan centres is going to be adversely affected by weakening demand, particularly in the finance sector. At the moment, vacancy rates are rising and rental rates are falling, so the outlook is not that optimistic. The real estate market is expected to benefit from lower interest rates, but the lack of financing is going to weigh on house prices, particularly in the middle-to-high end of the market. However, prices are expected to improve into 2010, by the time the economy recovers.

The Aussie dollar The Australian dollar (AUD) has fallen by more than 30% against the US dollar (USD) and by more than 25% against Australia’s trading partners’ currencies over the last six months. Falling commodity prices, the deteriorating outlook for global growth, narrowing interest rate differentials to the rest of the world and increased aversion to riskier investments have all worked against the Australian dollar. There is a mixed view about what the AUD/USD is likely to be priced at by year end. Access Economics believes the prospect of a ballooning current account deficit will make the Australian dollar especially vulnerable in 2009 and beyond. ‘We see the Australian dollar at around 65 cents at fair value but, that said, we also see that the currency is very vulnerable at the moment,’ Hutley said. ‘Potentially it could fall to 60 cents, but I don’t see it falling all the way down to 50 cents so probably in the high 50s, but it’s hard to see it falling significantly beyond that,’ Brennan said. JP Morgan forecasts a mild recovery in the economy and currency later this year. ‘As confidence starts to gradually return, we do think the Aussie dollar will benefit from that, so by year end we see the Aussie dollar at around 76 US cents. Now at the same time as that, confidence returns and investors feel more comfortable in investing in riskier assets, Australia will still have a slightly better yield advantage,’ Kevans said.

Quicklink

For the latest AUD/USD exchange rate, visit the RBA’s website at www.rba.gov.au:

> select ‘Exchange Rate’ under ‘Rates & Statistics’.

Investment outlook


Wrap up It is likely to take some time before the economies of the world start to recover from the global financial crisis. ‘Even though we’ve cut interest rates and the government is stimulating the economy as well, it’s going to take a while before we actually see the full benefit of that. We’ve seen some early signs in the housing market where there has been a little bit more interest, particularly among first home buyers, but the business sector generally still face a very difficult outlook,’ Brennan said.

Nicki Hutley says there have been some signs of normalisation of credit markets. ‘At one point after the Lehman Brothers collapse last September, spreads in the overnight swap market were out to 400 or more basis points, but that’s coming back to around about 100. That’s still a lot higher than you would see as a normal trend, but it’s coming back, and in the corporate bond market there’s evidence of corporate bond issuance starting to pick up again, particularly in countries where there’s a government guarantee, such as Australia … We are also seeing probably the end of the securitisation market as we have known it, and that has implications for smaller financial companies.’

Governments and central banks around the world have been throwing everything at the present situation. In Australia, there is consensus among leading economists that a recession is imminent, but there are also predictions that Australia will see GDP start to pick up by the final quarter of this year.

Even after the sharemarket starts to recover, its unlikely that the full impact of the global financial crisis on financial markets will be realised for some years yet. It will take quite some time before stability in investment markets returns and even then it’s likely that there will be much tighter regulation, particularly in the United States.

Investment outlook


References Access Economics (2009), Investment outlook, Report for Kaplan Professional, March.

Bureau of Economic Analysis (2008), Gross Domestic Product: Fourth Quarter 2008 (Preliminary). Available from www.bea.gov [cited 24 March 2009].

Claessens, S. and Kose, M.A. (2009), ‘What is a recession?’ Finance and Development, vol 46 (1), March, International Monetary Fund.

G-20 (2009) ‘Communique — Meeting of Finance Ministers and Central Bank Governors’, UK, 14 March 2009. Available from www.g20.org [cited 24 March 2009].


> Nicki Hutley, Access Economics, Principal Economist

> Helen Kevans, JP Morgan, Economist

> Paul Brennan, Citigroup, Chief Economist

DISCLAIMER


March 2009

Centrelink and asset values

Overview

Over the past 12 months, the global financial crisis has led to a significant drop in the capital value of many people’s retirement funds. The effect of declining asset values on a retiree’s income depends on the link between the asset value and the derived income. Retirees, and those who are close to retirement, may now find themselves with a depleted superannuation balance and the need to reassess their retirement plans. Falling asset values also mean that some retirees are experiencing financial hardship, or the likelihood of hardship ahead. It is particularly important that financial advisers are aware of the government benefits that are available for their clients and what it takes for clients to qualify for some assistance.

Did you know?

According to government statistics, 77% of Australians over age 65 receive government income support. (Department of Families, Housing, Community Services and Indigenous Affairs, 2008)

Learning objectives

After reading this article you should be able to:

> Identify assets that may have suffered a fall in value.

> Outline Centrelink measures for which clients might be eligible.

> Explain how financial advisers can manage their client’s finances in a declining assets environment.

> Outline the potential effect of a recovery in investment markets.


Knowledge areas

This article is relevant to the following knowledge areas:

> Social security (60 minutes)


March 2009 Page 2 of 10

Affected investments

Managed investments, superannuation and pension vehicles have all dropped in value over the past 12 months. The decline in asset values has stemmed from a global fall in the underlying value of shares, fixed interest, and listed property investment. These assets normally form a major component of the investment vehicles, which are market-linked and consequently driven by the success or failure of global economies.

Generally speaking, there has been a large decline in the value of Australian and international share portfolios, with share market values dropping by almost 50% since the highs of 2007. Deborah Wixted of Colonial First State explains the importance of assessing the various asset classes for investment:

‘Fixed interest investment held before the interest rate cuts of late 2008 may have actually seen an increase in their asset values and, according to both the Real Estate Institute and the Australian Bureau of Statistics, the residential property market in 2007 had quite a good, positive year, although more recent ABS data to September 2008 suggests that house prices are coming off, so it’s been a bit of a mixed bag’.

Clients with an extensive share portfolio might not have seen a flow-on effect to their income even with the decline in share values. This is generally the case when companies are still able to generate profits and pay dividends at the same rates. However, when an economy contracts, it often puts pressure on company profits, which can lead to a reduction in dividend distribution, such as with Australand; or at times to a cancellation of dividend distributions altogether — Babcock & Brown and Centro Properties being prime examples.

Retirees with investments in mortgage funds will find that in some cases redemptions may be frozen. This means that distribution payments, which some people rely on as income, could be reduced or even suspended.

Lower interest rates mean that cash investments and term deposits have also been affected.

Account-based pensions

The most common retirement investment vehicle affected by changes in the market is the account-based pension.

Under the current pension standards, minimum pension payments for the current financial year would have been calculated on the account balances of 1 July 2008, before most of the turmoil unfolded. Even though there is a strong possibility that account balances have since dropped, there is no opportunity to recalculate that minimum amount. Even if clients were in a position where they could actually choose to draw a lower amount of income, they aren’t able to do so, and so are taking potentially more than they need and therefore perhaps depleting their retirement capital more than would otherwise have been the case [see note below*]. This means that retirees exposed to market movements via allocated and account-based pensions may not realise the extent of the drop in asset values where they continue to receive the same pension payments.

*Note …

The government has given Australia’s self-funded retirees some temporary relief from their significant investment losses



by suspending the minimum drawdown requirement for account-based pensions for the second half of 2008/09. This was in response to concerns that meeting the minimum drawdown amount in 2008/09 would mean that retirees will have to sell investments assets and realise losses in a depressed market. In response to these legitimate concerns, the government announced relief in the form of a 50% reduction in the minimum payment amount for 2008/09.

‘The government recognises that the significant downturn in global financial markets has had a negative effect on retirees’ superannuation capital in account-based pensions’, Treasurer Wayne Swan said in an announcement on 17 February.

In circumstances where there is a drop in capital value of pension funds and the income stream remains steady, if there is limited access to cash within the pension account, units (capital) will need to be sold down to maintain the level of income. This is far from ideal in an environment where market-based assets have declined in value as it may result in the realisation of a capital loss.

Reducing the income level can help prevent capital erosion. While retirees who have been drawing a pension above the minimum level can reduce the income they receive, it is a requirement that at least the minimum annual income is drawn, which offers little relief to those seeking to preserve their capital.

One available strategy involves rolling over to a new account-based pension, which can trigger a recalculation of a new, lower minimum pension payment based on the lower account balance.

Increased eligibility for Centrelink benefits

Age pension

Self-funded retirees affected by the market downturn who were not previously entitled to any government income support payment may now be entitled to the age pension from Centrelink or the service pension from the Department of Veterans Affairs. The pension can help to supplement and maintain overall income level for the client. Successful applications for the age pension have risen from 2,000 a week to 3,000 a week since October 2008, according to Minister for Families, Housing, Community Services and Indigenous Affairs, Jenny Macklin. (Macklin, 2008)

Centrelink or the Department of Veterans’ Affairs (DVA) applies both an income and assets tests when assessing a claim for either the age pension or service pension, with the lower pension entitlement determining the benefit to be paid.

Quicklink

For more information on pensions available from the Department of Veterans’ Affairs, visit www.dva.gov.au

> select ‘Pensions’, then



> select ‘Test eligibility’, then

> select ‘DVA Factsheets system’.

Under Centrelink’s assets test, retirees can have assets up to certain thresholds and still receive a full or part pension. The allowable assets limits depend on whether the pensioner is a homeowner, a non-homeowner, a single or part of a couple. For the assets test, single homeowners can have up to $550,500 in assets and a couple who are homeowners can have up to $873,500 combined and still receive at least a part pension. The thresholds for non-homeowners are $675,000 and $998,000 respectively.

Quicklink

For more information on income and assets tests for age pensions, visit www.centrelink.gov.au, then under ‘Individuals’ on the left-hand side of the page:

> select ‘Payments’

> select ‘Age Pension’ under ‘Seniors or retired’

> select ‘Income and Assets’ under ‘Payment & Claiming’.

Pensioners who have experienced a decline in the value of their investments may now be entitled to a higher rate of pension.

For example …

Clients who have experienced a decline in their assessed assets from $400,000 to $300,000 have experienced a 25% fall in value of their investments. As a result, they’ll actually receive an increased $3,200 in age pension benefits per year. (Wixted, 2008)

People who have not yet reached age pension age may find they are able to now qualify for Newstart allowance, although this requires the recipient to be available for work rather than retired. While the assets test for allowances is stricter than that for the age pension, clients who have seen a decrease in assets may now be eligible where they weren’t previously.

Quicklink

For more information on income and assets tests for Newstart Allowance, visit www.centrelink.gov.au, then under ‘Individuals’ on the left-hand side of the page:




> select ‘Newstart Allowance’ under ‘Jobseekers’

> select ‘Income and Assets’ under ‘Payment & Claiming’.

Additional Centrelink measures

Due to the share market volatility and dramatic falls, the government has introduced a number of Centrelink measures to help people who are experiencing financial hardship. While Centrelink generally revalues the financial assets of pension recipients in March and September each year, it conducted a special one-off revaluation of unitised investments such as shares and managed funds in November 2008. It was based on asset values as at 13 October 2008 and, as a result, many clients received an assessment with much lower asset values.

Estimates suggest that the asset values of more than 840,000 pensioners have been updated automatically and about 370,000 people received an average increase of $4 a fortnight as a result. In some cases, the increase was more than $100 a fortnight. The new payment rates came into effect from 3 November 2008.

Deeming rules are central to the social security income test and are used to assess income from financial investments for social security and veteran affairs pension allowance purposes. It is assumed in deeming that financial investments earn a certain rate of income, regardless of what they actually earn. To ensure that deeming rates are appropriate, they are continually monitored and were reduced to reflect recent interest rate cuts and the global financial crisis. New rates were introduced on 17 November 2008 and were adjusted in January 2009, with the deeming rate on the first $41,000 of a single pensioner’s financial investments falling to 3%. The same deeming rate also applies to the first $68,200 of total financial investments held by a pensioner couple, and for the first $34,100 of total financial investments by each member of the couple. Any amount in excess of these limits is deemed at 4%. Hence, recipients affected by the income test may receive an increase in their age pension or service pension.

Quicklink

For the latest deeming rates, see www.centrelink.gov.au, then:

> select ‘A-Z index’ under ‘Quick find’, then

> select ‘Deeming’ under ‘D’.

Centrelink has also introduced asset hardship provisions that may assist clients who have had some of their investments frozen and are unable to realise their assets. In order to qualify under the hardship provisions, a single person must have $14,614.60 or less in readily available funds ($24,414 combined for a couple) and have no other course of action that they could reasonably be expected to take to alleviate their hardship. Special income test rules apply and the rate of pension payable under the hardship provisions depends on the circumstances of each individual case.



Quicklink

For more information on hardship provisions, visit www.centrelink.gov.au, then

> select ‘A-Z index’ under ‘Quick find’

> select ‘Hardship Information Factsheet’ under ‘H’.

Pension Loans Scheme

Another useful tool is the Pension Loans Scheme, where clients are of age pension age with property assets but lacking income. Similar to a reverse mortgage, the client gives a charge over their property, whether it be a family home or an investment property. Centrelink pays the difference between the maximum rate of age pension and whatever the client is getting on a fortnightly basis. The client can pay back the loan any time, at a low rate of interest. Alternatively, the loan will be repaid when the house is sold.

There are preventative methods to ensure that the amount borrowed is not more than the house’s worth, which would create negative equity. Eligibility for the loan states that the borrower must be at age pension age and unable to receive the pension by either the income test or the assets test, but not both. This would not be suitable for high income, high asset value clients, but for many other clients it is a useful tool to supplement their income during volatile times.

Quicklink

For more information the Pension Loans Scheme, visit www.centrelink.gov.au, then under ‘Individuals’ on the left-hand side of the page:


> select ‘Pension Loans Scheme’ under ‘Seniors or retired’.

Pension Bonus Scheme

In light of the current financial environment, many older Australians are forced to remain in the workforce. For someone who has reached age pension age and hasn’t retired, or perhaps has put their retirement plans on hold pending a market recovery, the Pension Bonus Scheme may be available. By registering for the scheme, continuing to work and deferring the claim for age pension, a person may be entitled to a tax-free lump sum when the claim is eventually made.



To be eligible, a person must be engaged in gainful work for a minimum of 960 hours for at least 12 months after becoming a member of the scheme. The amount of bonus depends on the amount of basic age pension entitled to when the retiree eventually makes a claim, the length of time they have been an accruing member of the scheme, and whether they were single or partnered during the time they deferred their age pension claim.

For example …

After one year the bonus is worth $1,373.80 for a single person, rising to $34,344.30 after five years (the maximum period of scheme membership). For a couple, both must be members of the scheme, but only one person must meet the work test.

Quicklink

For more information the Pension Bonus Scheme, visit www.centrelink.gov.au, then under ‘Individuals’ on the left-hand side of the page:


> select ‘Pension Bonus Scheme’ under ‘Seniors or retired’.

Lump sum payments — December 2008

Another measure to assist retirees was announced by the government in October 2008, whereby a total of $4.8 billion was paid to age pension recipients, carers and seniors, consisting of a lump sum payment of $1,400 to single and $2,100 to couples who were in receipt of the age pension, or held a Commonwealth Seniors Health Card or Veterans Gold Card eligible for Seniors Concession Allowance. Those entitled to the carer allowance also received $1,000 for each eligible person in their care. Payments commenced directly into bank accounts, with most being received by 19 December 2008.

The role of financial advisers

There are many simple and practical steps that a financial adviser can take to assist clients to access and maximise their social security benefits. Of course it is important to take care to ensure that any strategies implemented in the current environment are appropriate for their clients in the long term. The client’s current situation, needs and short- and long-term objectives always need to be taken into account to ensure there is a reasonable basis for advice.



One key step is to ensure that the correct value of a client’s assets and income are recorded with Centrelink. This is particularly important in the light of the November 2008 revaluation and continued market volatility. Deborah Wixted says:

‘If the client or the adviser has any concerns that Centrelink might be holding a higher value for an investment than what the real current market value is, they can request Centrelink to revalue the assets. If it works in the favour of the client, it will provide a higher benefit; however, if it works the other way around, the client does have the option of rejecting the revaluation.’

Clients with investments affected by the market downturn should approach Centrelink or the DVA for a reassessment. Cecile Apolinario recommends:

‘Clients with account-based pensions are reviewed in August each year and those who are affected by the income test are reviewed in February; but if they think their allocated pensions or account-based pensions have been affected by the market downturn, they should approach Centrelink or DVA, at any time, with a current account balance. It is also the same for shares or managed investments. If they think that the value of their investments have come down, they should go to Centrelink for a reassessment.’

Those who aren’t listed with Centrelink won’t have their assets automatically revalued. In light of the current economic situation, there are people who may now be able to successfully apply for a pension. A Centrelink Financial Information Services officer can assist in such a situation.

Clients with direct property can request a revaluation by Centrelink at any time. As Deborah Wixted noted:

‘The issue with property comes down to one of where you get the valuation from. Centrelink will accept a client’s estimate of the value of their property or professional valuations of properties provided that they’re done by a professional valuer and done according to the standards of the Australian Valuer’s Office.’

Centrelink retains the right to reject an estimate if it seems unreasonable. If the valuation is accepted and it works in a client’s favour, then the increased pension payment or benefit payment would be made at the next payment date. If it works against the client, then they can just ask for the revaluation process to be stopped and things would remain as they are.

For clients whose pension entitlement is determined under the income test, Wixted suggests, ‘Look at the client’s investments and ensure that, wherever possible and appropriate, they’re in an income test-friendly type of investment’, such as those which have a deductible amount that is excluded from the income test.

Even if they qualify for the pension, many self-funded retirees choose to remain independent of it. This can create a difficult situation for advisers, especially if using Centrelink is potentially a key component of the financial plan. With higher life expectancies and increased cost of living, it is a real risk that some retirees may outlive their capital, so social security provides an ability to combine a client’s capital and income that they are drawing from it with the income received from the government.

An adviser could frame the whole Centrelink issue as just one of the strategic tools that is available to the adviser and their client, to provide some additional income to help tide the client over through a difficult time. It is important to flag with the client up front that it may only be a temporary measure that’s needed and that they’re not necessarily going to be a long-term Centrelink client. It’s also worth investigating whether the client is entitled to concession cards, such as the Commonwealth Seniors Concession Card, which can be granted without the need to receive an age pension.



Cecile Apolinario believes that the key to this situation is knowing your client and knowing how to approach them:

‘It can be a very sensitive situation, especially if clients are used to being financially independent. However, financial advisers have a duty of care towards their clients and are obligated to present the entire picture to them and inform them of what they are entitled to.’

It may be appropriate to explain to clients that one advantage of receiving the age pension is the associated Pensioner Concession Card, as entitlements can amount to saving approximately $2,000 per annum of the client’s capital. The card provides many benefits including discounts on medicine, travel, public transport, motor vehicle registration and utilities.

Ramifications after market recovery

There are no guarantees about the extent of any recovery — or its timing — but asset values in general are expected to recover in the long term. Advisers should be mindful of this as clients who now just only qualify for a part–pension may be particularly affected. As Alena Miles says, ‘Centrelink and DVA both index their thresholds every year, so that provides a little bit of a buffer if the asset values increase’. Any increases in asset values above these thresholds will reduce pension entitlements and advisers will again need to review client portfolios and strategies.

Wrap up

The global financial crisis of the past 12 months has led to a significant drop in the capital value of many people’s retirement funds. Retirees, and those who are close to retirement, may now find themselves with a depleted superannuation balance and the need to reassess their retirement plans. Some retirees are already experiencing financial hardship, and others have the likelihood of hardship ahead. It is particularly important that financial advisers are aware of all the options available to clients, including government benefits.

The account-based pension is the most common retirement investment vehicle affected by changes in the market. Reducing the income level can help prevent capital erosion. However, only those retirees drawing a pension above the minimum level can reduce the income they receive, as it is a requirement that at least the minimum annual income is drawn [however, note that as at mid-February, the government has given Australia’s self-funded retirees some temporary relief by suspending the minimum drawdown requirement for account-based pensions for the second half of 2008/09].

Otherwise, those wishing to decrease their minimum annual income could roll over to a new account-based pension, which can trigger a recalculation of a new, lower minimum pension payment based on the lower account balance.

Self-funded retirees who are affected by the market downturn, who were not previously entitled to any government income support payment, may now be entitled to the age pension, or a part-pension, from Centrelink or the service pension from the Department of Veterans Affairs. As well, those who were already pensioners who have also experienced a decline in the value of their investments may now be entitled to a higher rate of pension.

Centrelink has also introduced hardship provisions for those who are currently experiencing financial hardship but would not normally be entitled to a pension or benefit. Other options available through Centrelink include the Pension Loans Scheme and the Pension Bonus Scheme.



References

Apolinario, C. (2008), Adviser Guide: Market Volatility — Centrelink and DVA Implications, MLC ThreeSixty, November, Sydney.

Department of Families, Housing, Community Services and Indigenous Affairs (2008), Pension Review Background Paper—Executive Summary, Department of Families, Housing, Community Services and Indigenous Affairs, Canberra

Macklin, J. (2008), Australian Government helps pensioners, Transcript, Minister for Families, Housing, Community Services and Indigenous Affairs, Canberra.

Acknowledgement & thanks

We thank the following people for their contribution to this article:

Alena Miles, Technical Analyst, Zurich Financial Services Australia

Cecile Apolinario, Technical Consultant, ThreeSixty Technical Services

Deborah Wixted, Senior Technical Services Manager, Colonial First State

DISCLAIMER

This document was prepared by and for Kaplan Education Pty Limited ABN 54 089 002 371. It contains information

of a general nature only and is not intended to be used as advice on specific issues. Opinions expressed are subject

to change. The information contained in this document is gathered from sources deemed reliable, and we have

taken every care in preparing the document. We do not guarantee the document’s accuracy or completeness and

Kaplan Education Pty Limited disclaims responsibility for any errors or omissions. Information contained in this

document may not be used or reproduced without the written consent of Kaplan Education Pty Limited.

November 2008

Centrelink traps for retirees

OverviewThe Australian social security system can be a minefield for retirees and their clients. While entitlements such as the age pension can seem relatively straightforward, the details can often become overwhelming once other financial factors are taken into account. With this in mind, financial advisers need to be aware of the tips and traps that can occur when dealing with Centrelink, as well as some of the strategies that can be used to maximise a client’s benefits.

Did you know?

Age pensioners can expect a payment from the Federal Government of $1,400 for single pensioners and $2,100 for couple pensioners between 8 December and 19 December 2008, as part of their Economic Security Strategy to strengthen the Australian economy.


> Identify areas of financial planning advice that might impact on a retiree’s social security entitlements.

> Outline strategies that can address these potential traps.

> Evaluate factors that need to be considered when providing advice to retirees.





Incorporating Centrelink into planning Central to the work of many financial advisers is informing retirees on ways to maximise Centrelink entitlements. Yet sometimes it is other areas of financial planning, such as selling an asset, commuting from income streams, or moving into an aged care facility that can have a significant impact on a client’s social security benefits.

Financial advisers need to stay up to date with the latest legal requirements affecting Centrelink customers, and also communicate the risks associated with strategies that might have an impact on a client’s Centrelink benefit.

Notification period Financial circumstances change regularly, and whether it’s for better or worse, a change in income can impact on a retiree’s social security entitlements. A client needs to notify Centrelink within 14 days of any change in their financial circumstances, such as selling their house or inheriting a lump sum payment, in case it affects their payment.

Jeannie Feng from Asgard explains what happens if a client doesn't notify Centrelink about changes in their circumstances. ‘If a client commutes from an allocated pension but forgets to tell Centrelink within 14 days, they may be over-assessed on the income test and have to repay any benefits.’

If a client deliberately doesn't tell Centrelink about changes in financial circumstances, they could be charged with fraud. Also, if incorrect information has been given to Centrelink, any excess payments will be recovered.

It is also vital that the client understands that the onus is on them, not the adviser, to notify Centrelink of any change in their circumstances.

The pension bonus scheme The Pension Bonus Scheme provides a tax-free lump sum to eligible Australian residents who defer claiming the age pension and continue in gainful work for at least 960 hours each year.

The bonus is a multiple of 9.4% of the basic age pension (which does not include extra benefits such as rent assistance, pharmaceutical allowance and remote area allowance) for each 'accruing' bonus period. The bonus is paid as a non-taxable lump sum once the recipient claims and gets the age pension. The recipient must be an accruing member for at least one year to be paid a bonus. A maximum of five years accruing membership can be taken into account for the bonus. Work after age 75 cannot be included.

The amount of bonus paid get depends on:

> the amount of basic age pension to which the recipient is entitled when they claim it after leaving the workforce (e.g. if you are entitled to 75% of the basic rate of age pension when you retire, your bonus will be 75% of the amounts in the table below)

> the length of time they have been an accruing member of the PBS, and

> whether they are single or have a partner during the time they are deferring the age pension.

November 2008 Page 2 of 10


Figure 1: Maximum amount of bonus payable

Bonus years Single Partnered (each)

1 year $1,373.80 $1,147.50

2 years $5,495.10 $4,589.80

3 years $12,364 $10,327.10

4 years $21,980.40 $18,359.30

5 years $34,344.30 $28,686.50

For a bonus to be payable, clients need to register as members of the scheme within 13 weeks of becoming eligible for the age pension. For men this is age 65, while for women the qualifying age for the age pension is currently 63 years and six months, gradually increasing to age 65 by 1 January 2014.

The need to register as early as possible is crucial to a client’s eligibility for the scheme although it is possible to backdate the registration even after the 13 week period. Government guidelines indicate that clients who register within 13 weeks of becoming qualified for the age pension automatically have their registration backdated to when they first qualify for the age pension, while people who register outside the 13 weeks generally have their registration start from the date they apply, unless special circumstances exist.

‘Recently a Centrelink delegate actually refused to backdate so, consequently, the client lost $20,000 to $30,000 of free money because of that’, said Feng. ‘Having said that, there is nowhere in the Social Security Act that denies such backdating. Therefore you need to look at your client’s situation on a case-by-case basis, depending on the discretion of the local delegate’.

Gifting above limits ‘Gifting’ is a term used when clients or their partners do one or more of the following:

> gift assets

> transfer assets for less than market value

> do not receive adequate consideration for the gift or transfer in the form of money, goods or services.

While clients can give away any amount of money or assets they choose, they need to be aware that, in doing so, the rate of their pension or allowance can be affected if they gift assets above the relevant limits.

Both single and couple pensioners can gift up to $10,000 per financial year, to a maximum of $30,000 over a five-year rolling period without affecting their age pension entitlements. If the gifting amount exceeds those amounts within the relevant period, the excess amount is counted as an asset and deemed for the next five years. ‘Sometimes clients think giving a lump sum gift of $30,000 is fine for just one financial year, but that is wrong. If they do that, they will find only $10,000 is exempt, the additional $20,000 is subject to deprivation for the next five years’, says Feng.



Centrelink recently amended the rules on breaches so that if someone inadvertently exceeds the limit but then has the money paid back to them or has the gift returned to them, they can ask for a reassessment of their situation, from the date on which they received the gift back.

Realising assets Because the age pension is a taxable payment and is subject to the income and asset test, it can come as a blow to clients if they lose the pension as a result of realising assets. Centrelink defines assets as any property or item of value the client or their partner owns or has an interest in, including international assets.

In most cases, for retirees, realising an asset has no effect at all. They are most likely to be substituting one asset, for example shares, managed funds and insurance bonds, with another, being cash. All are treated as financial assets and subject to deeming under the income test.

However, there may be a negative impact if a non-financial asset, such as property or private pension, is exchanged with a financial asset (cash), because property and pensions are subject to special treatment under the income test.

Commuting from a pension When commuting from a pension, the lump sum withdrawal is not itself held as income or asset. But depending on what the client uses the withdrawn amount for, further assessment may be necessary.

If the withdrawn amount is used for other non-assessable purposes (e.g. a holiday, repairs or improvements to the principal place of residence), no further assessment is necessary.

However, if all or part of the amount withdrawn is used to purchase an assessable asset, the relevant income and assets test assessments will apply. For example, if a car is purchased, its value is added to other assets. If the amount is deposited in a bank account, the balance of the account is an asset and subject to deeming.

Insurance bonds Care needs to be exercised when insurance bonds are involved. Under normal circumstances, an insurance bond is treated as a financial asset and is subject to deeming. However, a number of friendly society bonds declare themselves as life insurance policies, which have a different treatment. In that circumstance, the bond is not deemed while it is still running. But when surrendered, or upon maturity, all proceeds will count as income under the income test and assessed as a lump sum for 12 months in the year of receipt. The impact can be detrimental to some clients as they may be subject to the income test in one go, instead of under the deeming provision, spreading out over the years.

Selling a client’s home When it comes to selling the clients’ principal residence, the consequences depend on a client’s intention in regard to the proceeds, and how the proceeds are invested.

If the client intends to use the proceeds to buy another principal home, then the amount that is written down to purchase the new home will be exempt from Centrelink’s assets test with a 12-month exemption, or a 24-month extended exemption if the delay is reasonable. In addition, the client will continue to be assessed as a homeowner.



From the income test point of view, the proceeds will normally be subject to deeming and may reduce a pension entitlement. Pension can be reclaimed as soon as income falls below the upper limit. This is usually when payments have been made on the new home.

One possible strategy to avoid the deeming assessment is to temporarily ‘park’ the proceeds in an exempt asset, such as a super fund for clients who are under age pension age. However, advisers need to ensure that if this strategy is adopted, the client has ready access to the money when funds are required for the new purchase.

Borrowing against the family home Normally, if a client borrows money against their home, the encumbrance cannot be deducted from the home as it is secured against an asset that is exempt under the assets test. The loan is ignored by Centrelink and has no impact on the client’s payments.

However, when a pensioner borrows money against their home and lends that money to a third party, such as their child, and if that child uses the money for their own business or to purchase an investment property, the loan will be assessed as a financial asset and subject to deeming because the encumbrance is for the benefit of a person other than the client or their partner.

If the borrower does not pay the interest or the capital, Centrelink will continue to assess the outstanding balance and deem interest, unless the debt becomes legally unrecoverable.

Commuting income streams Income streams are investment products that allow a person to receive regular payments. These payments may comprise income only, or income plus return of all or part of the capital used to buy the product. These income streams are generally paid as a pension or an annuity.

The deductible amount for Centrelink purposes represents that amount that isn’t assessed for the Centrelink income test. If there’s a commutation from an income stream, the deductible amount is recalculated immediately by getting the original purchase price, less any commutations, divided by the original relevant number. The effect of this is that every time a client makes a commutation, the deductible amount becomes smaller.

If not planned carefully, the client, while on the same level of pension income for the financial year, risks reducing their Centrelink benefits under the income test. The reduced deductable amount will continue to result in a higher assessment of income for the life of the annuity.

When an income stream is rolled back/commuted fully to the accumulation phase, it is treated as a financial investment, and subject to deeming for clients over age pension age. If the client re-commences the pension, it becomes a new product. Everything is re-calculated based on the new account balance and new life expectancy number.

Income streams are only adjusted for purposes of the asset test on 20 September and 20 March (based on 30 June and 31 December account balances), and on the date of a commutation.

It is only on these dates that asset values are automatically reassessed. The recent share market volatility has caused the values of many portfolios to change dramatically in a relatively short period of time. Centrelink needs to be informed if the value of a portfolio has altered, and a re-assessment of income and assets may need to be undertaken, which could potentially increase or decrease the pension entitlement.



If an income stream is partially commuted, then the deductible amount needs to be recalculated immediately. It doesn’t matter what time of the year this happens, the account balance will be adjusted from the date of commutation, ‘so it may be detrimental to the client’s pension entitlement because the recalculation on the deductible amount could be significantly lower than it was before so all of a sudden, more of their pension income becomes assessable compared to before’, said Feng. ‘Ninety-nine percent of the time the deductible amount for Centrelink purposes will be much higher than the minimum pension payment under the new super changes, which means for the income test, nothing is assessed from the pension, that is, until a partial commutation occurs’.

For example …

For example, a client currently draws 4%, being the minimum, from his pension, then decides to commute 50% of the pension’s account balance half way through the year. The deductible amount will be reduced by half at time of commutation and any excess pension payment will be assessable under the Centrelink income test for half a year.

Strategies for commuting income streams One solution to help minimise this impact is to aim for the commutation to happen closer to the end of the financial year, thereby producing a more ‘realistic’ assessment of the client’s situation and minimising any negative impact on their pension payments.

Another strategy is to increase the pension payment towards the end of the financial year, instead of partial commutation. ‘For example, you’re drawing 4% for the first six months and then you’re increasing the pension payment to 50% for the remaining six months. In this case, Centrelink will assess 4% for the first six months and 54% for the second six months under the income test. If you defer the payment increase towards the end of the year, say drawing 4% for the first 11 months and 3 weeks and increase the payment to 50% on the last week in June, then Centrelink only assesses the 54% for that particular week instead of six months’, said Feng.

The benefit of the above strategy is that a deductible amount doesn’t need to be recalculated, so the higher original deductible amount still exists, even though the account balance has dropped down. A client needs to remember to inform Centrelink that the pension will go back down to the minimum again next year so they are not continually assessed based on 54% for future years.

Death of a Centrelink recipient The range of assistance that may be available following the death of a recipient, and sometimes dependants, includes:

> For carers and (single) parenting payments — continued payments for 14 weeks from date of death.

> For married/partnered — combined rate paid for 14 weeks after the date of death (the survivor may be reassessed for single rate during this period and a lump-sum adjustment paid).

> All other singles — one payment after the date of death may be retained by the person’s estate.



In addition, the surviving spouse is re-assessed by Centrelink. Any assets that were previously owned by the deceased are not counted against the spouse at that time, but any jointly-owned assets and any assets owned by the surviving spouse are then counted and their pension is recalculated on that basis. If any assets of the deceased are bequeathed to the survivor, Centrelink must be notified within 14 days of distribution so the survivor’s pension can be adjusted.

Going into residential aged care Centrelink offers a number of asset test exemptions for people going into an aged care facility or nursing home. If a single homeowner or a couple has an Aged Care Assessment Team (ACAT) rating and goes into care, the home is exempt from the asset test for a maximum of two years, provided that it is not sold. If a person, or either member of a couple, is paying the nursing home or hostel an accommodation charge or accommodation bond by periodic payment, and the house is rented out, then both the asset value of the house and any rental income received can be exempt indefinitely. There may also be exemptions if the house is occupied by another eligible person or long-term carer.

Transition to retirement For Centrelink reporting purposes, the annual pension payment is based on the grossed up value as opposed to the pro-rated amount per tax law. However, for transition to retirement income streams, the maximum of 10% is not subject to pro-rating. As a result, if the maximum is grossed up, this will result in an incorrect figure. Note that this is only the case if the income stream is commenced during a financial year. Jeannie Feng explains one scenario.

For example …

‘A client commenced a TtR of $88,283.94 on 11 March 2008. The maximum on that is $8,830 and is not subject to pro-rating as per the tax/superannuation law. However, on the Asgard Centrelink Schedule, that $8,830 was grossed up for Centrelink purposes, to a massive $28,855.18 for the financial year.

‘What this means is that Centrelink actually assessed the client as receiving $28,855 from the TtR as opposed to $8,830. In this particular case, Centrelink over-assessed him by a whopping $20,025.’

For advisers or clients in a similar situation, the product provider needs to be told to report the correct figure ($8,830 as per the above case) on the Centrelink schedule because if the maximum of 10% is not subject to pro-rating, then the client is actually receiving what they would have otherwise received for the full financial year.

Alternatively, a pro-rated pension (in dollar figures) can be requested from the product provider despite the fact that pro-rataring doesn’t apply to maximum transition to retirement (i.e. instead of requesting the maximum 10%). This should eliminate the pro rata issue.



Centrelink assesses income streams during the financial year by dividing the total dollars to be received during the financial year by the number of days from the commencement date to 30 June and then multiplying by 365.

Tying it all together Maintaining a good working relationship with clients who deal with Centrelink is crucial. Effective and regular communication goes a long way in avoiding unnecessary traps or mistakes. Leola Mullica from Isis offers a few key reminders to advisers:

> be very careful when dealing with Centrelink clients

> always check with a Centrelink Financial Information Service (FIS) officer about anything that is unclear

> ask the client to sign a Centrelink form that authorises an adviser to make enquiries on their behalf and to also receive copies of all correspondence

> advisers need to double-check and re-calculate a client’s situation in case Centrelink makes an error.

‘Usually our clients get quarterly statements from Centrelink detailing what their assets and income are, and I always get a copy as well just to double check. As well as that, twice a year, our clients get letters from Centrelink asking for their income stream details and we complete those on their behalf and we send the clients a copy and send it onto Centrelink’, said Mullica.

Consider …

How can an adviser utilise the services of the Centrelink Financial Information Services (FIS) Officer

> Centrelink’s Financial Information Service is a free education service available to all members of the community including advisers.

> FIS is an independent, confidential service that can assist clients by phone, face to face meetings made by appointment, or through seminars.

> Advisers are also able to seek information from FIS officers for the benefit of their own general knowledge or directly on behalf of their clients.

> The FIS officer will be able to assist in making decisions about investment and financial issues, and is a resource that can be very useful to advisers in helping their clients.

> FIS officers are not authorised to provide advice or to recommend investment products; they will simply discuss how certain factors such as investments or structures will impact a person’s entitlement.

> This service may save the adviser valuable time in conducting their own research, particularly if the client’s circumstances are unusual.

> They generally will not do calculations on a person’s eligibility for a benefit, payment or pension, but will



advise on how the decisions they may make will affect the Centrelink payment they wish to apply for.

> Information provided by the FIS officer will need to be recorded in a file note including the date and the officer’s name.

> While much of the published information regarding FIS and its officers relates to retirement clients, they are also able to provide information on many other situations including how certain investment decisions may impact upon payments available to families. In fact, the majority of FIS customers are wage earners not in receipt of Centrelink payments or services.

> For example: how holding investments in one person’s name or joint names may affect the benefit payment, other examples include family trust distributions and entitlements, family company share holdings and dividend payments.

> A FIS officer will assist clients (and advisers) in understanding their financial affairs and the options available to them.

Centrelink also produce booklets, brochures and flyers that can help educate both advisers and their clients on general issues concerning entitlements and changes to circumstance. Calling on assistance from a Centrelink FIS officer is often a wise move when advising on social security benefits.

Quicklink

For more information on the brochures and booklets that Centrelink make available to advisers and clients, refer to Centrelink’s website at www.centrelink.gov.au

> select ‘Publications’ from the left navigation tool.

Wrap up Central to the work of many financial advisers is informing retirees on ways to maximise Centrelink entitlements. Yet sometimes it is other areas of financial planning, such as selling an asset, commuting from income streams, or moving into an aged care facility that can have a significant impact on a client’s social security benefits.

Aspects of Centrelink policy discussed in this article that deserve careful consideration for clients who are age pensioners include:

> the requirement to notify Centrelink of changes in financial circumstances within 14 days of the changes taking place

> the specific details when assessing eligibility for the Pension Bonus Scheme

> the limitations that restrict how much pensioners can gift to a third party


http://www.centrelink.gov.au/internet/internet.nsf/home/index.htm


> the effects of commuting an income stream

> how insurance bonds are assessed under both the income and assets test

> the consequences of selling their home or borrowing against the family home

> what to do when a pensioner dies

> what exemptions are available to those going into aged care

> the effects of initiating a transition to retirement strategy.

Financial advisers need to stay up to date with the latest legal requirements affecting Centrelink customers, and also communicate the risks associated with strategies that might have an impact on a client’s Centrelink benefit.


> Jeannie Feng, Technical Services Manager, Asgard Wealth Solutions

> Leola Mollica, Adviser, Isis Financial Planning

DISCLAIMER



October 2008

Income producing products

OverviewIn the current economic environment, equity markets are volatile and Australian property markets and traditional yield investments such as listed property trusts (LPTs) have slumped in response to rising interest rates. As a result, investors are pouring into cash and fixed interest, also referred to as income producing investments. Savers and income investors appear to be reaping the benefits of higher interest rates with little risk attached, depending on the product selected. But are income producing products the safest bet in terms of yield in the current environment? And what are the risks that clients need to know about?

Did you know?

History tells us that the best time to invest in fixed income is at the end of a tightening cycle or when the official cash rate is at its cycle peak.


> Explain the benefits of higher interest rates in the current environment.

> Outline the range and features of income producing investments.

> Compare income generated from cash based and fixed interest products with income from equity products.



> Deposit products and non-cash facilities (15 minutes)

> Fixed interest (45 minutes)



The benefits of rising interest rates In the current economic environment, investors are witnessing high interest rates and share market volatility, combined with a depressed property market. As a result, they are turning to income producing products such as term deposits, high-yield accounts, debentures, hybrids and bonds. Campbell Dawson from Elstree Wealth Management says there is no better time than now to invest in these products, ‘This is the best credit market in the world at the moment, with yields of around 11–12% and inflation of 2–3% over the long term’. According to Dawson, this reflects a great return compared with historical standards.

In a concerted effort to fight rising inflation over the past 12 months, the Reserve Bank of Australia (RBA) has largely continued the trend of raising interest rates, with the official cash rate now sitting at 7% (following a 0.25% drop on 2 September), just below the seven-year high reached in June of 7.25%. The combination of high interest rates and increased wholesale funding costs has prompted Australian banks to raise their mortgage rates. Savers and investors in income producing products are the ones benefiting from exposure to products that have limited risk attached. When debt was relatively inexpensive a year or two ago, returns at approximately 8% would have been considered a high-yield investment with a relatively high level of risk attached. Today, some banks offer interest of 8% on at-call cash accounts, which are almost risk free.

Investors in floating rate or cash rate products have benefited from the rise in interest rates, compared with those who invested in fixed interest products that commenced some time ago. ‘This is because the income that they’ll get from these products will rise as the floating rate or cash rate goes up. In some cases when interest rates rise, people who have fixed-rate coupons will see the value of those securities fall but, in general, most investors in Australia are exposed to floating rate interest’, Dawson said.

Income investors can also benefit by purchasing risk-free, 5 to 10-year Australian government bonds, which hit an eight-year high of 6.75% in June, and have since retracted to 5.75%. State government bonds (also known as semi-government bonds or inscribed stock) and corporate bonds are also trading at higher yields, with other listed income products offering good value as well. Investors can access these products through the Australian Securities Exchange (ASX) interest bearing securities market, which offers a wide range of yields and credit ratings.

The reasons for rising interest rates The higher interest rates currently available have resulted from a number of factors including:

> the credit crisis resulting from the sub-prime mortgage crisis in the United States

> Australia’s strong economy over recent years

> an increase in costs, most significantly fuel and food costs.

October 2008 Page 2 of 13


The credit crisis The credit crisis has led to a tightening of the global credit market and Australia has not been immune. The drying up of global credit appears to have forced Australian banks to offer higher interest rates on their savings accounts and term deposits, to increase deposits as an alternative source of funding. ‘Banks were big borrowers in offshore markets so they typically borrow around 30% of what they need from offshore markets. The sub-prime credit crisis has basically meant those markets are closed, or are much more closed than they were last year, so they have been forced to come back to Australia to borrow here, and the only way you can borrow more is by putting the rates up. So, it’s good for investors because bank rates are now well above what you’re getting from an official cash rate’, Dawson said.

Tony Lewis, from Lewis Securities, says it wasn’t just the credit crisis that lead to the increase in rates, ‘they [bank rates] partly reflect higher RBA official interest rates, and partly reflect the increased cost in wholesale markets to the banks and their profit margins, because if banks can borrow cheaper from retail [markets] than they can from the wholesale market, they will’.

Australia’s economy In recent years the domestic economy has been strong, buoyed by a resources boom and full employment, which, combined with the rising costs of food and oil, has helped drive inflation higher.

The outcome … In early September, the RBA cut official interest rates for the first time in almost seven years, lowering the cash rate by 25 basis points to 7%, from 7.25%. Dawson says, ‘We can expect interest rates to stay high while the RBA remains worried about inflation. Currently we’re running some of the highest interest rates in the world. New Zealand was probably a little bit higher but they’ve cut rates, so there is likelihood that in 3-4 months time, we’ll have the highest interest rates in the developed world’.

Australia’s five biggest lenders reduced their mortgage rates in line with the RBA’s September rate cut, but they continue to maintain high mortgage rates in response to increases in wholesale funding rates following the near collapse of the global securitisation market.

Effective product solutions The exposure clients have to any particular asset class is largely dependent on their risk tolerance and risk profile. Each asset class offers a particular mix of risk and return over time, but at the moment it seems that defensive assets such as cash and fixed interest investments are among the safer investments. Currently, some of the banks are offering high-yield cash accounts (variable market rates) and term deposits (paying fixed market rates), where money is held at call, or has a maturity of anywhere between six months to five years. The range of rates on offer is approximately 7%–8.5%. A depressed property and fluctuating share market have also seen investors flock to high yielding savings accounts, such as the online versions offered by bank and non-bank providers.



These types of products are an appropriate choice for investors who are risk averse and want higher yields than those available from government bonds, while maintaining a high degree of security. All the banks are highly rated, and there is an implicit guarantee from the government that if a bank failed, the RBA would step in to ensure that customers received their money back.

Government bonds Government bonds or semi-government bonds are also an option for the risk-averse investor as they are considered secure with little chance of a default, because investors are basically lending money to the Federal or State governments. In return they receive:

> a fixed rate of interest until a set date or the bonds mature

> the face value of the bonds upon maturity (or market value if sold prior to this in the secondary market).

Currently, government and semi-government bonds are delivering approximately 6–7% p.a., and these rates can be locked in for longer periods of time. But the yield is probably approximately 3–4% less than buying a major bank hybrid. Some economists have also forecast further falls in bond yields as global growth slows and lower oil prices takes the pressure off inflation. Government and semi-government bonds can be difficult for retail investors to access due to the amount of capital needed to initially invest. Traditionally, retail investors access the fixed interest market by investing into a fixed interest managed fund.

Corporate bonds Corporate bonds are a growing part of the Australian fixed interest market. They are bonds, generally with a maturity of between two years to seven years, issued by companies. Although the majority of the issues into the Australian market are completed by Australian companies, international firms may also choose to raise money in our market to fund various Australian based projects. Conversely, Australian companies also raise debt funding from overseas markets, to fund projects overseas.

Corporate bonds offer a higher rate of interest than government bonds, but they also carry more risk. By investing in these, investors lend money to a company that wants/needs to raise funds. The benefits include a regular interest payment during the term of the bond and then the return of the initial capital investment at maturity. Corporate bonds are both unlisted and listed. As with government bonds, the amount of capital required may make it difficult for retail investors, so investing in a managed fund is one way that retail investors can achieve exposure.



Figure 1: Bonds issued in Australia

Source: RBA Chart Pack, 2008.

Hybrid securities Currently hybrid securities are another popular investment option, but they often carry more risk. Hybrids are predominately issued by the ASX top 100 companies. There are a number of different types of hybrids available in the market, although each has individual characteristics. Hybrids combine both debt and equity characteristics and pay a fixed or floating rate of return until a certain date. At that date, the holder has a number of options, including converting the securities into the underlying share or taking the cash. While the price of some hybrid securities behaves more like fixed interest securities, others behave more like the underlying shares into which they convert.



Quicklink

For more information on interest rate and hybrid securities, refer to the ASX’s website at www.asx.com.au

> select ‘Interest rate and hybrid securities’ from the left navigation bar.

‘We are seeing a few people who are realising that on some of the hybrid securities and corporate securities, you can buy them and get virtually equity returns, and we have a few people who have been cashing in shares and buying the higher yielding fixed interest securities, and know that they can buy a portfolio of stocks and probably get 15–20% per annum’, Lewis said.

For example …

Recent examples of hybrid securities offering competitive yields include the issue of convertible preference shares by Macquarie, Westpac and Suncorp. As Campbell Dawson points out, these shares were issued with yields above 10%; 2.5% above the current bank bill rate, which currently stands at approximately 7.75%. Although these securities carry a little more risk, for those clients who are comfortable with this, this could be considered a reasonable longer-term investment.

When investing in hybrids it is important to have:

> a one to two-year time horizon, particularly in the current environment

> a diversified portfolio.

‘It’s been the highest yields we’ve seen since 2000 but you’ve got to be able to sit it out; understand there is going to be a bit of volatility and they may get cheaper. You don’t want to have to sell them in six months time, so that’s probably the biggest risk you’re going to face’, Dawson said.

One risk with hybrids that has been highlighted recently is that many of the hybrid preference shares have discretionary income payments because they pay dividends with franking credits and are all subject to companies earning sufficient profits to be able to pay those dividends, ‘There is a risk, and it’s not been assessed yet by the marketplace, that some of these companies could pass on some of these distributions and dividends. We’ve been arguing for years, talking to a brick wall just about issuers issuing cumulative dividend payment securities. However, they keep getting away with non-cumulative securities so that if, for some reason, a company doesn’t pay a dividend in one period, you just don’t get it back again later on,’ Lewis said. The terms and conditions of each hybrid are different and need to be carefully analysed in terms of risk to the investor.


http://www.asx.com.au/index.htm


Figure 2: Issued hybrid securities in Australia and offshore

Source: RBA Chart Pack, 2008.

Managed funds Fixed interest funds invest in securities offered by governments, semi-government bodies and companies. Generally, fixed interest managed funds offer higher returns than cash and limited capital growth. Fixed interest exposure is also available globally, in addition to securities offered on the Australian market, to further diversify a portfolio.

Investing in a managed fund can expose investors to a wider range of products, including hybrids. ‘Now, it’s not feasible for a private investor to buy, for example, 35 individual hybrids and manage them, but if they don’t do that, they miss out on that diversification benefit. If you’re buying high risk ones, it’s an actual diversification necessity. So if you’re basically buying credit instruments, you have to be diversified … and what fund you should buy will depend on your risk profile and whether the fund suits that—most funds will be appropriately diversified’, Dawson said.



Consider …

Mortgage funds as an alternative to fixed interest exposure?

One important consideration when looking at fixed interest investments is the fact that the price of fixed interest falls on an increase of market interest rates. Interest rate rises have the same affect on share investments.

This leads to a potential problem in a standard portfolio, i.e. the same risk (interest rate risk) affects both major components of a portfolio in the same way and as a result the diversification benefit of having fixed interest securities is reduced.

Mortgage funds may provide a partial solution to this issue. Good mortgage funds use investor money to lend to mortgage lenders as first mortgages, usually at comparatively low ‘loan to valuation’ ratios. This results in a low default rate and a relatively steady and known income payment.

In addition, when interest rates rise, the returns from variable rate mortgage funds generally rise. This may provide some much needed diversification benefit in a share and fixed interest portfolio.

It must be remembered, however, that mortgage funds are made up of portfolios of mortgages and their reaction time to interest rate changes may lag by up to two years, depending on whether the loans advanced by the mortgage fund are on a variable vs. fixed interest rate basis. They are also vulnerable to risk of mortgage default, which, depending on its size, may cause the unit price to fall below its base $1.00.

This is particularly an issue in the current low interest rate environment as the mortgage fund performance rate will only be 0.5 - 2% greater than the cash rate.

The outlook for other products Given the volatile environment in the Australian share market and property sector over the past year, it appears that the income from cash, fixed interest and other interest rate securities is producing a better yield than many other asset classes, at least for the moment.

Australian shares Australian shares have declined some 28% from their peak, and some commentators are forecasting further weakness towards the end of 2008 as the global economic downturn feeds into more profit downgrades, particularly for cyclical sectors. After rising more than other major indices over 2007, the ASX 200 has underperformed in 2008. A number of company earnings downgrades are expected to affect dividend payout levels. Investors need to look carefully at dividend cover, not just potential yields.



Listed property trusts Listed property trusts (now known as A-REITs) have been a traditional source of strong yields and, for that matter, so have infrastructure funds, but the credit squeeze has impacted on them in a significant way.

‘Recently we’ve seen, and we’ll continue to see, all property-based entities reducing their distribution and dividend pay out. They might look at it historically but, going forward, that income stream might be dramatically reduced. The other typical high yielding areas have been banks and insurance companies; IAG has just reduced its payout ratio with some chance that banks might reduce dividends as well, particularly if there is concern about credit losses or if they need to increase capital. A lot of bank dividend yields look really attractive and they may well stay and continue to be attractive, but the important thing is that they are variable and they can be changed’, Dawson said.

Tony Lewis comments that the property trust sector may take some time to recover from the recent market woes, and due to increased borrowing costs, their ability to pay distributions may be compromised or even discontinued. This may lead clients to turn to more reliable sectors such as cash and fixed interest.

How an adviser can help While it is good to compare the pros and cons of cash, fixed interest and hybrids, it is important to build a diversified portfolio. Tony Lewis suggests that when preparing a portfolio for clients that includes exposure to fixed interest investments for income producing purposes, ‘… take a portfolio approach—you’ve decided to buy X% of your portfolio in fixed interest for economic income. You should get a spread by issue, or a spread by year of maturity, or by regularity of income payment, but it’s all spread. The next thing to look at is the client’s need for income—where income from shares and property trusts is likely to be low for a couple of years, or lower than we have been used to, if a client requires $X income, then you need to maybe allocate $Y of a portfolio to produce that $X income into forms of fixed interest and we can help people construct a portfolio of fixed interest at super safe, or higher yielding securities, or a mixture of both. Then it’s the rest of the portfolio that can then go into shares or property or non-income discretionary investments, rather than the approach that a lot of financial planners have, which is putting X% of shares, Y% to fixed interest, Z% to overseas; because that formula approach is unlikely, in the current environment, to produce the required income for the client’.

Advisers have a responsibility to manage their clients’ expectations during these volatile times and there are a number of important points that need to be covered when having these discussions with clients:

> comprehensively outline the risks involved with all investment types and products, along with the benefits and consequences of these risks

> ensure that clients have a full understanding of the relevant risk profile

> explain the loss of income if interest rates fall in the short to medium term

> explain market volatility

> discuss the benefits of diversification.



Product risks It’s also important for advisers to ensure their clients understand that if some products are higher yielding than others, the risks will also be high. These risks might include:

> credit risk, which is whether a product provider will be able to pay coupon payments and the principal initially invested

> liquidity risk

> market risk.

Risk profiles Understanding a client’s risk profile is even more important when markets are volatile. While the yields are great for a lot of the hybrids and financial products, it’s a one or two-year term and investors need to be happy to hold on to them for that period to generate the optimal return.

Falling rates So what are the risks for investors in the short to medium term? Dawson points out that one of the risks faced by short-term investors is the reduction in income if the RBA continues to lower interest rates to manage the economy. The potential for a loss of income is something that clients need to be aware of.

Market volatility It’s also necessary to ensure that a client is fully aware of the market’s current fluctuations. ‘We’re in the top decile of volatility and although things might be cheap, they are volatile and that’s the trade off you’re getting, so financial planners need to be cognisant of the fact that the there is extra volatility and the only thing that can solve that for fixed interest products is that you’ll get your return over time—but you won’t get it over one or two months. If you’re looking for a low volatility income sector, bank deposits are a great idea … if investors understand fully what they’re getting into, it’s a good time to be buying credit’, Dawson said.

On a final note, it is important that investors are aware that if they have their funds locked up in fixed interest or other income producing products, and equity markets look like they have bottomed, then the real long-term gains of exposure to equities may be unavailable to them. Again, the benefits of a diversified investment portfolio across all equity classes and a long-term perspective cannot be forgotten in the rush to gain from short-term yield.



Consider …

What can an adviser do to ensure that the investor’s perception of the products is accurate?

> Many clients misunderstand the potential risks of fixed interest products, so it is important to ensure that they understand exactly what they are investing in, and that they are not misled by their own perception or by advertising.

> Explain the risks involved and how their money is going to be used. Many find it difficult to understand the concept that they are lending money to the provider, and this might be something that the investor has not experienced before.

> Time and effort needs to be taken when helping clients to understand hybrid and structured products.

> Many clients simply trust their adviser and don’t question them. While this may sound like a good client/adviser relationship, it can cause problems down the track when investment returns don’t meet with the client’s expectations.

> Ask the client to explain what a particular risk means or involves, check their understanding, and/or ask them relevant questions, listening carefully to their responses.

> Where couples are involved, the adviser needs to ensure that both members of the couple understand.

> From a compliance perspective, keep copies of any diagrams that were drawn or notes that were taken during the interview in the client file, and maintain detailed file notes of the efforts taken to ensure the client’s understanding.



Wrap up The volatile times and poor equity market performance of late have seen investors focus on cash and fixed interest investments, where high interest rates are available. As Campbell Dawson pointed out, we currently have the best credit market in the world.

The high interest rates have resulted from:

> the credit crisis resulting from the sub-prime mortgage crisis in the United States

> Australia’s strong economy over recent years

> an increase in costs, most significantly fuel and food costs.

In this environment, investors wanting to reduce risk and earn higher yields can consider:

> government bonds

> corporate bonds

> hybrid securities.

Advisers have a responsibility to manage their clients’ expectations during these volatile times and there are a number of important points that need to be covered when having these discussions with clients:

> comprehensively outline the risks involved with all investment types and products, along with the benefits and consequences of these risks

> ensure that clients have a full understanding of the relevant risk profile

> explain the loss of income if interest rates fall in the short to medium term

> explain market volatility

> discuss the benefits of diversification.

Diversification is still the key to weathering tough market conditions. It is important to be aware of what different markets are earning to ensure that appropriate exposure for clients, within their determined risk profile, is established at all times.

References Australian Securities Exchange (2008), Hybrid debt securities. Available at www.asx.com.au [cited 21 August 2008].

Baker, P. (2008), ‘Time to consider hybrids but be selective’, Australian Financial Review, 28 June.

Dunn, J. (2008), ‘Good terms—getting the best for your savings’, The Australian, 9 July.

Gottliebsen, R. (2008), ‘Safe solid yields’ Eureka Report, 21 July.

Kavanagh, J. (2008), ‘The flight to safety’, Sydney Morning Herald, 23 July.

Reserve Bank of Australia (2008), ‘Statement on Monetary Policy’ 9 May. Available at www.rba.gov.au [cited 22 August 2008].

Turek, D. (2008), ‘Cash: the deceptive security’ Eureka Report , 24 July.

Tribe, N. (2008), ‘Changing channels: tuning into fixed income funds’, Money Management, 11 September.


http://www.asx.com.au/

http://www.rba.gov.au/



> Tony Lewis, Managing Director and Dealer, Lewis Securities

> Campbell Dawson, Director, Elstree Investment Management

DISCLAIMER



March 2009

Asset allocation in troubled times

Overview

Although the global financial crisis has caused many clients to be concerned about the state of their investments, it doesn’t mean that financial advisers were necessarily wrong in the decisions made around asset allocation, provided that a client’s risk profile, objectives and investment timeframe have been taken into consideration. However, the crisis does highlight the need to ensure that client portfolios are properly allocated to withstand market volatility. This may require some ‘rebalancing’ of portfolios. There may be certain cases where exposure to specific product groups within asset classes will need to be changed; however, the exposure to the overall asset class should not necessarily change unless the client’s situation alters.

Did you know?

The sustained bull market in Australian equities before the downturn in 2008 was driven by a boom in commodity markets. During this time, investors who didn’t rebalance their portfolios certainly benefited; however, they also became over-exposed to equities.

Learning objectives


> Discuss how to respond to market volatility in terms of asset allocation.

> Consider the different asset allocation strategies, both short- and long-term, that can be used in volatile times.

> Identify how financial advisers can avoid missing the recovery in financial markets.


Knowledge areas



> Managed investments (15 minutes)



Recent market turmoil

The current financial crisis has caused much angst among investors, especially those who are heavily involved in the stockmarket. The volatility of the past six months has meant that many financial advisers have been inundated by phone calls from anxious clients wanting to opt out of volatile investments and change their asset allocation, prompting the question ‘Is there a correct allocation mix?’.

Declining values across asset classes, weakening investor confidence and relatively high interest rates in mid-2008 has led to many investors favouring cash. To help provide some stability in a nervous market, the government stepped in and introduced a three-year guarantee on bank deposits. This encouraged investors and superannuation funds to stockpile cash, but it also had the effect of making cash products offered by non-bank providers appear riskier because they were excluded from the guarantee.

Additionally, some fixed interest products with higher yields (such as mortgage funds) became less appealing due to their higher levels of risk and exclusion from the guarantee scheme.

Recent bull markets have seen a reduction in portfolio allocation of fixed interest products. A balanced portfolio in a superannuation fund may have held 20% of assets in fixed interest products 10 years ago, whereas this is now down to around 9%. This also reflects the fall in the number of government bonds issued to the market, resulting in fixed interest allocations redirected towards alternative assets, which added to greater portfolio volatility.

Recent market turbulence is causing financial advisers to move away from assets such as emerging market equities, private equity and alternative investments. Instead there has been a return to more traditional portfolio allocations, consisting largely of Australian equities and, to a lesser extent, international equities.

Back to basics

Despite the market uncertainty, the traditional approach to asset allocation that a financial adviser has should remain based on solid foundations, which take into account a client’s:

> risk profile

> goals and objectives

> investment timeframe.

It is crucial that advisers listen to a client’s attitude towards these issues. To build a portfolio that matches key objectives with the appropriate assets, the adviser might like to ask themselves, ‘What does my client want to achieve and how comfortable are they with the level of risk undertaken to get them there?’.

Responses to the market

While the approach to deciding asset allocation remains the same, the current conditions present not just a challenge to pick well performing investments, but an opportunity to revisit a client’s risk profile. Adam Dawes from Shaw Stockbroking explains, ‘Some risk profiles should be changing and there is some talk out in the market that the long-term investor “buy and hold” type strategy will not work at the moment due to the volatility’.



While the asset allocation should reflect the client’s risk profile, Dawes says that changes may need to be made to portfolios to ensure that client goals are achieved. For example, to meet the needs of an investor who seeks income from their assets, ‘We’re seeing listed property trusts coming off and hence distributions have been coming off, so even a long-term income style investor should definitely be looking at the different asset allocations going forward’.

Increasing the amount of time spent with a client and monitoring their portfolio can also ensure that the asset allocation doesn’t detract from their goals and objectives. For advisers and stockbrokers, this might mean having quarterly reviews instead of an annual review in order to gain a really good understanding about how things are changing and also to reassure their client about the management of their assets.

‘In the world of stockbroking, we’re monitoring clients’ portfolios on a daily basis and trying to keep up with the changes that are going on consistently in the market. The market is so volatile that what happened last week will not happen again and it will just continue to move on. Advisers should definitely be looking at asset allocation and revisiting that on a regular basis to try and keep the client up to date with what’s going on’, Dawes said.

Short-term stop gaps

Most licensees set asset allocation strategy benchmarks to guide their advisers in the strategic allocation of the client’s funds over the long-term. If a client’s asset allocation strategy is correctly matched to their risk profile, goals, objectives and timeframe then that will help achieve the long-term goals of the portfolio. Correctly matching a client’s needs reduces the chances of misallocation, inappropriate exposure to risk and subsequent effects on returns.

Rebalancing

Strategic asset allocation accounts for the majority of returns achieved over the long-term, so it is also critical that a client’s portfolio doesn’t become too weighted towards ‘trendy’ high-performing asset classes. Rebalancing back to the strategic asset allocation is a good way of capturing the long-term characteristics of asset classes and it ensures that a client doesn’t stray from an appropriate weighting of the portfolio.

For example …

For example, if a client has a 70% exposure to shares within their portfolio and stock prices move up over time, the value of the equity portion of the portfolio will change, and will represent a larger proportion of the total portfolio. In this case, a rebalancing strategy will force the investor to sell shares and reduce their stock allocation when the market is high.

On the other hand, if the proportion decreases, rebalancing will require investors to buy more shares, which means they're most likely to be buying when a market is lower.



Annette Vlismas from Russell Investments said there are a number of ways to rebalance a portfolio, ‘One method is to use cash and invest back into equities. Another way is to use the cash distributions, or any form of capital distributions that a managed fund is providing, and directly top up that equities weighting’.

While there is no definitive strategy that is low risk but guarantees high returns in the short-term, Russell Investments offers five different types of rebalancing strategies for consideration.

1. Let it ride — if a client doesn’t follow a rebalancing rule, the market will usually do the job for them.

2. Adopt the ‘Robin Hood’ strategy — take from the rich (higher performing)

assets. However, by selling investments that have increased in value, clients may be liable for capital gains tax on any realised profits.

3. Change the way future contributions and investments are allocated to the

portfolio. This is particularly suited for regular superannuation contributions.

4. Buy new units in the underperforming asset classes. If the client doesn’t have new money to put to work, consider having the funds’ income and capital gains distributions paid into a bank account, then using that cash for rebalancing.

5. Large superannuation and managed funds may also use futures to rebalance.

Advisers shouldn’t rebalance portfolios by moving assets based on what they think may be the next ‘hot spot’ of the market, but rather adjust their client’s portfolio to ensure it keeps in line with their client’s risk profile and associated objectives.

Case study: Rebalancing

The sustained bull market in Australian equities from 2004–2007 was driven by a boom in commodity markets. During this time investors who didn’t rebalance their portfolios certainly benefited; however, they also became over-exposed to equities.

Figure 1 shows a sample portfolio which allocated 70% to Australian equities and 30% to Australian bonds in 2003. It would have had an 83% Australian equities exposure by 2007, with only 17% in Australian bonds. By July 2008, the domestic share market began to tumble and investors who held this position without rebalancing would have suffered huge losses.



Figure 1: Effect of not rebalancing during the bull market

* The model portfolio above begins with an asset allocation consisting of 70% Australian shares and 30% Australian bonds.

** Yearly returns and subsequent portfolio reweighting is based on calendar year index returns for 2003–2007.

The Australian shares index used is the S&P/ASX 300 accumulation index, the Australian bonds index used is the composite bond index.

Source: Russell Investments, 2008.

There are clearly a number of different views in the market at the moment about where the best place is to invest in the short-term.

One thing that cannot be denied is that many assets that contain higher risk (for example shares and different types of debt securities) are very cheap at the moment compared with historical averages and could therefore represent good value. ‘One of the actions of trying to factor in uncertainty is you reduce the prices of the risky assets. If you consider equities, over time, they have tended to average a return of 4–5% better than cash. I think it’s a big decision to say that history is not going to repeat itself and show a rebound in equities,’ Vlismas said.

If history is right then rebalancing to ensure that clients are not underweight in equities is a good strategy for the short-term as it should ensure that investors don’t miss the recovery when it happens. Simon Doyle from Schroders explains ‘One of the things we’re thinking a lot about is the overall reliance on equities in portfolios, so we are looking at building portfolios that have less dependence on equities than the sort of 60/40 (growth/defensive) or the 70/30 (growth/defensive) model would suggest. I think the next two to three years are going to actually be ones where credit assets deliver very good outcomes for investors for much lower risk than equities within their portfolios.’

However, the decision to reallocate also depends on where a client is situated in their investment cycle. Whether they are close to retirement or in a wealth accumulation phase will affect the implementation of this.



Up until recently the Australian economy has been strong. This has helped boost investor confidence and fuel the assumption that the prices of equities always go up. However, the return on United States equities after inflation for the period between 1966 and 1982, was zero. Therefore an investor who had a 70% growth/30% defensive mix in their portfolio would have achieved very poor returns.

Difficult choices

Today, many investors are feeling the effects of a dramatic economic crisis; company earnings are likely to be under pressure and credit is scarce. Global economies are in de-leveraging mode, and economic growth around the world is predicted to slow down significantly.

‘It’s going to be a tough environment for equities, so I would expect that while we will see swings in equity prices that are quite pronounced, the broad trend with equities is going to actually be quite poor, so investors that are locked into a strategy which is basically relying on equity markets going up every year for the next 10 years are going to find their portfolio struggling,’ Doyle said.

However, the return on cash has already declined quite sharply in recent months. Economists are predicting that in 2009, interest rates will most likely sit between 2% and 3%. If this proves correct, cash could well be one of the poorest performing asset classes in 2009.

‘It used to be that cash was the safest in the market and you would never lose your money. A lot of cash products, to get a higher rate of interest, are investing in mortgage-backed securities or investing in something else that will try and lift that rate. I think cash is a fantastic investment, but it doesn’t work for you over the longer term and I think equities will outperform any other product that’s in the market at the moment’, Dawes said.

Fixed interest is also presenting a number of investment opportunities at present, with many banks releasing new hybrid issues that are trading at serious discounts to the market at the moment.

The current market has also opened up opportunities in assets that have since been re-priced and where there is a risk premium. ‘Today we have the Australian hybrid market that have substantially re-priced and are pricing-in a substantial risk premium, so capturing that risk premium or the risk premium that’s available in credit assets now makes sense. We’d probably argue it’s a much less risky time to be invested in say credit than it was a year ago,’ Doyle said.

Long-term strategies

Long-term asset allocation strategies are focused on being able to lower the overall risk of a client’s portfolio, provide further diversification and produce higher returns.

However, because of the current environment of poor returns across all asset classes, investors need to be careful that they don’t panic and make hasty decisions to change their long-term allocations into what seems safer. Simon Doyle recommends shifting a client’s exposure towards those assets that have been beaten up the most:

‘If we were to have more than our normal amount of money allocated to a particular part of the portfolio, we would allocate into credit. That might seem a little counter-intuitive because that’s where most people are worried about at the moment, but often it’s when people are worried that the best opportunities actually present themselves.’



In equity markets, Adam Dawes believes that blue chip stocks remain a good long-term investment as they’re relatively cheap, and provide a good buying opportunity:

‘Obviously materials, resource stocks and financials will fluctuate in the current environment. However, the Biotech sector is still looking quite good and even the consumer discretionary sector.’

The performance of fixed interest will depend on credit conditions. However, the current environment has seen a flight towards government bonds because they are perceived to be safer, regardless of their future return prospects or the change in price that could occur.

‘The government bond market is now pretty much fully priced for very low rates of interest or very low cash rates. In contrast, credit markets have been moving in the opposite direction, so I think there are good opportunities in credit markets, right across the credit curve from very high-quality pay-rated bonds, triple B rated, still investment grade, through into the sub-investment grade space where investors have sold assets to an extent where prices have fallen probably too much’, Doyle said.

Managed funds are also providing another investment opportunity at the moment for clients who feel ill-equipped to do their own asset allocation.

The recovery

It is impossible to time the market. As the saying goes, ‘No one rings the bell when the recovery is happening, and no one rings the bell when the market reaches its top’.

It will probably take some time before the current turmoil eases and the global financial and banking systems recapitalise. Another uncertainty is whether the action being taken by governments and central banks — so far, cutting interest rates and handing out stimulus packages — will be enough to kick-start economic activity.

Annette Vlismas reminds us that markets do rebound eventually, and that it can happen in the first 12 months after a period of a sharp correction:

‘Markets always look ahead, they deal with the current conditions, but then they always start to look ahead to what 2009 might be offering and, at the moment, the way share markets are pricing the earnings for companies for 2009, they’ve pretty much factored in a sharp decline in corporate profitability, so it would only be any lingering doubts about whether there’d be a further contraction in company profits that would stop share markets from stabilising and credit markets themselves starting to thaw’.

There have also been signs of a possible recovery.

For example …

For example, Vlismas says, ‘The banking system has seen the rates fall where banks are lending to each other; you can see that by looking at the 90-day bank bill rate, it’s starting to come down and all of those signs would be positive for the credit markets starting to thaw and credits starting to be used by companies and activity getting back to a more normal pace.’



In the meantime, these glimmers of recovery certainly do not mean the market has bottomed. Many companies are already downgrading their earnings forecasts, and governments, including Australia’s, have announced a raft of spending measures in a move to stimulate the economy. Central banks have also been lowering the cash rate target for interest rates.

Consider …

Simon Doyle believes it may be the second half of 2009 or even 2010 before we actually start to see the sustained signs of recovery working through the global economy:

‘Can equity markets recover in that time? Yes, I would expect them to. Equity markets have already discounted a very weak economic outlook. They’re already toying with the idea of an economic outlook that’s weaker than in recession, so a lot of bad news is priced in. Equity markets typically lead the recovery in an economy.’

One of the obvious challenges for advisers is to remain objective and try to allay their cilent’s concerns about their portfolio. Markets will fluctuate, and people naturally do panic, but timing and patience will be critical in the months ahead. Financial advisers need to look at the value for money in investments in order to see the opportunities.

Wrap up

The global financial crisis has highlighted the need to ensure that client portfolios are properly allocated to withstand market volatility. This may require some ‘rebalancing’ of portfolios. There may be certain cases where exposure to specific product groups within asset classes will need to be changed; however, the exposure to the overall asset class should not necessarily change unless the client’s situation alters.

Recent market turbulence is causing financial advisers to move away from assets such as emerging market equities, private equity and alternative investments. Instead there has been a return to more traditional portfolio allocations, consisting largely of Australian equities and, to a lesser extent, international equities.

However, because of the current environment of poor returns across all asset classes, investors need to be careful that they don’t make hasty decisions to change their long-term allocations into what seems safer. Advisers need to revisit a client’s asset allocation on a regular basis to keep the client informed of changes in the market.

References

Hoyle, S. (2008), ‘Unstress and shift the risk’, The Age, 18 October.

Oderberg, I. (2008), ‘Goodbye Mr Gekko’. Available at www.businessspectator.com.au.

Russell Investments (2008), ‘Don’t lose your balance’, Investor, November. Available at www.russell.com.





Simon Doyle, Director — Fixed Income and Multi-Asset, Schroders.

Adam Dawes, Head of Portfolio and Financial Services, Shaw Stockbroking.

Annette Vlismas, Client Portfolio Manager, Russell Investments.

DISCLAIMER







August 2008

Insurance bonds in the new regime

OverviewInsurance bonds have been around for years, yet are often overlooked for newer, ‘sexier’ products. The ‘simpler super’ legislation and the recent changes to aged care rules have brought about some opportunities to use insurance bond strategies, especially in the areas of estate planning or arranging social security. Combined with the flexibility and tax advantages that insurance bonds can offer, these stalwarts of financial planning are looking like they will die another day …

Did you know?

Insurance bonds are often considered a ‘tax-free’ investment. However, although the owner of the bond pays no tax for the duration of the bond, the life insurance company or friendly society is taxed at 30% each year on earnings. This tax too, is often offset by franking credits.


> Discuss the features of insurance bonds.

> Outline the tax advantages that insurance bonds offer.

> Examine how insurance bonds can be used for effective estate planning and social security strategies.



> Estate planning (15 minutes)


> Managed investments (15 minutes)



What is an insurance bond? An insurance bond is an investment instrument that combines the security of a managed fund with the tax benefits of a life insurance or friendly society provider. They are most commonly a single premium life insurance policy, and have historically been a staple of financial planning strategies.

How insurance bonds work A client purchases a 10-year insurance bond, and the life insurance company or friendly society invests the proceeds in a range of investment options chosen by the client. The variety of choice will depend upon the product provider. The return offered to an investor by an insurance bond is generally treated as capital rather than income. Ross Higgins, Managing Director of Austock, points out, ‘The increase in unit value is a capital amount. It’s only if you deal with it in 10 years that it becomes income, but because it produces capital when you invest into one you can’t get a tax deduction producing capital.’

The earnings within an insurance bond do not have to be declared in an investor’s tax return unless a withdrawal is made within the first 10 years. Investors are normally free to switch between the range of investment options within an insurance bond, without incurring personal tax consequences. Proceeds from the insurance bond can be withdrawn in part or in total at any time.

A tax-effective investment The taxation of insurance bonds is similar to the taxation treatment of investment earnings within superannuation, except that the life insurance company or friendly society pays the corporate rate of tax (30%) on the investment earnings of the bond. It is important to note that this process means that insurance bonds are tax-paid, rather than tax-free investments, because although the investor will normally have no personal tax liability on the earnings of the bond, the tax is paid by the product provider.

Tony Jacob, Chairman of the Tax Committee, Friendly Societies of Australia, points out the main tax advantage of an insurance bond is that:

‘Monies are set aside and during the period of saving are not counted as your money and the income earned is not counted as your money for tax purposes but, really, it is your money and you get the benefit of that money when you draw on it.’

This means that extra income can be earned by the client from the differential between their personal or marginal tax rate and the corporate tax rate. ‘Because the bonds effectively produce capital, they don’t produce income, they have no assessable income and that’s a really interesting feature of the product’, said Higgins. Upon maturity, after 10 years or upon death, there will be no further individual taxation.

The abundance of market-linked insurance bonds on offer over the past decade has given investors an array of investments, including cash. Ross Higgins refers to these bonds as ‘tax paid masterfunds’ as they offer the investment choices of a masterfund, but the tax advantages that insurance bonds have historically provided. ‘Modern insurance bonds have lots of options, such as an imputation bond product that has 25 options under the one insurance bond; [this] will allow an investor to move from one option to another, say from cash to Australian equities or whatever it may be, and there’s no tax or capital gains tax implications’, said Higgins.



These market-linked insurance bonds enable investors to receive tax-paid lump sums without the preservation requirements of superannuation. This means that they are useful for planning for specific life events, such as education costs, renovations, children’s weddings and estate planning.

Unlike superannuation, insurance bonds can be used as security for a loan, ‘If you in turn go and invest that loan in an income producing area such as in your own business or you invest it into managed funds or invest it into shares, the interest on the loan is tax deductible’, said Higgins.

Little known facts about insurance bonds

How much tax is really paid? While it is widely publicised that earnings within an insurance bond are taxed at the corporate rate of 30%, it is rare that this is the effective rate paid by the life insurance company as there will often be tax offsets such as franking credits. Ross Higgins illustrates what this means:

‘The tax paid rate is generally nominally 30%, but for a lot of modern insurance bonds it could be 20%, 21%, 25%. So if you’re a highest marginally taxed taxpayer or investor taxed at 46.5%, then the bond is paying tax at 25%; there’s a natural arbitrage between the personal tax rate and the rate of the bond. That’s a primary benefit of the tax structure.’

The tax on capital gains for insurance bonds is based on 30% of the capital gain, which is often compared unfavourably with the 50% discount on capital gains that investors receive if they hold investments at an individual level. Tony Jacob points out that the capital gain component is not the only component of income when considering taxation:

‘Investment returns typically comprise a mixture of income, revenue profits and capital gains, which may then be either discounted or undiscounted and it's only the discounted capital gain component of the total return that enjoys the 50% tax relief.’

For example…

An individual investor holds assets via a unit trust investment and is on a marginal tax rate of 46.5%. The tax on discounted capital gains (capital assets disposed of after 12 months) is 50% x 46.5% = 23.25%; while tax on other income (interest, rent, dividends), undiscounted capital gains and profits on sale of revenue assets is still 46.5%.

This means that, if the investment yield mix from the above two types of return is 50/50, the average tax rate becomes (23.25% + 46.5%) / 2 = 34.875%.

In this scenario, the bond's 30% tax rate is better than the unit trust-generated average tax rate of 34.875%, and the compounded effect of this tax differential becomes greater over time.

It is when capital gains consistently exceed 70% of the investment yield mix that the unit trust will obtain a better tax result than the insurance bond (for example, with high growth type investment options).



Other tax advantages There is a tendency to focus on the fact that when the bond has matured after the 10-year period, there is no personal tax or capital gains tax (CGT) payable. However, insurance bonds can be tax-effective even within the 10 years in which the bond is being held as tax is deferred until the year of withdrawal, upon which the money will be taxed at the marginal rate. To further enhance the tax effectiveness of this, a 30% tax offset, calculated on the income component of the withdrawal amount will apply upon withdrawal.

This means that the timing of withdrawals can be structured over years where the 30% tax offset can be best used. Higgins provides an example of when this would be an advantageous strategy, ‘You’re a high taxpayer during part of the bond but then suddenly you retire, you become a low taxpayer. So you’ve had the benefit of the tax shelter as we’ve gone along, you retire at year seven of the insurance bond, you suddenly become a 30% taxpayer then you start your draw-down and get a 30% tax offset’.

A sliding scale, shown in Figure 1, applies to the inclusion of the income as assessable income when withdrawing amounts from the bond prior to 10 years.

Figure 1: Sliding scale of assessable income

Before the eighth anniversary… all income is assessable

During the ninth year… two-thirds of the income is assessable

During the tenth year… one-third of the income is assessable

After the tenth anniversary… all income is tax paid

If the 30% tax offset is not fully absorbed against the income of the bond, it can be used against other tax liabilities, including capital gains and ordinary wages and salary income or other investment income. ‘Even when it’s withdrawn before 10 years and the growth portion is subject to the margin rate of the individual in the year of withdrawal, there’s a compensating 30% tax rebate for the fund tax already paid so you’d only pay any additional tax if your marginal tax rate were higher than 30%’, said Jacobs.

Switching investment portfolios while within an insurance bond does not affect the bond’s tax status, nor does it trigger taxable events for personal tax or CGT.

Insurance bond contributions There are no contribution caps, work tests or age limits that apply to contributions made to insurance bonds, and no preservation limits around withdrawing funds. This makes insurance bonds ideal for clients who are finding superannuation contribution caps frustrating, as they can contribute up to the contribution limits into their super fund, and invest the remainder into an insurance bond.

For example…

This may be appropriate when clients receive redundancy payments.



Insurance bonds can also be used to hold money that has come out of superannuation, but Higgins points out:

‘Bear in mind we’re only one year into the new super system, so the monies that came out last year have been in the bank and the clients are coming back to the planner and there’s another lot of money coming out and they say “well I only live on $10,000 a year and my allocated pension is distributing $50,000, I have to put it somewhere.” A bond is a natural repository because it’s the next best tax structure.’

The 125% rule The fact that there are no contribution caps applicable to insurance bonds is one of the key advantages it has over superannuation, but there is still an integrity measure – the 125% rule. A maximum of 125% of the previous year’s contribution can be made in the current year for the commencement period of the 10-year tax period to remain unchanged; otherwise the 10-year period will recommence from the start of the policy year in which the excess contributions were made. Jacobs points out that the bond year is a unique measurement: ‘It’s not the financial year, it’s not the calendar year, it’s the bond year which is unique to each bond so if you start on 5 August, the bond year ends on 4 August the next year.’

If no contributions are made in any one year and further contributions are made in subsequent years, this will mean that the 10-year tax period for the bond recommences. This results from the fact that if no contributions are made during a year of the bond term and 125% of the previous year’s contributions are allowable, then because 125% of zero is zero, any contribution more than zero will be in excess of the 125% rule, triggering the start of a new 10-year term.

Some may actually want to take advantage of the opportunity to extend the accumulation phase (for example, the initial 10-year period prior to any withdrawal) of the insurance bond. ‘Say for example your marginal tax rate was only 15% in the year of withdrawal, you still get a 30% rebate and you could use the excess rebate of 15% to offset tax on other income you earn so there probably are some situations where you might want to be assessed. Let’s say you’re in your 15th year, you’ve gone past the 10 years, and you get tax-free proceeds. Now tax-free proceeds are really proceeds after 30% tax has been paid at the fund level so many would be happy with that. But if you want to get the tax rebate on that tax paid and be assessed in your hands because your personal tax is less, you could actually invite that situation by deliberately breaching that 125% rule’, said Jacob.

The 125% rule continues beyond the maturity date of the bond. You can only make a contribution up to 125% of the total amount of the immediate bond year’s total contributions or else the 10-year tax clock restarts.

Strategies for the elderly Insurance bonds are also very useful in strategies for the elderly, as the income added to the bond is not counted as assessable income, enabling one to qualify for the seniors card. The social security definition of income is different to how personal income is assessed for taxation. For social security purposes, it takes into account earnings from an insurance bond in a special way. It doesn’t take into account the actual earnings. It actually deems a rate of earnings as it does with most forms of financial investments.



However, this deeming rate can be avoided if you have a family trust or a private trust owning the insurance bond, as there’s no deeming involved. ‘The actual income from the trust is what gets counted for social security income purposes. Now if the family trust were to invest in a bond and the bond doesn’t distribute income, it just accumulates it generally, then the trust does not receive income from the bond and the trust does not distribute income as a consequence and therefore, from a social security point of view, that arrangement where the family trust owns the bond results in real income being earned but no income being counted for social security purposes’, says Jacob.

Holding an insurance bond within a trust structure can assist clients to qualify for the aged pension and higher aged care benefits. ‘If the bond is owned by a trust, it doesn’t produce any assessable income. In turn the trust hasn’t got any distributable income, hence clearly there’s aged care strategies around using insurance bonds within trusts that have been really successfully used over the last three or four years’ said Ross Higgins.

Quicklink

For more information on how insurance bonds are assessed, visit the website of the Department of Families, Housing, Community Services and Indigenous Affairs at <www.fahcsia.gov.au>, then from the list on the right,

> select ‘Legislation’

> under ‘Portfolio Legislation’, select ‘Social Security Law and Guide to Social Security Law’

> select ‘Guide to Social Security Law’

> navigate through to page 4.6.5.70 ‘Assessing Personal Assets & Financial Investments

Case Study: Aged care Shirley is a widow and has sold her home to move into aged care and after paying the accommodation bond she has $270,000 in financial assets:


http://www.fahcsia.gov.au/


Figure 2: Shirley’s assets

Bank accounts: $20,000

Term deposits/managed funds: $250,000 (home sale proceeds)

Contents/car/personal effects: $10,000

Age pension entitlement is:

Under the assets test, the full entitlement of $552.60 ($14,367.60 p.a.)

But the income test reduces this to $371.18 ($9,650.68), which is what she will receive.

Her cost of aged care is:

Income tested care fee $115.88 per fortnight or $8.28 per day

Total = $14,720.45 p.a. ($32.05 daily care fee + income tested fee $8.28 per day) leaves a shortfall of $5,069.77 over her ‘age pension’ income.

If we restructure Shirley’s assets using an insurance bond within a family trust, the outcome is quite different, as seen in Figure 3:

Figure 3: Shirley’s assets after restructuring

Bank accounts: $20,000

Term deposits: $50,000

Insurance bond through family trust: $200,000

Contents/car/personal effects: $10,000

Age pension entitlement is:

Assets test: $552.60 ($14,367 p.a.)

Income test: $552.60 ($14,367 p.a.)

Cost of aged care will be:

Income tested fee: $0

Total = $11,698.25 p.a. ($32.05 daily care fee) a surplus of $2,668.75

Shirley will be better off by $7,738.52 p.a.

Importantly, the deficit between Shirley’s pension entitlement and Shirley’s cost of care under the first structure is $5,069.77 p.a. which must be funded from her investment income. After restructuring, Shirley’s cost of care is funded fully by her pension and she has $2,668.75 p.a. as surplus income.

Note: Case study calculations have been made as at 1 July 2008.

Source: Austock Life, 2008.



Estate planning strategies Upon death, insurance bond distributions will be tax-free to all recipients, regardless of dependency status. This provides a significant advantage over superannuation, where proceeds (taxable components) paid to non-dependants are currently taxed at a minimum of 16.5%.

The flexibility of nominations means that many of the restrictions that apply to setting up nominations in a trust do not apply. ‘You can have as many children as you want nominated, you can specify that if one of the children pre-deceases [the bond owner], his or her share will automatically revert to the survivor. You can include companies as beneficiaries, you can include trusts, you can include charities.’ said Mr. Higgins. Nominations and proportions of the proceeds can be changed at any time.

An insurance bond does not form part of an estate, which means that they can be used to convey tax-effective inheritances outside Wills and the estate, and upon death they will be beyond the reach of creditors. This is a feature unique to insurance bonds and can be ideal for complex situations. It can also be used to give to charities ‘It’s secret almost via the insurance bond to give money to a charity that otherwise if you did it in your Will becomes public and becomes known and possibly open to challenge from children saying “we’re not adequately looked after”’, explains Higgins.

Case Study: Gloria Gloria, a widow in her 70s, wishes to leave $500,000 to her five grandchildren. As she is a high taxpayer, she wants a tax-effective investment that will vest at each child’s 25th birthday with certainty of this occurring, irrespective of whether she is still then alive.

Gloria wants to do this privately, and outside her sizeable other estate arrangements under her Will. These provide for her children – two of whom are estranged. She is concerned to place her grandchildren’s investments beyond possible estate legal challenges.

Gloria sets up five imputation bonds of $100,000 each using its child advancement feature.

Each imputation bond will automatically vest in each of Gloria’s nominated grandchildren at age 25, irrespective of Gloria’s death. Each grandchild (instead of Gloria) is the life insured of each bond, which is why the bond can survive Gloria’s lifetime.

Until vesting, Gloria retains full ownership and control of the bonds, just in case she changes her mind about a grandchild. This enables Gloria to make withdrawals, switch investments and alter vesting ages.

For Gloria (and her estate if she is deceased), during the bond’s accumulation phase, there is no annual tax or CGT reporting obligations as the bonds do not distribute taxable income or taxable gains.

For her grandchildren, as each bond is structured with a vesting age after 10 years, its proceeds will then pass as tax-free distributions to them. At vesting, each grandchild can elect to continue the bond, or fully or partially make tax-free withdrawals from it.

Because an imputation bond is legally a form of life insurance, it is an ‘excluded asset’ from Gloria’s estate, and so these arrangements are not subject to legal contest from her estate beneficiaries.

Source: Austock Life Limited, 2008.



Succession planning Ownership of an insurance policy can be transferred from one party to another and providing there is no consideration paid for the transfer, no CGT will be involved. Parties can include individuals or companies and there can be joint ownership or single ownership.

Jacob explains that this occurs because taxation on an insurance bond is treated like life insurance. ‘If there’s been no consideration in the transfer assignment of the bond from A to B, and B disposes of the bond later on, there’s no CGT problems for B either because B received the bond for no consideration although B is not the original owner of the bond.’

Ross Higgins provides some examples of where using this transfer strategy would be appropriate:

‘Classically we’ve had a situation where a life insurance policy is taken out that will give a lump sum of money if one of the partners die, which is right to fund out from the proceeds of the life policy, but somebody’s got to die. What we can use the insurance bond for is a funding vehicle to actually pay out upon a succession without anybody dying. It could be a farm interest situation or it could be a joint property long term which we want to keep going for a long time, or it could be a business and the business either through the company or through a couple of joint owners who are part of the business saying ‘we’re chucking this in to the insurance bond’ and it’s a good tax structure to do that with the objective to get a lump of money that will be there if one day we have to buy a shareholder out, buy a partner out.’

Wrap up Insurance bonds create planning opportunities that help clients achieve specific objectives or requirements. They provide significant flexibility and allow contributions without caps, the nomination of beneficiaries and in practical estate planning and aged care strategies. They also act as a true set-and-forget strategy, with no need to fill in details on annual tax returns.

Compared with holding a direct or unit trust investment for more than 12 months, the CGT on an insurance bond may be higher. However, it is important to assess how the overall income from an investment will be derived. Whether or not insurance bonds will provide the best outcome for the client, tax matters will not always be the primary driver for the investment.

A close eye will need to be kept on contributions to ensure that the 125% rule is not violated. This rule continues beyond the maturity date of the bond, and the main consequence will be the re-setting of the 10-year tax period.

Ross Higgins reminds us that insurance bonds can be a way to tailor a plan to specific events in a client’s life:

‘The financial plan is not about a big superannuation nest egg; it’s about all those things that happen along the way. It’s about the $360,000 needed to educate the kids, it’s about the $250,000 to pay the mortgage out, it’s about the specifics of estate planning and how this can play a role in estate planning. If you’re really a financial planner doing your job, you should be thinking all these things along the way and this structure works very well for a lot of them and planners need to have their thinking caps on.’




> Ross Higgins, Managing Director Austock Life Limited

> Tony Jacob, Chairman Tax Committee, Australian Friendly Societies Association

DISCLAIMER



February 2009

Inside the First Home Saver Account

Overview

Buying a home remains one of the biggest investment decisions a person is likely to make over their lifetime, so it is imperative that home buyers are given the right advice. The housing affordability crisis has made it increasingly difficult for new home buyers to enter the property market. Although the First Home Saver Accounts (FHSA) were one of the most praised policy features of the Federal Government’s 2007 election win, since the release of details surrounding their operation, they have also been criticised as being too complicated.

Did you know?

The recent Demographia ‘5th annual housing affordability survey’ found that out of the major metropolitan markets, Vancouver, Canada, was the least affordable, followed by Sydney, Australia, then San Francisco and San Jose in the United States, followed by Adelaide, Australia. (Cox & Pavletich, 2009)

Learning objectives


> Describe the operation of the First Home Saver Accounts.

> Identify the legislation and rules applicable to First Home Saver Accounts.

> Outline some of the tips and traps of First Home Saver Accounts.


Knowledge areas



> Deposit products (15 minutes)

> Fixed interest (15 minutes)


February 2009 Page 2 of 9

What are First Home Saver Accounts?

In recognition of the difficulty experienced by new home buyers seeking to enter the Australian residential property market, the government introduced the First Home Savers Account Act 2008. This legislation created the First Home Saver Accounts (FHSA), which were officially launched by financial institutions on 1 October 2008. The purpose of the accounts is to make it easier and more attractive to save for a first home.

Quicklink

A copy of the legislation governing the First Home Saver Accounts can be found at www.comlaw.gov.au

> select ‘Compilations – current’ under Acts

> select ‘Fi’ from the alphabetical list

> browse for ‘First Home Saver Accounts Act 2008’

> download the Act.

To open a FHSA, applicants must be between age 18 and 65 years old and have never owned a home in Australia as their main residence.

Deposits of up to $5,000 made into the FHSA may be eligible to receive 17% government co-contribution. To qualify for the government contribution, account holders must be Australian residents for tax purposes for at least part of the financial year and the government co-contribution is only received upon the lodgement of a tax return at the end of each financial year. There is a $75,000 (indexed) cap on at the overall account balance and the interest earned on the account is taxed similarly to superannuation at 15%.

Quicklink

To read the government fact sheet about the First Home Saver Account, visit www.homesaver.treasury.gov.au

> select ‘fact sheets’

> download the fact sheet ‘First Home Saver Accounts – Account holders’.



Why use a First Home Saver Account?

In the previous decade, property prices have surged in many countries. According to Shane Oliver of AMP Capital, Australian house prices are estimated to be overvalued by an average of 23%, making domestic residential property relatively more expensive than overseas markets, particularly the United States and the United Kingdom. A recent study by the public policy group Demographia compared housing affordability among metropolitan cities in Australia, New Zealand, the United Kingdom, Ireland, the United States and Canada. The study ranked Australia’s housing market as ‘severely unaffordable’, with Sydney in particular ranked as the fifth most unaffordable destination. (Cox & Pavletich, 2009)

The global recession and market volatility has had repercussions throughout the world and even though Australia’s financial system is better placed than most countries to withstand this, housing is a particularly vulnerable area as a result of the overvaluation.

Quicklink

To read Demographia’s study of housing affordability in full, visit www.demographia.com and download ‘5th Annual Demographia International Housing Affordability Survey’.

When asked to measure the success of the FHSA among first home buyers, Andrew Morgan from First Home Shop said, ‘In the current environment there are probably other factors which encourage first home buyers into the market. Interest rates are very topical at the moment … secondly, the First Home Owner Grant has been increased. And for a second quarter, house price growth has moderated. A combination of three factors is going to potentially drive more activity in the first home buyer market’.

As at 1 February, the official cash rate sits at 4.25%, and the First Home Owners Grant has been boosted up to $21,000 for new properties.

Quicklink

To find out more about the First Home Owners Grant, visit www.facsia.gov.au, then

> select ’housing’

> select ‘First Home Owners Boost’ from the menu on the right of the screen.

Paul Pappas from Mortgage Choice agreed that there is a consequential increase in demand for housing, but given the bigger picture, this is addressing the wrong side of the supply and demand equation. ‘This has done something about giving people more incentive to buy and certainly increase their ability to save for a deposit, but the main obstacles at the moment are on the supply side and the tax side; there is just simply not enough property going around for first home buyers to buy and this has done very little to actually address the supply issues of the property market.’

The trend of house prices and affordability over 2009 is likely to be a key determinant of how well Australia weathers the global financial crisis.



Legislation and regulation

Perhaps the most significant requirement for the FHSAs is the four-year rule, which states that personal contributions of $1,000 must be made over the course of at least four separate financial years (not necessarily consecutive years). This means that an account must be open for a minimum of four years. Morgan points out that this is more advantageous to someone looking to buy in the medium- to long-term. ‘Someone who’s looking to buy within four years is probably not going to be able to use the account particularly well. The fact that there is that rule in place means it’s of limited benefit to someone who’s looking to buy in the short-term.’

Once the four-year rule conditions have been met, the account holder can withdraw their funds and put it toward a variety of costs — such as the purchase deposit, associated finance and government fees; settlement costs and stamp duty as well as building inspection and construction. However, if the funds are not used within six months, the money must go back into the FHSA.

Only the individual opening the account is entitled to the funds in the account, and while money can be deposited by someone else on behalf of the account holder, joint accounts cannot be held.

The FHSA rules also state that the owner of the property is required to live at the address for at least six months. The six-month period must start within 12 months of either the purchase settlement date or the building completion date. This is known as the ‘occupancy rule’.

If, for some unforseen reason, the account holder acquires a house without using the account (for example, inheriting a property) the account must be closed and the money rolled into superannuation. There is a 14-day cooling-off period from the day the account is open, should a person change their mind about saving. Thereafter, the only exit scheme available is to roll money into superannuation. The funds are then subject to the usual restrictions of superannuation, meaning that a person cannot withdraw their money until they meet a condition of release, such as retirement.

Penalties apply to those who misuse the FHSA. If an individual ceases to be eligible for an account, they need to inform the account provider within 30 days, transfer the balance into superannuation and close the account. Penalties will also be incurred for statements of false eligibility, or if the individual fails to meet the withdrawal and occupancy criteria. Account providers may also be subject to penalties.

For example …

Account providers can be penalised if they open an account for an individual who has not confirmed their eligibility, or has not quoted their tax file number. The onus is on the account provider to check the eligibility of the individual opening the account. The account provider will not be required to confirm the occupancy rule as the ATO will conduct compliance activity to assess whether requirements have been met.



Tips and traps

The most significant drawback of the FHSA is that minimum personal contributions need to be made over the course of at least four separate financial years before the account holder can withdraw their funds. Pappas believes this could discourage people from signing up to the accounts. ‘Most first home buyers tend to be Generation Y and they don’t think far ahead; ideally they’d like to be buying property within four years. Most of the first home buyers that we deal with have a vision to be buying property anytime between now and the next 12 months, so four years is too far away.’

On the other hand, Dascia Bennett of Members Equity Bank believes that many parents may encourage their children to take up the FHSA as a means to improve their prospects for home ownership in the future. ‘It is purely for a single purpose — buying and saving for your first home. It is not set up to save to pay off a credit card, to save for a holiday or to buy a car.’ Bennett said that as the account has a specific purpose, parents and grandparents can contribute to the account, enabling them to be of financial assistance while also having peace of mind that the money will go towards the definite purpose of buying a property.

Bennett further explains that banks will also encourage the FHSAs. ‘Banks and lending institutions these days will want to see people with good savings and I imagine that with this account, lenders will look favourably at individuals who have got these accounts and can show a good savings regime … I would imagine a financial planner will use this account in their overall financial strategy that they would build for an individual. An individual would come in and sit down and speak to a financial planner, talk about what their personal aims are. A financial planner will use this product along with other products to build a full strategy for an individual.’

Andrew Morgan believes that the accounts are well suited for 18 to 25-year-olds who are looking to buy over the medium to long term. A 10% deposit generally takes five to ten years to save for, and the government’s co-contribution could be seen as offsetting any inflation in the housing sector over the time it takes to save.

For example …

By paying $20 per week into a FHSA a person can save about $1,000 over the course of one year, and if this continues over the four-year minimum, they will meet the four-year rule and be eligible to withdraw. Increasing that amount to $100 per week will be enough to receive the maximum government co-contribution. When making large contributions, amounts over $5,000 could be spread and balanced over the years, thus maximising the government co-contribution without exceeding the annual cap.

In comparison to a standard savings account, the obvious difference is that the FHSA receives the government co-contribution and, regardless of an individual’s tax bracket, all interest earned in the account is charged at 15%.



Case study

If an individual within the 30% marginal tax bracket contributes $3,500 at the beginning of each year for five years, they will receive $3,958 interest in their FHSA after tax (assuming an interest rate of 7% p.a.). This is $1,211 more than the $2,747 after-tax received in the standard savings account over the same period.

Figure 1: First Home Saver Account vs. standard savings account

Variables

Interest 7%

FHSA tax rate 15%

Co-contribution rate 17%

Personal tax rate 30.00%

FHSA

Year

Yearly

deposit

Government co-

contribution Total Net interest

Closing

balance

2008 $ 3,500 $ 595 $ 4,095 $ 244 $ 4,339

2009 $ 3,500 $ 595 $ 8,434 $ 502 $ 8,935

2010 $ 3,500 $ 595 $ 13,030 $ 775 $ 13,806

2011 $ 3,500 $ 595 $ 17,901 $ 1,065 $ 18,966

2012 $ 3,500 $ 595 $ 23,061 $ 1,372 $ 24,433

Total $ 17,500 $ 2,975 $ 3,958 $ 24,433

Standard savings account

Year

Yearly

deposit

Government co-

contribution Total Net interest

Closing

balance

2008 $3,500 $0 $3,500 $172 $3,672

2009 $3,500 $0 $7,172 $351 $7,523

2010 $3,500 $0 $11,023 $540 $11,563

2011 $3,500 $0 $15,063 $738 $15,801

2012 $3,500 $0 $19,301 $946 $20,247

Total $17,500 $0 $2,747 $20,247

This may be enticing to some, but Pappas questions whether the government’s incentive goes far enough, especially when compared to the recently doubled and tripled First Home Owner Grants. ‘When you really look at the numbers, the benefit is that you’re getting $850 per year or 17% co-contribution from the government. When you compare that to the First Home Owner Grant of up to $21,000, and even the stamp duty discounts of up to $17,990, the $850 [per annum] from the FHSA is quite miniscule.’



Of course, when providing advice to clients who may be eligible to commence a FHSA, such an account would generally form only part of the overall strategy provided by a financial adviser. A full plan for clients in this category may also incorporate other strategies such as saving into a managed fund, investing in equities, making additional super contributions and using the investment choice option in super, as well as insurance cover relevant to the client’s position.

Consider …

> Advisers may also want to ensure clients are aware of the additional costs that come with buying a home. For example, most people when they move into a home want to ‘personalise’ it. This could include buying new furniture, new carpet and window furnishings, small renovations and perhaps undertaking necessary maintenance.

> If the new owner/s have been renting, there may many items they need to purchase, e.g. white goods, gardening equipment etc. A budget for all of these items should be calculated and factored in to the total price to avoid subsequent large credit card debt in addition to the home loan.

> Advisers should also ensure that all of the necessary insurances are in place, including both life and general insurance. If the advisers is not licenced to provide advice on general insurance products, they should at least discuss the need for the insurances and the implications of not having them and then refer the client to the appropriate professional for detailed advice.

While younger clients are the most likely group to use FHSAs, the accounts may also be relevant to older clients as well. If a client is over age 60 and eligible to commence a FHSA, they may be able to get around the super contribution caps on non-concessional contributions. Moreover, there are no negative returns on FHSA and the income earned does not count in the Centrelink income test. However, as the account is restricted to savings and therefore represents an asset allocation towards cash, consideration should be given to the fact that investment options within super are broader and perhaps provide better options than the FHSA.

Quicklink

For a checklist to determine if a client is suitable to open a First Home Saver Account, visit www.fido.gov.au

> select ‘deposit accounts’ from the menu on the left

> select ‘First Home Saver Accounts’

> select ‘FIDO's first home saver checklist’.



In a falling interest rate environment, such as the present, cash deposits can currently earn between 5% and 8%, which could be a feasible alternative to the FHSA. This is a particularly good option for those in the low-income tax bracket, who earn less than $44,000 per annum, as the effective personal tax rate may be less than or equal to 15%, therefore cancelling out the tax advantage benefits of the account.

Quicklink

In November 2008, the consumer advocacy group, CHOICE compared the features of the various First Home Saver Accounts on offer. To read their findings, visit www.choice.com.au

> select the ‘money’ tab

> select ‘banking’

> select ‘First Home Saver Account’ from the list.

Early reactions

Given the current financial climate, financial institutions were expected to welcome the FHSA because it encourages the making of deposits. The ANZ Bank has reported a better than expected take-up of the account. Approximately 1,000 accounts were opened within the first month of launching, with a further several thousand enquiries via the website, call centre and branches.

‘I think if such institutions like banks, building societies and super funds who are able to offer the accounts have the ability to deepen an existing relationship with a customer, or have the ability to create a new customer relationship, then it’s going to be of benefit to them’, said Morgan.

Super funds are also expected to benefit from the accounts. If a person opens the account but doesn’t use the funds as a deposit on a home loan, they must transfer the money into their super account. Bennett believes that although there are complex regulations, funds will be able to use this as a tool for their members. ‘Utilisation for this account will be to educate their members about savings and having a whole plan from ownership, first home ownership, right through to retirement planning.’

Pappas argues that the account is not as attractive when compared with other options, such as the high interest savings accounts offered by many institutions. ‘I believe there are potentially better alternatives out there. This account is not necessarily suited to everybody and certainly if you compare it to just having a regular savings scheme that you invest in, one of those internet-style direct deposit accounts or any other form of at-call type investment that could potentially earn you a good rate of return; yes, you’ve got to pay tax on the returns; no, you’re not going to receive any government co-contribution of up to 17%; but yes, the money is available to you at call whenever you choose, no four-year clauses.’

Bennett believes that the accounts are a step in the right direction. ‘The reason why we’ve released this and set up this account early is because we see it as a benefit for people to save. If someone opens a FHSA and shows that they have saved a substantial amount over a period of time and have a nest-egg, it would be favourable to transfer that account over into a mortgage product, so it’s a seamless banking path.



And of course, in today’s environment, any product that encourages people to save via their bank is a great advantage.

References

Cox, W. and Pavletich, H. (2009), ‘5th Annual Demographia International Housing Affordability Survey: 2009’. Available from www.demographia.com [cited 28 January 2009].

Oliver, S. (2008) Oliver’s Insights, Edition 35, AMP Capital Investors, Sydney, 12 November.



> Paul Pappas, Principal, Mortgage Choice

> Andrew Morgan, CEO, First Home Shop

> Dascia Bennett, National Relationship Manager, Members Equity Bank

DISCLAIMER







May 2008

Tailoring insurance policies and benefits

Overview

When it comes to choosing benefit structures for risk, one size does not necessarily fit all. Some people may not require death benefits, and others may see no need to separate their life, total and permanent disablement (TPD) and trauma policies. This Ontrack training details how insurance benefits can be customised to fit the particular need of the client’s risk management strategy.


> Explain the differences between bundled, standalone and hybrid benefits

> Identify the appropriate type of benefit structure for clients’ specific needs > Develop risk management strategies using each of these benefit structure

types



> Life insurance (45 minutes)


Traditional vs. renewable term insurance Historically, life insurance or life (death) cover was provided either as a whole of life benefit through a traditional whole of life policy or alternatively as a death benefit through an endowment policy. Subsequently ‘term’ (death) insurance was introduced to provide the life cover, death sum insured or death benefit through a renewable term insurance policy. Furthermore total and permanent disability (TPD) insurance could be added as an optional, additional or rider benefit that could be as much as (but not greater than) the death benefit that was provided through the renewable term insurance policy. In the 1980s, trauma benefits became available as a rider benefit on the base life insurance policy, with trauma cover limited to the base life insurance cover or death sum insured. With product design limited to a primary life (death) benefit with trauma and TPD benefits as add-on options, it was common for risk management solutions to follow the design of the products rather than the client’s specific needs.

Today the scope of advice is often holistic with detailed risk needs analyses conducted to quantify the specific financial impact of individual death, TPD and medical trauma events. This means that in most cases, it is appropriate to conduct a needs analysis for individual risk events, and formulate risk management scenarios in an effort to determine the most appropriate strategy for the client’s situation.

Unlike traditional whole of life or endowment insurance policies (that can be likened to owning insurance), term life can be viewed as a rental arrangement that requires regular premiums to be paid for the policy with its benefits to remain in force prior to the policy expiry date.

Yearly renewable term insurance or ’term life’ as it is also called, describes life, total and permanent disability and trauma benefits within a policy that does not accumulate a ’cash’ or ’surrender’ value, unlike whole of life and endowment policies. Term insurance policies are usually non-cancellable and guaranteed renewable.

Renewable term life insurance originally offered life cover as the principal protection benefit with optional TPD and trauma cover that could then be added to the policy. These TPD and trauma benefits can now be provided as:

> bundled or linked rider benefits that are added to the life benefit (meaning they reduce the value of other benefits in the event of a claim payment)

> standalone benefits that are in addition to the life benefit (meaning they are individual benefits that do not reduce or offset the value of other policy benefits when a claim is paid), or

> hybrid benefits that are made up of both rider and standalone benefits under one policy or a portfolio of benefits.

May 2008 Page 2 of 17


Bundled or linked rider benefit structures Bundled benefits have the following conditions:

> the insurer’s liability is limited to the amount of life cover on the policy or the death benefit

> the TPD and trauma benefits must not exceed the value of the life cover on the policy or death benefit, and

> the benefits paid for one insured event reduces the underwriter’s liability for any remaining insured events covered by the policy.

For example…

Alex is insured for $1.5 million of life insurance with a TPD rider of $1 million. In the event that Alex is totally and permanently disabled, he would receive a benefit of $1 million. If he was to subsequently die his estate would receive a further $500,000 and the policy would cease. In this way the insurer’s liability is capped at $1.5 million.

Life

1,500,000$ 1,400,000$ 1,300,000$ 1,200,000$ 1,100,000$ 1,000,000$

900,000$ 800,000$ Life TPD700,000$ 600,000$ 500,000$ 400,000$ 300,000$ 200,000$ 100,000$

Life Cover $ 1.5miTPD Cover $ 1miTotal potential benefits $ 1.5mi

A $1 million TPD claim would reduce the remaining life benefit by the amount paid, leaving $500,000 of life cover on the policy.



Standalone benefit structures In the case of standalone benefits, the conditions that apply to bundled benefits are removed, allowing for TPD and/or trauma sums insured to be independent of each other (i.e. these benefits do not require a principal life cover benefit, nor are remaining benefits reduced as claims are paid). If the client has a standalone benefit structure, the TPD and/or trauma cover can be any amount that the client needs or requires, up to the underwriter’s maximum limits.

For example…

Ed is insured for $1 million of life insurance, TPD and trauma insurance as standalone benefits under one policy with one policy fee. In the event that Ed was totally and permanently disabled, he would receive the $1 million TPD benefit.

If he was subsequently diagnosed with a medical trauma (as defined in the policy), he would receive a further $1 million trauma benefit, leaving a $1 million life cover benefit that could be paid if Ed was to die while the policy remains in force, prior to the policy expiry date.

The total potential value of all three benefits within this standalone policy structure is therefore $3 million.

1,000,000$ 900,000$ 800,000$ Life TPD Trauma700,000$ 600,000$ 500,000$ 400,000$ 300,000$ 200,000$ 100,000$

Life Cover $ 1milTPD Cover $ 1milTrauma Cover $ 1milTotal potential benefits $ 3mil

In this case there are three potential events that exist on the same policy but are independent of each other (just like they would be if they were on separate policies).



The benefit of this over separate individual policies is the simplicity of a single policy, with a single policy fee and the value of large sum/policy discounts that may reduce costs or qualify for special loyalty incentives. However, it must be noted, that standalone benefits implemented side-by-side in this manner are individually more expensive than they would be as bundled benefits. This is because there is no ‘risk offset’ effect across the different benefits.

For example…

A TPD and trauma benefit written as bundled will be collectively cheaper because the risk of, say, paraplegia does not need to be incorporated in the cost of both the TPD and trauma premium –it will only be claimable on one of the benefits, not both. Overall the standalone ‘package’ will always be more expensive although any lump sum discounts may reduce this cost difference somewhat.



Hybrid benefit structures The term ’hybrid’ refers to life risk policies or portfolios that are made up of both bundled and standalone benefits. This is often required to satisfy specific trauma and TPD protection needs within a customised strategy that is more cost effective than a full standalone solution. Hybrid structures may also fit the need better than strategies achieved with the use of bundled benefits (which often require an unnecessary level of life cover or a reduction in TPD or trauma cover to satisfy the product rules).

The following figures describe the differences in available benefits and premium costs when using hybrid and standalone structures.

Note: The premiums for these scenarios have been calculated for a 45 year old non-smoking male professional using AXA’s Premium Quote Tool and ‘Any Occupation’ TPD.

Figure 1: Hybrid – Bundled life, trauma and TPD with supplementary standalone TPD

1,000,000$ 900,000$ SA TPD800,000$ 700,000$ 600,000$ 500,000$ 400,000$ 300,000$ Life TPD Trauma200,000$ 100,000$

Life Cover 700,000$ TPD Cover 1,000,000$ Trauma Cover 500,000$ Total potential benefits 1,000,000$

In figure 1, $700,000 of life and TPD is bundled with $500,000 of trauma and $300,000 of standalone TPD. This can also be expressed as $700,000 life cover with a $700,000 TPD rider and a $500,000 trauma rider with an additional $300,000 of standalone TPD. The total possible benefit payable is $1 million with the premium of this benefit combination being $3,849.



Figure 2: Standalone solution

1,000,000$ 900,000$ 800,000$ 700,000$ 600,000$ 500,000$ 400,000$ Life SA TPD SA Trauma300,000$ 200,000$ 100,000$

Life Cover 700,000$ TPD Cover 1,000,000$ Trauma Cover 500,000$ Total potential benefits 2,200,000$

In comparison, this is a package of full standalone benefits that provides a potential of $2.2 million in claim payments at a cost of $4,567

The third alternative would be to provide a fully bundled package with an additional $300,000 of life cover at a cost of $4,226 as shown in figure 3 below.

Figure 3: Fully bundled with additional life cover

1,000,000$ 900,000$ 800,000$ 700,000$ 600,000$ 500,000$ 400,000$ 300,000$ Life TPD Trauma200,000$ Rider Rider100,000$

Life Cover 1,000,000$ TPD Cover 1,000,000$ Trauma Cover 500,000$ Total potential benefits 1,000,000$



The cost of each of these structures is shown in figure 4.

Figure 4: Comparisons of premium

Standalone Bundled Hybrid$4,567 $4,226 $3,849

93% 84%

In this case, the difference between the most expensive and the cheapest premiums was 16%, which will vary from case to case depending on the insurer, the values of life, TPD and trauma insurance required, the age of the insured and possibly the states in which stamp duty is applicable.



When are standalone and hybrid benefits required? Standalone benefits are required when there is a difference between the amounts of insurance needed to satisfy the financial consequence of premature death, TPD or trauma; or there is a requirement for protection of individual events.

The purpose of standalone benefits is to cover specific risk events that may either jeopardise the fulfilment of a financial goal or diminish the value of a current or future asset. The purpose of hybrid benefits is to cover specific risks without necessarily replicating protection across multiple events.

Situations that may require standalone or hybrid benefit structures The amount of life, TPD and trauma benefit requirements can vary due to many factors. The following are just some examples of situations that can require particular strategies to satisfy specific needs:

> people who have a strong desire for self-sufficiency even though they may not have any dependants (i.e. needing little or no death cover but requiring TPD and trauma benefits)

> the insured requires additional TPD benefits to cover any tax payable on a superannuation benefit payment (this may be additional benefits within or outside the super fund depending on the flexibility of the insurance arrangements within the super fund)

> trauma benefits when all other life risk insurances are held within superannuation

> ‘own occupation’ definition TPD benefits to fulfil any retirement savings shortfall and supplement trauma benefits

> legacies for the benefit of non-tax dependent beneficiaries (i.e. adult children, siblings or other persons not in a close personal relationship with the deceased and not provided financial or domestic support from the deceased at the time of death)

> capital purpose business insurance that is owned by a business entity, resulting in the proceeds received from a trauma and/or TPD claim triggering a capital gains tax liability. As CGT will not be payable on death benefit proceeds, trauma or TPD, requirements may need to be grossed up above the value of the death cover in order to provide the same net (after-tax) benefit, and

> additional benefit requirements to account for tax on employment termination payments associated with claims from employer sponsored group life or TPD claims.



For example…

Paul is single without dependants. His primary risk lies in his inability to support himself in the event of total and permanent disablement or a trauma. As he does not have any dependants his need for death benefits is likely to be negligible.

As a result there are significant differences between his need for life, TPD and trauma cover. For people in Paul’s situation there is often no way that a bundled product can satisfy the need without paying for something that is not presently required (i.e. life cover). In such situations a cost comparison of bundled, standalone and hybrid benefit combinations may be necessary to determine the most appropriate risk management strategy.

For example…

Brian is a 49 year old non-smoker. He requires life cover, TPD and trauma protection. Both he and his wife are career professionals without dependent children. Their relationship is one of inter-dependence (rather than dependence) upon one another for their future financial security.

Together they have decided that if either dies they would like to see their personal debt extinguished and that legacies are left to specific charities that they have represented. As each partner is independently occupied there is no need for future income support of either surviving spouse.

Brian’s main concern is for the self fulfilment of his retirement funding needs which naturally involves risks associated with temporary disability, TPD and trauma.

In the event that Brian’s needs analysis quantifies that his requirement is $1 million of life insurance, $2 million TPD and $1.4 million of trauma insurance, the strategies offered by each type of benefit structure could be illustrated in figure 5.



Figure 5: Brian’s risk requirements

2,000,000$ 2,000,000$ 1,900,000$ 1,900,000$ 1,800,000$ 1,800,000$ Part B1,700,000$ 1,700,000$ Life or TPD1,600,000$ 1,600,000$ 1,500,000$ 1,500,000$ 1,400,000$ 1,400,000$ 1,300,000$ 1,300,000$ 1,200,000$ 1,200,000$ 1,100,000$ 1,100,000$ 1,000,000$ Life TPD Trauma 1,000,000$

900,000$ 900,000$ 800,000$ 800,000$ Part A700,000$ 700,000$ Life or TPD or Trauma600,000$ 600,000$ 500,000$ 500,000$ 400,000$ 400,000$ 300,000$ 300,000$ 200,000$ 200,000$ 100,000$ 100,000$

Brian's actual need Life Cover $ 2milLife Cover $ 1mil TPD Cover $ 2milTPD Cover $ 2mil Trauma Cover $ 1.4milTrauma Cover $ 1.4mil Total potential benefits $ 2mil

Annual Cost 15,023$

In the above bundled solution, this policy would provide two potential claims made up of either:

> a trauma event (Part A) for $1.4 million with a subsequent life or TPD event ’Part B’ for a further $600,000, or

> a single claim of $2 million in the event of either TPD or death (being the combination of Parts A and B made within a single claim application).

From the above tables it is clear to see that strategies implemented by bundled solutions will either over-insure Brian (at needless expense) or under-insure him for TPD and trauma cover that would be contrary to his risk exposure. Given the availability of both standalone and hybrid benefit structures these bundled benefit solutions may not be appropriate for Brian’s situation.



Figure 6: Brian’s risk requirements – hybrid and standalone structures

2,000,000$ 2,000,000$ 1,900,000$ TPD 1,900,000$ 1,800,000$ Part C 1,800,000$ 1,700,000$ 1,700,000$ 1,600,000$ 1,600,000$ 1,500,000$ 1,500,000$ 1,400,000$ TPD Trauma 1,400,000$ 1,300,000$ Part B 1,300,000$ 1,200,000$ 1,200,000$ 1,100,000$ 1,100,000$ 1,000,000$ 1,000,000$

900,000$ 900,000$ Claim B800,000$ 800,000$ Life TPD Trauma700,000$ Life TPD Trauma 700,000$ Claim A Claim C600,000$ Part A 600,000$ 500,000$ 500,000$ 400,000$ 400,000$ 300,000$ 300,000$ 200,000$ 200,000$ 100,000$ 100,000$

Life Cover $ 1mil Life Cover $ 1milTPD Cover $ 2mil TPD Cover $ 2milTrauma Cover $ 1.4mil Trauma Cover $ 1.4milTotal potential benefits $ 2mil Total potential benefits $ 4.4mil Annual Cost 14,086$ Annual Cost 16,262$

In the above hybrid strategy the policy could provide a number of potential claims made up of either;

> death, resulting in the payment of ’part A’ for $1 million and an obvious end to the policy and all other benefits, or

> a TPD event that would incorporate a claim for the amount of $2 million being the sum of ’parts A, B and C’, or

> a trauma event that would provide payment of $1.4 million being the sum of ’parts A and B’ leaving a residual benefit (part C) that could be claimed if Brian was to suffer a subsequent TPD event.

In the case of a standalone strategy, each event is independent resulting in a potential $4.4 million in claim benefits.

Figure 7: Cost comparison of Brian’s insurance premiums

Standalone Bundled Hybrid$16,262 $15,023 $14,086

92% 87%

All the above premiums have been calculated using AXA’s Premium Quote Tool



Case study

Capital purpose key person insurance owned by a business entity As a result of trauma and TPD insurance policy proceeds attracting a CGT liability, it may be necessary to gross up the trauma and TPD benefits by the value of the potential tax liability.

Marcus is currently working for a small business consisting of two partners, and is considered a key person in that small business. It has been identified that there is a need to insure against losses incurred if Marcus was unable to work. Assuming that Marcus’s cost base was $100,000 and the business risk is calculated to be $1 million, it will be necessary to gross up the trauma and TPD sums insured by the value of any capital gains tax liability.

Assuming a company tax rate of 30% and a cost base of $100,000 the gross benefit required for a net benefit of $1 million after capital gains tax would be calculated using the following equation:

X – (X - $100,000) x 0.3 = $1 million

That is the gross amount less the amount of CGT must equal the net $1 million. This is achieved by using the above formula as follows:

X – [(0.3 x X) + (0.3 x $100,000)] = $1 million

0.7 x X + $30,000 = $1million

0.7 x X = $1 million - $30,000

0.7 x X = $970,000

Or X = $1,386,000 (rounded to nearer $1,000)

The amount of $1 million grossed up to accommodate a tax liability at 30% would equal $1,386,000 (rounded to the nearer thousand dollars). This is the amount of trauma insurance and TPD that the business would need to buy on behalf of Marcus as a key person. For life insurance, the business would need to buy $1 million on behalf of Marcus as a key person because no tax is payable on the policy proceeds.

Note: If the cost base was zero the gross amount required would be $1,429,000 - that is using a similar formula to that above (X – 0.3X = $1 million) with no cost base to offset. That is 0.7 X = $1 million or X = $1,429,000 (rounded to nearer $1,000).



Figure 8: Grossing up of trauma and TPD benefits

1,386,000$ SA TPD & Trauma1,100,000$ Part B1,000,000$

900,000$ 800,000$ 700,000$ Life TPD Trauma600,000$ Part A500,000$ 400,000$ 300,000$ 200,000$ 100,000$

In this case the policy would pay either

> a death benefit of $1 million (part A) that would not attract any CGT liability, or

> a TPD or trauma benefit of $1,386,000 being the total of part A and B accounting for the CGT liability

Not all life offices offer the flexibility of standalone benefits. Some offer benefits that stand alone while others can offer a combination of the two. Figure 9 identifies products that have offered the flexibility necessary to satisfy specific needs.



Figure 9: Range of products offered*

Life office — product provider

Bundled life, TPD & trauma

Bundled life & trauma

Bundled TPD & trauma

Standalone trauma

Standalone TPD

Hybrid life, TPD & trauma

Hybrid life & TPD

AIG Yes Yes Yes Yes Yes Yes Yes

AMP Yes Yes Yes Yes Yes Yes

Asteron Yes Yes Yes Yes Yes Yes

Aviva Yes Yes Yes Yes

AXA Yes Yes Yes Yes Yes Yes Yes

CommInsure Yes Yes Yes

ING Yes Yes Yes Yes Yes Yes Yes

Macquarie FutureWise

Yes Yes Yes Yes Yes Yes Yes

MetLife Yes Yes Yes

MLC Yes Yes Yes Yes Yes

Suncorp Yes Yes Yes Yes Yes

Tower Protection Policy

Yes Yes Yes Yes Yes Yes

Tower Partner Insurance Portfolio

Yes Yes Yes Yes

Zurich Yes Yes Yes Yes Yes Yes Yes

* Note that the information in this table is subject to change. Please contact the insurance providers directly to enquire about their current offerings.



Some ‘health warnings’ on standalone benefits It is vital that if clients are being offered standalone benefits as a part of their overall life risk protection portfolio recommendations, then any specific restrictions of standalone policies be pointed out in the advice process. The key one of these is the survival period for trauma events. Each standalone trauma policy has its own conditions attached to this, but in summary, a standalone trauma policy will require that a claimant survive a set number of days after a trauma event or diagnosis, before a trauma claim will be paid. For example, if an insured suffered a heart attack, then died 4 days later, it is possible that the standalone trauma policy will not pay a benefit as their required survival period may be, say, 14 days.

Managing clients’ knowledge of how their standalone policy works is crucial to avoid misunderstanding and incorrect expectations at potential claim time.

The other area which must be explained to clients is, to which elements of a hybrid or standalone ‘package’ the ‘waiver of premium’. Each tailored package will usually have a waiver of premium applying in some measure – clients must be advised exactly how these waiver benefits apply in their particular circumstances. For example, upon payment of the benefit or total sum insured under the trauma insurance, the waiver of the ‘premium benefit’ will apply to the term life insurance, provided it is in force at the time the (sum insured) benefit is paid under the trauma insurance. Premiums will be waived in respect of life (death) cover (and TPD cover if applicable).



Wrap up Given the broad availability of standalone and hybrid benefit structures, the number of quality tools that can quantify specific life, TPD and trauma risks and the sophistication of some research and quotation systems, tailored risk management strategies should probably be the advisers benchmark offering.

This will assist advisers in effectively competing in the growing direct DIY market space by enabling them to continue to develop in the practice of professional life risk management advising.


> Doug Scriven – Informed Decisions Pty Limited and author of the new CCH Guide to Life Risk Protection and Planning 2nd Edition

DISCLAIMER



January 2009

20 things clients might not know about super

Overview

For people who are involved in superannuation in their day-to-day work, many of the rules and principles seem obvious. However, for many clients, super often remains a mystery. An adviser can help to broaden a client’s understanding of superannuation, thereby helping them to gain the maximum benefit from their super.

One problem for members of super funds is that the rules have changed over time — they might remember an old rule that has since been changed, or they might not have ready access to the most up-to-date information.

This article identifies 20 superannuation issues that an adviser might wish to discuss with their clients — to help them to better understand their superannuation and the importance of planning for retirement.

Learning objectives


> Identify key issues to raise with clients in relation to their superannuation.

> Explain the implications of these issues for clients.

> Outline the benefits of addressing these issues for clients.


Knowledge areas


> Superannuation (60 minutes)


January 2009 Page 2 of 11

Issue 1 Superannuation is not an investment

Superannuation is not itself an investment—rather, it is a vehicle designed to make investing for retirement more attractive by the use of tax concessions. These concessions are reported by Treasury to be worth about $20 billion a year.

Subject to certain rules, a super fund can invest in virtually any of the assets that a member could invest in personally. Most super funds offer members a choice of how they invest. These can range from conservative options invested mostly in cash and fixed interest to highly aggressive options invested exclusively in shares and property.

The media may add to the confusion about super fund performance results with headlines such as ‘Super gets returns of 15%’ or ‘Your super goes backwards’. The inference is that all super funds are the same, which is not the case. Usually, the media is talking about balanced funds in super, often the default investment option when members make no choice themselves. However, even balanced funds are not all the same. The balanced option in one fund may have 70% invested in growth assets, whereas the balanced option in another fund may have only 50% invested in growth assets.

Issue 2 Superannuation is not for everyone

Superannuation gets ‘talked up’ so much that the implication is often that everyone should have super. In fact some members are disadvantaged by being forced to have super.

Employer and other concessional contributions are taxed at 15% in super and investment earnings are taxed at 15%. Capital gains in super are effectively taxed at 10% where relevant assets are held by the fund for at least 12 months.

A person earning a taxable income of $44,000 will have an effective tax rate of less than 15% when the low income tax offset (LITO) is considered. This is demonstrated in Figure 1 below.

Figure 1: Effective tax rates on low incomes

Taxable income Tax (ex Medicare levy)

LITO Net tax Tax rate

$35,000 $4,500 $1,000 $3,500 10.00%

$40,000 $6,000 $800 $5,200 13.00%

$44,000 $7,200 $640 $6,560 14.91%

As Figure 1 demonstrates, if tax effectiveness only is considered, it would be better for people on lower incomes to invest outside of super. Of course, there are other benefits relating to super, including the following:

> it is a form of forced savings

> super can provide life insurance cover

> it potentially provides access to the government co-contribution.

In fact, it can be argued that the co-contribution is a ‘rebate of tax’ for people on low incomes.



The same point applies to salary sacrificing extra contributions to super. If a member earns a taxable income of $44,000 or less, they will get no tax advantage (excluding any effect of Medicare levy) from this strategy because their effective tax rate is less than the 15% that applies in the super environment.

Issue 3 Other people can ask about a member’s super

Superannuation funds must have a privacy policy to ensure that members’ details are only available to people who are authorised to access the information. Super funds may release information to third parties for administrative reasons, for example, to a life insurer for underwriting or for setting premiums.

Other instances where information about a member and their account may be released include:

> Where the member has authorised the release of information, e.g. to their financial adviser.

> Where the member has given authority under a power of attorney.

> In a criminal investigation, where the police request information.

> In a divorce, the member’s partner can request details of their spouse’s super. This enables super to be considered in a property distribution. The super fund does not have to tell the member that information has been released to their spouse.

> In bankruptcy, the trustee in bankruptcy can request information to determine if contributions have been legitimately made and whether any of the member’s account with the fund may be available to creditors.

Issue 4 Superannuation guarantee is paid quarterly

One of the potential drawbacks of the superannuation guarantee (SG) is that an employee does not need to take any action to receive it. It is all arranged by their employer. Because of this, it is easy for an employee to forget it. If the employee earned $50,000 a year, the SG would be $4,500. If this amount was included in their pay, they certainly wouldn’t forget it.

The SG is calculated every pay day by an employer as 9% of ‘ordinary time earnings’. The employer is required to pay the SG contributions for each financial quarter into super by the 28th day of the following month (except for the December quarter when they have until 28 February).

The SG is calculated on ‘ordinary time earnings’. This definition includes most of an employee’s income except overtime. Recent cases have highlighted misunderstandings by employers where underpayments have been identified. Employees should confirm that their employer is calculating the SG correctly and that the contributions are recorded on their annual benefit statement.

Some employers will show the SG contribution on employee pay slips. This was previously a legal requirement but is now no longer required. However, it remains good workplace policy to show the contribution that is being made by the employer.

The SG need not be paid if an employee earns less than $450 a month. This may also cause confusion if a weekly paid employee earns less than $450 per week. For example, if an employee earns $400 in the first week of a month there would generally



be no SG shown on the payslip. If they earn $400 in the second week, the employer will generally show $72, being 9% of the earnings for the month to date.

Issue 5 Contribution caps are an individual’s responsibility

There must be some limit on the tax concessional super available to any individual. Before 1 July 2007:

> The Australian Taxation office (ATO) monitored reasonable benefit limits (RBLs).

> Employers monitored the deductible contributions that were paid in a year.

From 2007/08, there are limits (caps) on concessional (tax deductible) contributions and on non-concessional (after tax) contributions. The caps apply:

> for each tax year > for each individual > for all applicable contributions to all super funds.

Contributions over the caps are subject to excess contributions tax — effectively 46.5%. In an extreme case where a member exceeded both caps, a contribution could be taxed at 93%.

No one (with the possible exception of a financial adviser) monitors whether the member is at risk of exceeding the caps. It is the member’s own responsibility and they will usually only discover the extra tax six to nine months after the end of the tax year.

Issue 6 Up to age 65, anyone can have super

In the past, superannuation was only for the employed. The restrictions on who can contribute to super have been relaxed over the years and from 2004, anyone under 65 (whether they are employed or not) has been able to put money into super.

This provides good opportunities:

> for members who are no longer working to put extra money into super before starting an income stream

> for people without super to save inheritances or other windfalls in a tax advantaged structure.

Issue 7 Tax in super can be less than 15%

Superannuation funds pay tax at a flat 15% on all their assessable income. This includes concessional contributions and investment earnings such as interest, rent and dividends.

In practice, most super funds pay tax at less than 15%.

> For an asset held more than 12 months, the capital gain when the asset is disposed of is discounted by a third — effectively reducing the tax rate to 10%.

> Funds can claim a tax deduction for the expenses of running the fund as well as the premiums for life, total and permanent disablement (TPD) and income protection insurance cover.

> Dividends paid by Australian companies can carry a tax credit under the dividend imputation rules. The credit can be up to 30% (the company tax rate)



and can be used to offset tax payable by the super fund. For example, if the tax credit was large enough it could eliminate the tax on concessional contributions paid by the fund.

Statistics released by the Australian Prudential Regulation Authority (APRA) indicate that most members remain in the default balanced investment option in large super funds. A balanced fund usually has 25–35% invested in Australian shares and the imputation credits and other tax concessions could reduce the effective tax rate of the fund to less than 10%.

Issue 8 Life insurance in super can be tax effective

On the death of an individual, life insurance provides a lump sum to pay off debts and support dependants and it can provide capital for other purposes. Life insurance can be arranged privately or through a super fund.

The advantages of having life insurance in super are:

> The size of the super fund may allow it to negotiate cheaper premiums with a life insurer.

> A set amount of cover may be provided (called automatic acceptance) without the need for medical examinations or health checks.

> The super fund can claim the premiums as a tax deduction, thereby reducing the cost to the member.

> Premiums are deducted from the member’s account so there is less chance of the policy lapsing because premiums are not paid on time.

> The member can make salary sacrifice contributions to pay the premiums, so premiums are paid in pre-tax dollars.

> Benefits paid to tax dependants are tax free with no maximum limit.

Many super funds will allow the member to buy extra life insurance, though this is likely to require a more detailed underwriting process.

There are also circumstances where holding life insurance privately would be a better arrangement. This is an area where a skilled adviser can help.

Issue 9 Insurance in super can carry on between jobs

One of the traps of having life and TPD insurance in a super fund occurs when the employee changes jobs. The cover may continue for a limited period (say 30 or 60 days) and then cease.

Many funds offer a ‘continuation option’ that allows the member to continue the same level of insurance cover in a personal policy without going through the normal underwriting process — medicals, blood tests and so on. Funds may have different rules but often:

> The continuation of the life cover will require just a short health statement.

> The continuation of the TPD cover will require a short health statement and an employment declaration.

The continuation option will only be valid for a limited time — 60 or 90 days after leaving employment so it pays to see an adviser promptly.



Issue 10 Super funds will consolidate your super

Some individuals who have had a number of jobs, find the thought of finding and consolidating all their super accounts too much of a hassle. There are two steps to take. First, locate all the accounts and second, consolidate the accounts into one preferred account.

Finding lost super can involve:

> checking for paperwork at home

> calling the ATO on 13 28 65 or 13 10 20 with name, date of birth and TFN

> using the SuperSeeker tool on the ATO’s website.

Quicklink

For more information on finding lost super visit www.ato.gov.au/super then

> select ‘Individuals’

> select the SuperSeeker tool link in the ‘Online Services’ box on the right-hand side of the webpage.

Consolidating super is made easy by most super funds because they will do the majority of the work for the member. The member completes one form for each account and the super fund will arrange the rollover. Note the identification issues covered below in Issue 11 will apply.

Issue 11 Super funds require members to identify themselves

When an individual opens a bank account they must identify themselves (the 100 point test). Opening a superannuation account is a lot easier, and for members who receive only SG contributions, no action need be taken on their behalf at all.

Identification will be required when the member comes to take money out of the fund. That is, when they:

> claim a lump sum

> make a rollover

> start an income stream.

Most funds will require a certified copy of a form of ID with a photograph and signature. The copy will need to be signed as ‘a true and correct copy’ by a JP, police officer or similar person.

It pays to be prepared to have this identification available to avoid delays in processing payments.



Issue 12 Super funds will (sometimes) pay out before retirement

While super is for retirement, there are circumstances when it can be paid out (in full or in part) before retirement.

Obvious (though undesirable) examples are:

> death

> total and permanent disablement (called invalidity in super-speak)

> diagnosis of terminal illness.

Other examples are:

> In financial hardship: to release money in this way requires the member to have been receiving Centrelink benefits and to be unable to pay bills.

> On compassionate grounds: to release money in this way requires the member (or their immediate family) to have significant medical expenses, to have funeral expenses, or to be at risk of foreclosure on their home mortgage.

> Unrestricted non-preserved benefits: when the current preservation rules were introduced in 1999, some members had money in their super that they could have accessed immediately in cash. This amount was quarantined and can still be accessed at any time (though tax may be payable depending on their age and the amount involved).

> Once the member reaches preservation age (currently 55) they can access their super as a ‘transition to retirement’ pension.

These are legitimate ways for the member to gain access to their super. The super regulators are concerned about schemes where members access their super early and illegally. Promoters of such schemes have had legal action taken against them and members have had tax penalties imposed on them.

Issue 13 Super is tax free from age 60, but retirement comes first

When the major super changes came into effect from 1 July 2007, the headlines said ’Super is free from age 60’. Some members misinterpreted this to mean that they could claim their super tax free at age 60.

To be able to access super as a lump sum, a member must satisfy a ‘condition of release’. Usually this will mean they have satisfied a Superannuation Industry (Supervision) Act 1993 (SIS Act) retirement definition. The three definitions are:

> To have reached age 65.

> To have left a job after age 60. This can be any genuine position of gainful employment. It does not have to be the person’s main job.

> To have reached preservation age (currently 55) and have declared an intention to never work again. The member can change their mind and return to work but if they abuse the rule there may be tax penalties.



Issue 14 Super can be left to grow after age 65

Until May 2006, members were required to ‘use their super’ at age 65 unless they were still working. They also had to use their super at age 75 even if they were still working. ‘Use their super’ meant to start an income stream or take the money as a lump sum out of the concessionally taxed super structure.

This so called ‘compulsory cashing’ rule has since been abolished. Members can access their super when they satisfy a condition of release. However, the only time their super must be paid out is on death. This creates new opportunities for members, including:

> Retaining money in super as part of an estate planning strategy. However, members should be aware of the potential tax on death benefits paid to tax non-dependants.

> Saving extra money in super as a source of capital to pay for medical expenses or aged care.

Members should bear in mind that where super accounts are in the accumulation phase they do not attract the same tax-free status as those in pension phase, i.e. used to pay a pension to the member.

Issue 15 Super will not automatically be dealt with by a Will

Many people think that estate planning means having a Will. While a Will is very important, super will not automatically be paid into the member’s estate.

Superannuation fund trustees are required to pay death benefits to a member’s dependants. The trustees will make enquiries into the deceased’s circumstances and will pay the money to the member’s estate only where they cannot identify any dependants.

Some funds allow a member to nominate a ‘preferred’ beneficiary to receive their benefit on death. They can nominate for the money to go to their estate but the trustees are not bound by this preference. Some funds allow a member to make a ‘binding’ nomination and again the member can nominate their estate (or any other dependant).

Depending on the member’s circumstances, there can be advantages and disadvantages of having super paid to their estate. A key role for an adviser is to help the member make the appropriate decision as part of a comprehensive estate plan.

Issue 16 Superannuation should last a lifetime

One of the variables in planning for retirement is working out how long the client needs their money to last for. It is made more complicated if they are part of a couple as they have to plan for the lifetime of the surviving spouse if they die first.

The government publishes life expectancy tables showing the average age of death for males and females of a given age. For example, the life expectancy of a 60-year-old male is 21.66 years and a 60-year-old female is 25.44 years. On this basis, the man should plan to live to age 82 and the woman to age 86.



However, there are flaws in this approach:

> The figures are averages. This means that 50% of individuals will die before the life expectancy table’s age and 50% outlive this age.

> The figures are out of date. These figures are based on the 2000/02 census data. Life expectancies have been increasing, so members can expect their average life expectancy to be greater than that given in the tables.

> The figures show that the longer an individual lives, the longer they can expect to live. In the example above, if the 60-year-olds live to age 70, their life expectancy will be 84 and 87 respectively. If they live to age 80, their life expectancy will be 88 and 90 respectively.

An adviser needs to work with their client and consider other factors (such as longevity of family members, health, etc) and agree on a retirement period to be funded. It may be five to 10 years longer than the average life expectancy.

Issue 17 A superannuation pension can help money last

A member reaching an age and time when they can access their super can be a daunting experience. If they have been saving for retirement, they will have access to a large sum of money and will need to make it last for their lifetime. They may refer to it as their ‘last pay cheque’.

A super pension can help a member make the money last.

> A pension pays the member regularly (monthly or quarterly) so they can get used to managing the cash flow. Although the member has the flexibility to access the money as a lump sum, they may be less inclined to do so if their short-term needs are met.

> The assets backing a pension are exempt from tax rather than being taxed at 15% when the fund was accumulating money for retirement. This means investment returns will usually be greater and the money will last longer.

Issue 18 Some pensions are guaranteed, some are not

The word ‘pension’ is used to describe an income stream, but not all income streams are the same.

The age pension is paid by the government to men over age 65 and (currently) to women over age 63.5 years. The pension is a guaranteed fortnightly amount but the amount of pension paid depends on the assets and income of the recipient (and their partner if a member of a couple). It is possible to lose the age pension if the recipient fails the income or asset test, though they may requalify at a later date.

Some super funds pay a guaranteed pension for the lifetime of the member (and at a lower rate to their spouse when they die). These are similar to a lifetime annuity payable by a life office.

Allocated and account-based pensions paid by super funds are not guaranteed. They will continue to be paid until the money runs out. The amount of income payable each year is also not guaranteed, though once the member has retired there is no upper limit on how much can be withdrawn from the pension account each year.



Issue 19 A pension can carry on after death

When an individual dies, the age pension for that person stops. If they have a partner, their age pension will increase to the higher single person’s rate — but this is less than the combined age pension received by a couple. The surviving pensioner will be subject to the single person’s income and asset tests so they may not receive the maximum pension.

Some guaranteed pensions paid by super funds (and annuities) will continue to pay out after the death of the primary pensioner. They will usually pay a reduced pension to a person nominated as the ‘reversionary’ beneficiary.

Allocated and account-based pensions paid by super funds can also nominate a reversionary. In this case:

> The reversionary must be a dependant of the primary pensioner — a spouse, child under 18 or someone who is financially dependent on, or in an interdependent relationship with, the deceased.

> A pension payable to a child can only continue until the child reaches age 25 and must then be cashed out.

> The new pensioner chooses the amount of income to be paid by the pension and the way the funds are invested.

Issue 20 Superannuation is more than just a retirement nest egg

The ‘compare the pair’ advertisements oversimplify super. Super is portrayed as being nothing more than an investment and that the fund with the lowest fees will generate the largest retirement benefit.

A good adviser can tailor a super fund to suit the current and future needs of a client as part of a complete financial plan. For example, the adviser could:

> recommend an appropriate fund

> recommend an appropriate amount of life, TPD and income protection cover

> recommend contribution strategies to maximise tax benefits

> identify tax traps, such as excessive contributions tax

> recommend appropriate long-term investments

> develop target retirement benefits and strategies to attain them

> ensure death benefits align with the client’s estate plan.

Over time, the client’s needs and circumstances will change, superannuation legislation might change and the product features may change. Advisers need to review the client’s situation periodically to ensure that their super fund is still being used in the most effective way.



Wrap up

Superannuation is not an investment, but rather a tax structure designed to make investing for retirement more attractive by the use of tax concessions. While anyone earning over $450 per month receives the superannuation guarantee from their employer, super is not necessarily beneficial to everyone. An adviser can broaden their client’s knowledge of super on many issues, including tax and super, life insurance and super, lump sums, pensions and super, and estate planning and super.



> Peter Grace, Words and Training, Independent consultant.

DISCLAIMER







May 2009

Superannuation in a falling market

Overview Often when we talk about superannuation we imagine steady returns as the fund grows towards the member’s retirement. Reality, of course, can be very different because returns tend to vary from year to year — and the results are not always positive.

A sustained period of negative returns will raise investors’ concerns, but the laws and regulations surrounding superannuation can also result in other, less obvious, implications. An adviser needs to understand how these rules work to plan for the impact of falling markets.

Did you know?

Since 1987, a typical balanced fund returned on average 10.43% per year up to 30 June 2008. This average is likely to be lower once the 2008/09 year is included. The highest returns were 35.6% in 1987, and 23.4% in 1997. A typical balanced fund has returned negative results four times — in 1988 (-1.0%), 2002 (-3.9%), 2003 (-0.8%) and 2008 (-11.29%). Source: Vanguard.


> Explain some basic principles about superannuation and investments. > Recognise areas of superannuation where negative returns may cause concerns

or require action. > Identify opportunities for clients in periods of negative returns. > Outline some retirement re-evaluation strategies.



> Superannuation (30 minutes)

> Retirement income streams (30 minutes)



Superannuation is not an investment People often talk about superannuation as if it is an investment. However, superannuation is not an investment in itself — rather, it is a concessionally taxed structure in which investment assets are held, which is set up to encourage Australians to save for retirement. A flat tax rate of 15% levied on fund income and capital gains means most people who earn over $34,000 per annum are able to achieve better after-tax returns than investing in the same assets outside superannuation.

However, superannuation does have its drawbacks — money is generally locked away until a client meets a condition of release, such as retirement, and there are restrictions on how the money can be invested.

Public perceptions and education For many Australians, superannuation is all too hard. It is often easier to accept whatever they are given, ie. the default fund under fund choice and the default investment option. Many super fund members do not realise that they may be able to choose their super fund and their investments.

For example …

An Ernst & Young report in October 2008 stated that 10% of employees (1 million people) have exercised choice regarding their superannuation fund. Increasing employee mobility, greater education about superannuation and a poor current investment environment (which may lead to more rigorous member scrutiny of fund performance) is expected to drive more members to make a fund choice. (Ernst & Young, 2008)

A recent Investment and Financial Services Association (IFSA) report publishing investment results showed that 60% of assets in funds over $100 million in size were invested in options other than the default investment option. Members who seek advice and who have more money invested are more likely to make an investment choice. The report also indicated that members of retail funds were three times more likely than members of industry superannuation funds to exercise investment choice. (IFSA, 2009)

The recent push for greater financial literacy by the government and by superannuation funds aims to enable members to:

> understand asset classes and risk and return

> accept that short-term returns can be volatile in assets where long-term returns are higher

> appreciate the value of ‘dollar cost averaging’ where assets are bought regularly

> understand the business and investment cycles.



Quicklink

For more information on the government’s campaign to increase financial literacy, visit www.understandingmoney.gov.au.

Understanding negative returns One area that is often misunderstood by super fund members and investors generally is the effect of negative returns on their account balance and the return required to restore the account balance following a loss.

All investment options, other than a 100% allocation in cash, have the potential to provide fluctuating and possibly negative returns from year to year. This means that most investors are likely to receive a superannuation statement showing a negative return at least once during their lifetime.

While negative returns tend to be short-term in nature, it often takes time to recover from a fall in asset values and it isn’t simply a matter of achieving an equivalent positive return in subsequent periods. To illustrate, if a super fund account falls by 7% in one year, it will need to earn more than this amount in the following year just to recover the loss.

For example …

If an investor has $200,000 and earns 7% in year one their capital will grow to $214,000.

If the fund loses 7% in year two, the capital value will fall below $200,000 to $199,020.

If in year three the fund earns 7% it will grow to $212,951. It would need to earn 7.54% just to recover to the same position it was in at the end of year one.

The impacts of negative returns The impacts of negative returns can be examined in seven different areas:

1. contributions

2. benefit components

3. after-tax effect between accumulation and pension funds

4. investments

5. pensions

6. insurance

7. benefit payments.



Contributions While these effects are restricted to defined benefit funds, and are relevant to a relatively small number of clients, it is important to understand the implications. Negative returns may affect employers making contributions into defined benefit funds where the risks are borne by the employer and the member has a guaranteed benefit (as long as the employer can support the plan).

An actuary will recommend a long-term contribution rate for an employer based on variables such as expected salary growth of employees and investment returns. If investment performance is better than expected (such as from 2003 to 2006) the employer contribution can be reduced or even stopped all together.

Conversely, when investment performance is worse than expected (as it was in 2002 or in 2007/08) the employer contribution may have to increase.

This can be a double-edged sword for an employer — weaker economic conditions and lower profits occur at the same time as superannuation contributions have to be increased. This lack of certainty over contribution rates is one reason for the demise of defined benefit funds.

Benefit components Superannuation accounts are divided into components for taxation and preservation purposes.

Preservation A member can have three preservation accounts:

1. Preserved benefits (PB) — must remain in superannuation until a condition of release is satisfied.

2. Restricted non-preserved benefits (RNPB) — not preserved, but not accessible until the member leaves their current employment.

3. Unrestricted non-preserved benefits (UNPB) — available at any time in cash.

Since July 1999, all contributions and fund earnings have been added to the PB account. The RNPB and UNPB accounts were calculated as fixed dollar amounts at that time, but negative investment returns may result in the non-preserved benefits being reduced if the amount is more than the value of the member's preserved benefits. Any negative investment return must be debited firstly against the member's preserved benefits, then against the member's restricted non-preserved benefits and finally, if required, against the member's unrestricted non-preserved benefits. Any subsequent earnings are preserved benefits.

For example …

Henry has $200,000 in a super fund, of which $10,000 is preserved (PB) and $190,000 is unrestricted non-preserved (UNPB). If investment returns are negative $15,000, this will be firstly applied against his preserved benefits, reducing this amount to nil. The remaining $5,000 loss will be applied to his UNPB balance.

His whole account of $185,000 will be unrestricted non-



preserved (UNPB) and the preserved account will be zero.

If Henry’s superannuation fund subsequently earns a $20,000 return, this will be applied to his preserved benefits. The UNPB balance will remain at $185,000 ad the PB will be $20,000.

Tax components A member can have two accounts for tax purposes:

1. Tax-free component — made up of the amount crystallised at 1 July 2007 plus contributions which are not assessable in the fund (for example, personal contributions where no tax deduction was claimed, co-contributions, spouse contributions). It is made up of fixed dollar amounts.

2. Taxable component — the balance of the account once the tax free component is deducted. This means that investment gains (and losses) are included in this component.

These components only need to be calculated when a member takes a lump sum from their fund or starts an income stream.

Lump sums If a member withdraws part of their superannuation, the amount paid is proportioned between the tax-free and taxable components at that time. The member cannot ‘cherry pick’ between the tax-free and the taxable components.

If they make a second withdrawal, the amount paid is proportioned between the tax free and taxable components at that time — different proportions are likely to apply from the first withdrawal.

Income streams If the member starts an income stream, every payment will be proportioned between the tax-free and taxable components at the inception of the income stream.

Some members may be concerned that they will ‘lose’ all or part of their tax-free component when returns are negative. The tax-free component is a fixed dollar amount and will not be affected by investment returns, although the percentage may be.

The changes in the tax-free and taxable components with a fall in investment values do not directly affect a super member unless they take a lump sum or start an income stream.

For example …

Ahmed has $200,000 in a superannuation fund and a tax-free component of $190,000.

If he took a lump sum, or started an income stream, his super would be proportioned 95% tax-free.

> If the value of his investments rose by 5%, his super would grow to $210,000 but the tax-free amount would be unchanged. The tax-free proportion would be calculated as 90.5%.



> If the value of his investments fell by 2%, his super would decrease to $196,000, but the tax-free component would be unchanged at $190,000. The taxable component would be $6,000. The tax-free proportion would be 96.9%.

> If the value of his investments fell by 5%, his super would decrease to $190,000, but the tax-free component would be unchanged at $190,000. The taxable component would be nil. The tax-free proportion would be 100%.

> If the value of his investments fell by 10%, his super would decrease to $180,000 but the tax-free component would be unchanged. The tax-free component would be $180,000 and the taxable component would be nil. The tax-free proportion would be 100%.

After-tax effect between accumulation and pension funds Income and capital gains on assets backing pensions are exempt from tax. Income and capital gains on assets backing superannuation in the accumulation stage are taxed at 15%. Two identical portfolios will normally show a higher investment return for the pension fund because of the tax difference.

This is not necessarily true when there are negative returns. The tax-free pension fund cannot use losses to offset gains because it pays no tax. Similarly it cannot claim tax deductions because there is no income against which to claim the deductions.

Quicklink

The QSuper website http://qsuper.qld.gov.au provides a typical example with the returns from the balanced option

Over five years the accumulation fund returned 3.93%, while the allocated pension fund returned 4.65%.

In the 12 months to 28 February 2009, in which there were negative returns, the accumulation fund returned negative 20.35%, while the allocated pension fund returned negative 21.65%.

Investments

In-house assets In-house assets are investments in or loans to a related party of the fund, investments in a related trust or an asset leased to a related party. Falls in asset values can cause problems for small funds where the trustees hold these assets.

The maximum in-house asset level is 5% of the market value of the fund. This test is applied continuously — both at acquisition and at the end of the year.



Considering the negative returns on many listed assets recently, trustees may find the value of in-house assets exceeding the 5% limit.

For example …

Jacob and Julie hold two sculptures in their self-managed super fund (SMSF). They are displayed in their company offices and the company pays rent to the SMSF at commercial rates. The bulk of the fund is invested in small company shares because they believe they will grow faster than blue chips over the long-term.

The small company sector has suffered in the last two years and their shares have fallen in value by 65%.

At 30 June 2009 they discover that the artwork is worth 7% of the market value of the fund. Their auditor tells them they must prepare a plan to rectify this problem by 30 June 2010.

Pensions Anyone who retired and started an account-based pension (ABP) since 2003 will have found a period of negative returns to be a significant learning experience.

Minimum payment on account-based pensions Account-based pensions are designed to provide an income in retirement. To ensure they are used as pensions and not tax-free holding vehicles, the pensioner is required to draw down a minimum amount each year. This is a percentage of the capital values of the account at the last 1 July (or the opening balance in the first year). The percentage ranges from 4% up to age 64, to 14% when the pensioner is over age 94.

The need to make a minimum draw down became an issue in 2008 when some investors were being forced to liquidate growth assets that had fallen in value. They had to turn paper losses into real losses. This occurred because:

> companies were paying lower dividends

> managed fund distributions had fallen

> some unlisted funds had been frozen (e.g. mortgage and property funds).

In February 2009, the government granted temporary relief and halved the minimum pension payment for the 2008/09 year. The decision will be reviewed again for 2009/10.

For example …

Isabel is age 68 and at 1 July 2008 her account-based pension was worth $480,000. She must take a pension of at least 5% or $24,000 in 2008/09. She asks the super fund to pay her $2,000 a month.



She had invested the pension in shares, property trusts and mortgage funds. She expected the distributions from these investments to be enough to pay her pension and if they were not quite enough she would draw some money from the mortgage fund. Isabel’s mortgage fund has been frozen and she will be forced to sell some share and property investments at rock bottom prices to meet the minimum pension for the year.

The relief means she must take 2.5% in the year or $12,000. Her super fund has already paid her seven monthly instalments so she can suspend payments or reduce them to avoid having to cash out shares or property assets at low prices.

At 1 July 2009, Isabel’s super fund must recalculate her minimum pension based on the value of her account at that time. Assuming share and property markets have still not recovered, her account is worth $240,000. Based on the normal rules, the minimum pension for the 2009/10 year will be $12,000 or $1,000 a month. Isabel could ask the super fund to pay less than $1,000 a month knowing she can always catch up later in the year — it all depends on how much she needs to meet her lifestyle expenses.

In the example above, Isabel may be advised to hold a larger cash reserve in the fund to ensure she has enough to pay her pension and not be forced to crystallise paper losses.

One trap for pensions with account-based pensions is that the minimum pension payment will be lower at 1 July 2009 if the capital value is lower. This may come as a shock to pensioners who are accustomed to drawing the minimum pension and then finding out the new, lower level is insufficient for their living expenses. They may be required to draw a larger amount from their account at a time when capital values have fallen.

Life of an account-based pension A retiree starts an account-based pension at age 65. If they take the minimum payment, they will use 5% of the capital value in the first year (ignoring fees).

Most illustrations by financial advisers would assume consistent annual returns — for a balanced portfolio they may assume returns of 7%. This means in the early years of the pension, the account’s capital value will grow. It is only when the retiree gets into their 80s that the draw down rate is higher than the assumed earning rate and the capital value starts to decline.

A period of negative returns at the inception of an account-based pension will mean the initial capital value will fall and may never be recovered.

Options to consider for account-based pensions These pensions are very flexible and provide members with a range of choices, depending on their needs. For instance, a client might:

> reduce living expenses and reduce the pension payments to the minimum



> roll back the ABP capital to the accumulation stage to avoid having to make minimum payments. Note the pro-rata minimum payment must be paid before this occurs

> roll back the ABP capital to the accumulation stage and starting a new ABP with a lower capital value — consequently with a lower minimum pension requirement

> retain the ABP, but pay surplus cash needs back into super as non-concessional contributions. This will require the member to be under age 65 or be able to satisfy the work test. If they cannot pass the work test, they could make contributions to family member

> see if they qualify for the age pension (or more age pension) if they are asset tested — applications can be made to Centrelink to be assessed or re-assessed at any time if asset values have changed (up or down). Centrelink clients have an obligation to tell Centrelink when the value of their assets change significantly.

Solvency of defined benefit pensions Until 20 September 2007 certain annuities and superannuation pensions were wholly or partly exempt from the assets test. These income streams provided a guaranteed income and an actuary must provide an annual certificate that the assets backing the pension are sufficient for the income to be paid for the life of the contract.

The fall in asset values has meant that many lifetime and term pensions in SMSFs and small APRA funds will be unable to pass the solvency test. Under the Centrelink rules, an assets test exempt (ATE) pension can only be commuted to another ATE pension or annuity.

If an ATE pension is restructured in a small fund without a solvency certificate, it will lose its ATE status and the pensioner can be required to repay up to five years of Centrelink benefits.

The government has provided temporary relief up to 30 June 2010 for pensions that cannot get a solvency certificate. A pensioner will be able to retain the assets in the small fund, restructure the pension and not be required to repay Centrelink benefits. The new pension will be 100% assessable under the assets test — this may mean loss or reduction of the age pension.

The loss of assets test exemption will be permanent — even if the assets backing the pension recover their value and the solvency test is passed in the future, the ATE status will not be restored.

Insurance One of the advantages of holding life insurance in a superannuation fund is that the premiums are deducted from the member’s account. This means the cover is less likely to lapse because of unpaid premiums; the member’s cash flow for daily living is not affected so there is no temptation to skip paying premiums if unexpected expenses arise, and the premiums are effectively paid with pre-tax dollars.

When negative returns occur, the member’s balance will fall and the cover is more likely to lapse if the account is exhausted.



For example …

Jack is age 58 and working part time. He earns $500 a week and his employer is paying superannuation guarantee contributions of $180 a month. Jack has arranged to have extra life insurance so he can pay off some debts and meet funeral expenses if he dies.

Due to the economic downturn, Jack’s work is cut back and the superannuation guarantee contributions stop because he earns less than $450 a month. The value of his account falls because of the negative returns. At Jack’s age, insurance premiums are high and, depending on the balance, his account may quickly be exhausted.

Benefit payments Superannuation is a long-term investment for most members and default investment options will typically have 60–70% growth assets. While the member is a long way from claiming a benefit, this is probably a reasonable choice. There may be short-term volatility in returns, but over the long-term a balanced option can be expected to generate higher returns than a more conservative fund.

This situation changes when the member knows they are soon to take money out of super. At this time an investment option that can be volatile is probably a poor choice.

Death benefits When a member dies, the death benefit must be paid out to the member’s dependants or to their estate. Determining who should receive the benefit, in what proportions and in what form can be time consuming.

The Superannuation Complaints Tribunal has highlighted recently how falling markets can cause problems. A recent case dealt with a substantial death benefit that fell significantly in value between the date of death and the date of payment. It had remained invested in the deceased member’s choice of investment option.

This is a situation where it is known that the payment must be made soon — death of a member is the only situation where a superannuation benefit must be paid out. The deceased’s personal legal representative would be advised to request that the trustees switch the account to a cash option, pending a decision on payment of the benefit.

Total and permanent disablement benefits Like death benefits, TPD payments may take time to resolve. It is not certain that the disabled member will request a withdrawal from the fund, but it is more likely than not to happen.

The member (if they are physically capable) can request a change to a more secure investment option. Alternatively, anyone with a valid Power of Attorney can act for them.



Strategies to take advantage of falling markets

Dollar cost averaging Dollar cost averaging is the term used to describe the strategy of adding to an investment at regular intervals over a period of time. The period could be months or years and the regular intervals, weeks or months.

Dollar cost averaging works because:

> the decision of when to invest is removed

> by investing regularly, assets are bought when the price is low as well as at other times. Where a set amount is invested each time — as often occurs for superannuation guarantee contributions — more shares or units can be purchased when prices are lower. If over time the asset values rise (which historically has always occurred), the investor will have benefited by buying low.

Dollar cost averaging works best over a medium to long period of time in either a volatile market, or a market that falls and recovers, but it will not guarantee a profit.

Most employees unknowingly use this technique when investing into super because their employers pay super guarantee contributions quarterly or more frequently.

In specie contributions A fall in asset values can be a good time to transfer ownership of an asset from a member to a super fund, particularly SMSFs. The investment rules allow an SMSF to acquire listed shares or managed funds from a member. The shares can be purchased in the normal way by the SMSF, or transferred in-specie as contributions.

Shares held in superannuation can be more tax effective than being held personally because imputation credits are worth up to 30% of a fully franked dividend payment whereas the fund’s tax rate is 15% (in the accumulation stage) or nil (in the pension stage). Unused credits are refunded to enhance returns.

In addition, future growth will be taxed at these rates, so undervalued shares transferred now have the potential to grow in value in a lower tax structure.

The relative tax advantage depends on the individual’s circumstances. For instance, the benefit is greatest if the individual is on the high tax rate and there is no tax advantage if the individual pays no tax (for example, a retiree whose income is under the threshold for the Senior Australian’s Tax Offset).

The transfer is a capital gains tax event so the individual will be taxed on any gain. If the investor crystallises a loss, it can be offset against existing capital gains or carried forward and offset against future gains).

Impact on retirement plans A period of negative returns has shocked many people who were planning to retire in the near future. After four years of double-digit returns, some may have become blasé and felt retirement planning was easy. They may now be disillusioned and looking for options.

A common cry advisers are hearing is ‘I’ve lost my money’. To be more precise, the client has purchased assets and the assets have lost value. If they don’t panic and sell their assets, they have not lost money. The restoration in the value of the assets they own will depend on the economic recovery and the quality of the assets.



The choices for someone near to retirement in a volatile market are:

> defer retirement by working longer — perhaps moving to a less stressful job or one with shorter hours

> increase contribution levels

> invest more aggressively for higher returns when the markets recover

> accept a lower standard of living in retirement.

None of these options may be palatable, but they do reflect reality.

Wrap Up A period of negative returns will raise new issues for advisers and their clients. Some issues may be of concern to clients, but the adviser can explain these in such a way as to allay their concerns.

Other issues can be addressed by good forward planning or an awareness of how to manage an issue if it ever arises.

As long as an adviser is aware of possible negative situations and the options available, they can ensure that the impact of negative returns on the client’s goals and objectives is minimised.

References Ernst & Young (2008), The super iceberg: What’s beneath the surface of choice? October. Available from www.superchoice.com.au.

Investment and Financial Services Association (2009), IFSA submission to APRA’s discussion paper, Fund level disclosure from the APRA superannuation statistics collections. 23 January. Available from www.ifsa.com.au.


> Peter Grace, Independent consultant.

DISCLAIMER


January 2008

Getting the best out of Wills

Overview Financial advisers have a significant role to perform in helping their clients understand the importance of preparing a valid Will. While it is clear that Wills require specialist knowledge perhaps outside the financial adviser’s usual area of expertise, there is certainly a significant role to be played by an adviser in helping clients recognise the importance of preparing a properly constructed Will and understanding the costs and ramifications of dying without a Will.

This Ontrack training provides an overview of relevant legislation and common law as it applies to Wills and probate, with a focus on the issues that advisers need to communicate so their clients can understand the questions they need to ask of their solicitors.


> Identify the requirements for a valid Will

> Describe the reasons why a Will can be challenged

> Describe the consequences of not having a valid Will in place




Estate planning

Financial advisers and Wills In most people’s estimation, estate planning is all about Wills and the administration of an estate — matters that solicitors advise on. However, financial advisers also have a significant role to play. They need to understand and explain to their clients the financial implications of different legal arrangements prepared by a solicitor.

As with other areas of specialist advice, good financial advisers benefit from having some understanding of the law as it applies to Wills and probate (administration of an estate). You will not be expected to have an in-depth understanding of relevant legislation and common law. Rather, the focus of this article is to provide some insight into the issues that financial advisers need to consider for their clients, and the kinds of questions that they need to ask of their clients.

What is a Will? A Will is a legal document that describes the intentions of the deceased (testator) with respect to the division and distribution of their assets. It is important to understand that courts recognise and uphold a Will provided that it has been drafted correctly and that the intentions of the testator are not unlawful.

Sometimes other laws will also apply. For example, to achieve fairness and equality, family law principles may override the express intentions of the testator. The Family Provisions Act 1982 (NSW) provides a legal right for family members to contest a Will, where the deceased has not ‘provided adequately’ for them.

Laws governing Wills are primarily state-based. While many factors are underpinned by common law (that is, law made by judges in court decisions), each state and territory has legislation dealing with Wills, probate and intestacy. So, while basic principles will apply beyond state boundaries, these principles will often be subject to local variations.

A Will only operates once death has occurred. It can be said that a Will ‘speaks from death’. This raises the issue of what occurs when it is desirable or necessary for one person to control another’s affairs before death, i.e. power of attorney.

Formal requirements of a valid Will There are certain formal requirements for the execution of a Will. If these requirements are not followed, the Will might be invalid. Although there can be variations in the requirements of a valid Will from state to state, figure 1 on the following page itemises general requirements.


Estate planning

Figure 1: General requirements of a valid Will

Requirement Description

The Will must be in writing. The Will can be either typed or handwritten or presented by any other means of producing words in a visible form. It may be written in any language, although to avoid problems of translation and interpretation it is desirable that it be in English.

The Will must be signed. The Will must be signed by the testator or by a person at their direction and in the presence of the testator.

The signature of the testator must be attested. The signature of the testator must be attested by two independent witnesses; that is they must be present when the Will is signed.

Alterations must be made before it is signed. Any alterations to the written Will as typed must be made before it is signed and the alterations initialled by the testator and the two witnesses.

In addition to the formal requirements of a Will, the testator must have had the intention to make a Will.

One exception to these requirements is ‘privileged’ Wills. These are Wills made by military personnel during actual military service. Such Wills do not have to comply with the formal requirements relating to witnessing. Note that amendments to some state laws abolished privileged Wills being granted to persons involved in the armed services (e.g. Western Australian Wills Amendment Bill 2006 assented 26 October 2007 as Act 27 of 2007). Advisers may wish to seek specialist advice on the status of privileged Wills relevant to their own state jurisdiction.

Substantive compliance legislation

Many states have introduced so-called ‘substantial compliance’ legislation, which ameliorates the ‘harshness’ of the formal requirements noted above. Statute law in Victoria, South Australia, New South Wales, Western Australia, Queensland and the Northern Territory allows the particular jurisdiction’s Supreme Court, in certain situations, to admit documents to probate that do not strictly comply with formal requirements.

Different approaches have been adopted in different jurisdictions, but the general rationale for relaxing the strict requirements is essentially that the document should not be placed ahead of allowing the testator’s intentions to be carried out.

For example…

In Western Australia, since the 1988 amendments to the Wills Act, all manner of documents that are not properly signed can be proved as Wills, provided that it can be proven to a court that the document is indeed the person’s Will. This legislation might have the bizarre effect of making things such as suicide notes provable as Wills.

The Succession Bill 2006 (assented Act No 80 of 2006) made a number of important changes to the law of Wills in New South Wales, namely: making provision for court-authorised Wills for people who lack testamentary capacity; giving statutory guidance to the court when it considers authorising a minor to make a Will; including new rules about beneficiaries who witness Wills, survivorship, identifying who is entitled to see a Will on the death of a testator and the deposit of Wills with the court; revising the law on foreign Wills; and including provisions relating to the admission of limited evidence to aid in the interpretation of Wills.


Estate planning

When do Wills apply? A Will only deals with assets that the testator (the person who makes the Will) actually owns in their own right. Examples are properties owned wholly in the testator’s own name or as a tenant-in-common with another person or entity. If the asset is owned by the testator and if it is part of the testator’s ‘estate’, a Will can be used to pass it to the intended party.

Given the increasing tendency of individuals to hold wealth in non-estate assets (such as superannuation), Wills have become only one of several important mechanisms transferring all of an individual’s wealth upon death.

Revoking a Will

Part of an adviser’s duty of care to a client is to make sure that they are aware that Wills are not necessarily the final word on how their estate will be settled. Clients need to understand that Wills are not absolutely binding; they can be revoked or changed. As such, clients may need to re-draft their Will if their circumstances change. A Will can be revoked in any of four different ways:

1. by another Will

2. by a clause in a later Will

3. by destruction of the Will, or

4. by marriage or divorce.

The first three methods listed above are voluntary revocations and the remaining method is an involuntary revocation (or revocation by operation of law).

As a general rule, when a testator marries, a Will made before the marriage is automatically revoked. However, there are exceptions to this rule. A common one is the exception where the Will is explicitly made in contemplation of that marriage. The position varies between jurisdictions.

Challenging a Will

Family provision

A Will is not absolutely binding — it can be contested after the death of the testator either on the basis that it is invalid, or valid but failed to make adequate provision for one or more beneficiaries (commonly called ‘family provision’ legislation).

Wills can be invalid for a range of reasons, including:

> a later Will has been prepared or by an act of revocation

> it has been incorrectly executed

> lack of testamentary capacity

> undue influence over the Will maker

> an error has been made, and

> fraud.

Claims under the family provision legislation do not challenge the validity of the Will but seek to have it varied on the basis that the testator failed to ‘make adequate provision for the proper maintenance and support of the deceased’s widow, widower or children’. The court can then order that a certain percentage of the deceased’s estate be allocated to particular family members.

Only estate assets may be the subject of a family provision application.


Estate planning

Limits to court powers

The court may not make an order (even by consent) for the purpose only of:

> rewriting the Will to remedy unfairness

> providing a fairer distribution

> benefiting other than eligible applicants

> providing compensation for unrewarded services or expenses for the deceased or past wrongful conduct of the deceased, or

> enabling the applicant to provide testamentary benefits to others.

Essentially, all a court can do is determine whether the deceased made adequate provision for the proper maintenance and support of the applicant — this issue is determined by looking at matters as at the date of death. Then, if the deceased did not do so, the court must determine what amount would adequately provide for the proper maintenance and support of the applicant. This second issue is determined by looking at matters as at the date of judgment.

The Family Provision Act 1982 (NSW) and its equivalents in other states specify who may apply to a court for an order to vary a particular Will so as to make ‘adequate provision’ for their maintenance, education or advancement. Generally, this includes:

> spouses

> children

> de facto spouses

> former spouses, and

> others who have been wholly or partly dependent upon the deceased at some time.

The required adequate provision is calculated as at the date of hearing of the application.

It should be noted that the New South Wales legislation is perhaps the broadest and widest reaching in the country.

De facto spouse and illegitimate or ex-nuptial children The question of who is a de facto spouse for the purposes of a family provision claim needs to be considered. The person claiming to be a de facto must establish to the satisfaction of the court that they were living on a genuine domestic basis with the deceased as at the date of death. So far, the law requires that the parties need to be of the opposite sex and in a ‘spouse-like’ relationship at the time of death.

Matters that a court takes into consideration in deciding whether or not a genuine domestic relationship exists include factors such as:

> conduct in the manner of husband and wife

> joint parents of a child

> the exclusiveness of their living arrangements and sexual activity

> permanence of the relationship

> pooling of resources

> a subjective belief in their relationship being that of husband and wife, and

> the legal right to enforce each other’s obligations.


Estate planning

A de facto spouse has full legal recognition as a spouse in the Northern Territory, New South Wales (two-year requirement), South Australia (five- to six-year requirement) and in Queensland. Broadly, they enjoy the same rights and benefits in these jurisdictions as married people do. A de facto spouse generally enjoys statutory rights and privileges over a deceased estate as an ordinary spouse.

The Children (Equality of Status) Act 1976 (NSW) has the effect that the word ‘children’ now includes, unless expressly otherwise stated, both legitimate and illegitimate children of the deceased. Even where there is no Will, the ex-nuptial child will be recognised as an equal to a legitimate child following the death of the parent.

Avoiding potential challenges to a Will Challenges to a Will are more common than people realise. Most are settled before they reach court and with very just reason. The Family Provision Act 1982 (NSW) provides that those who are entitled to take action against the estate are also entitled to have their legal costs for such an action taken out of the estate. In other words, both sets of lawyers (the claimants and the estate lawyers) will be paid out of the estate to argue whether or not adequate provision exists. This usually represents a very large incentive for the claimants and the beneficiaries to agree to a compromised settlement. With proper care, the risk of a successful Family Provision Act claim can be minimised.

There is no universal panacea for a challenge against a Will. All that a testator can do is to ensure that when excluding or substantially reducing (in comparison with other beneficiaries) a person’s benefit under their estate, this is done without any socially improper motive.

For example…

An example of a socially improper motive is when a child is excluded from a Will because the child married against the testator’s wishes and married ‘outside’ the testator’s religious beliefs. Whatever they are, the ‘socially proper’ motive(s) should be clearly recorded for the executor to ‘access’ in order to assist in staving off a claim.

Unless the permission of the court is granted, a claim must be made within 18 months from the date of death of the deceased. This time limit on claims may vary between jurisdictions.

Avoiding a family provision claim The court is able to accept evidence of the deceased person’s reasons for making certain provisions in their Will, and evidence of the reasons for not making greater provision for the applicant.

The reasons for lack of provision for the prospective applicant can be recorded:

> in the Will — this makes the reasons public and might also forewarn the potential applicant

> in a statutory declaration, or

> in a signed statement.

If the testator wishes to exclude any of the possible applicants from their Will, notes of their reasons should be taken.

It has been held that by making an entitlement under a Will subject to forfeiture, it is void as being contrary to public policy. Similarly, a person cannot contract out of their right to make a challenge unless the appropriate legislation provides to the contrary.

It might be possible to implement certain strategies in an attempt to ensure that a claim against an estate will not be successful, at least to any significant extent.


Estate planning

One such strategy might be to ensure that property does not form part of the testator’s estate, and therefore the property will not be the subject of any claim. This can be achieved by:

> making an outright gift to the intended beneficiary prior to death

> transferring it into joint names with the intended beneficiary

> transferring the asset to a trust, or

> contracting to leave property by Will or a mutual Will or a gift donatio mortis causa (a gift in the case of death). This vests the property in the hands of a donee upon the death of the testator and does not form part of the deceased’s estate.

Note, however, that some jurisdictions (e.g. NSW) have legislation that reduces the effectiveness of the last-mentioned strategy.

Some testators leave a small gift in an effort to forestall an application.

Consequences of dying without a Will In explaining the importance of drafting a Will, financial advisers should describe the legal effects of dying intestate. Intestacy occurs where someone dies without disposing of the whole of their property by Will.

Where intestacy occurs, distribution of property is determined according to a statutory formula. This can bring about results that the intestate would not necessarily have desired or intended.

Note: Think about your existing clients. How many have thoroughly prepared their Wills? Are your clients aware of the consequences of an ill-prepared Will and the repercussions it can have on their families?

Scheme of distribution All Australian states and territories have their own statutory scheme for disposing of assets upon intestacy. There are minor variations but, in general terms, it is fair to say that property not effectively disposed of by a Will is distributed to the deceased’s spouse or children. If the deceased’s spouse or children do not take the estate, the property will fall to the next of kin. If there is no spouse, children or next of kin, the Crown (the State) will take the estate pursuant to the doctrine of bona vacantia (goods without any apparent owner will revert to the Crown).

The mere thought of the State taking one’s hard-earned property should be sufficient to make the most hardened cynic give instructions for the preparation of a Will. When a person dies intestate, their property is distributed in accordance with the rules set out in the relevant legislation. Without a proper Will, the management of a deceased’s estate can be very complex.

Spouse

In some jurisdictions, but not all, the spouse automatically gets everything. The difficulty comes in the case of a couple dying together, for example in a car accident.

It is a generally accepted rule of law that if it is not possible to determine the actual time of death, the older person is presumed to have died first. Therefore, if the time of death of a married couple is not known and both died without a Will (ie. each died intestate), then

> the whole estate of the older of the now deceased married couple will pass first to the other partner, and

> the other intestate estate will then include the second deceased’s assets as well as the assets of the spouse.


Estate planning

It is possible that all of this may then pass (subject to the relevant state laws) to the next of kin of the second deceased and nothing will pass to the family of the presumed earlier deceased spouse.

As marriage invalidates an earlier Will (unless made expressly in contemplation of marriage or in Western Australia), newly married couples should prepare new Wills.

Summary of the consequences of intestacy The laws governing intestacy are governed in large measure by state and territory legislation. If a client has real estate in more than one jurisdiction or if there is some question as to where an intestate lived, these differences can prove important in the final distribution of the estate.

Failure to make a Will may therefore:

> cause the estate to be distributed in a way contrary to the deceased’s wishes

> result in confusion over who should apply for administration

> cause additional heartache and uncertainty for the deceased’s spouse and family

> result in a failure to provide for the particular needs of the deceased’s family

> mean significant additional expense for, and diminution of the value of, the estate

> delay the administration of the estate, and/or

> result in no provision being made for the deceased’s de facto spouse or step-children in those jurisdictions that do not recognise de facto relationships. (De facto spouses miss out in some jurisdictions. A de facto might have lived with someone for 20 years and helped pay for the assets, yet have no right to claim.)

Intestacy laws

To demonstrate how the intestacy laws work, this figure on the following page details the situation for New South Wales.


Estate planning

Figure 2: The statutory order for persons to benefit from an intestate estate in New South Wales

If there are … then the estate is given to …

Spouse and no children The surviving spouse

Spouse and children If the estate is less than $150,000, then all to the surviving spouse.

If the estate exceeds $150,000, then the first $150,000, plus all household effects, plus one-half of the remaining estate to the spouse and the balance to the children.

The spouse, however, has an option of taking the matrimonial home in full or partial satisfaction of their interest.

Children but no spouse The children equally

No spouse and no children The parents of the deceased equally

No spouse, children or parents The first to fall into the class of person in the order below:

> brothers and sisters

> half-brothers and half-sisters

> grandparents

> uncles and aunts

> uncles and aunts, resulting from the remarriage of the deceased grandparents.

No one else The state of New South Wales

Note: Where the deceased’s children or brothers and sisters otherwise entitled are deceased, but they have left children (ie. the intestate’s grandchildren or nieces and nephews), those children will in turn take equally the share their parent would otherwise have taken.

Wrap up The potential costs of dying without a Will (i.e. dying intestate), or one that has not been properly constructed, are significant and the ramifications can go well beyond financial matters and can cause considerable grief and even conflict for the deceased’s family and friends.

The threat of challenges to a Will, or for assets to benefit parties not intended by the testator, needs to be clearly expressed to a client. Taking steps to enable the client to recognise the importance of this aspect of a financial plan and helping them to seek appropriate advice is an important aspect of a financial adviser’s role, and one that should not be discounted.


Estate planning

While it is clear that Wills require specialist knowledge, perhaps outside the financial adviser’s usual area of expertise, there is certainly a significant role to be played by an adviser. Guidance for clients based upon a general understanding of the issues involved and the kind of advice needed should be a basic foundation for a financial adviser to ensure they can provide a comprehensive plan for a client’s financial future.

DISCLAIMER

This document was prepared by and for Kaplan Education Pty Limited ABN 54 089 002 371. It contains information of a general nature only and is not intended to be used as advice on specific issues. Opinions expressed are subject to change. The information contained in this document is gathered from sources deemed reliable, and we have taken every care in preparing the document. We do not guarantee the document’s accuracy or completeness and Kaplan Education Pty Limited disclaims responsibility for any errors or omissions. Information contained in this document may not be used or reproduced without the written consent of Kaplan Education Pty Limited.


November 2008

Estates without borders

OverviewA power of attorney (POA) authorises a trusted person to make financial and legal decisions for someone else, usually for a specific period of time. Some may think that a working knowledge of the specifics on POAs is best left to the lawyers, but this is not necessarily the case. POAs in different jurisdictions can have a significant impact on estate planning, particularly if clients have assets that span across state and territory borders.

Did you know?

The legislation in relation to POAs varies across the different Australian states and territories, so it is important to be aware of these differences for clients who are based interstate or hold assets in two or more jurisdictions.


> List the different types of powers of attorney and describe situations when each is appropriate.

> Consider some of the differences in powers of attorney between the states.

> Identify medical and other issues when considering powers of attorney.





POA and the estate Most clients understand the value and purpose of having a Will. However, it is difficult to account for the complexities of life in one document. A POA can be used effectively to give clients peace of mind in knowing that someone they trust can be appointed to look after their assets should they (the client) be unable to look after their own financial and legal affairs.

A POA is an instrument (i.e. a document) that enables one person (known as the ‘principal’) to appoint another person (known as the ‘attorney’) to act on their behalf.

A valid POA allows the nominated attorney to sign any document or do any thing that the document allows, subject to certain legal limitations. In order for a POA to be valid, certain formalities must be adhered to. These requirements vary from state to state, and are detailed later in the article.

Types of POAs There are two main types of POAs:

1. general power of attorney

2. enduring power of attorney.

A general POA gives permission for an attorney to make financial decisions about specific assets, but on the condition that the principal still has capacity to make decisions. Robert Monahan, from Australian Executor Trustees, points out that general powers exist to differentiate situations where powers are, and are not meant to continue beyond capacity. ‘A general power of attorney ceases to have effect if the principal (the person creating the POA), loses their capacity. The law says that you can revoke a POA at any time, but clearly if you lose your capacity you no longer have the capacity to revoke the POA, hence the law says that it is automatically revoked.’

If a general POA is appointed and then the principal loses capacity at a later stage, the appointment will no longer be valid and the person who has been appointed will no longer be able to make decisions on behalf of the principal.

An enduring power of attorney has all the same characteristics as a general POA with the exception that an enduring POA will continue to be effective even if the principal has lost the legal capacity to act for themselves. This allows the finances of the incapacitated person to continue to be managed and made available for the incapacitated person and their family.

Given that estate planning is primarily about putting plans in place for situations where the principal is incapacitated, an enduring POA is a natural fit. Catherine Dwyer from ANZ Trustees says ‘if a client loses capacity, it can certainly leave that person and also loved ones in the lurch if they haven’t put appropriate steps in place to cover that situation’.

The definition of lost mental capacity is when a person cannot manage his or her affairs or cannot understand a document that he or she is signing. If there is any doubt about whether or not a POA applies, medical practitioners will be able to provide advice.



Consider …

What is it that has made enduring POAs so vital?

> Medical technology has advanced to the point where people often survive health conditions and impairments that in past decades would have resulted in death.

> These medical advancements often mean that people are living to advanced ages.

> However, while the technology can mean survival for many, often in the last few years of life, a person might not have their full physical and mental capacity.

> While medical technology may be able to overcome many physical impairments, the medical industry has not learned how to overcome the debilitating effects of the mental decline that comes with advancing age.

> For these reasons, enduring POAs are becoming increasingly important.

Scope The scope of a POA will be governed by common law, relevant state legislation and the wording of the document itself. It can be as broad as being able to operate bank accounts; buy, sell, mortgage and lease property; and arrange any other financial investment. The scope can also be as narrow as a specific transaction at a point in time.

There are some functions that a POA cannot legally perform. These include:

> writing a Will for the principal

> delegating the POA to another person (unless specified in the document)

> exercising a power as trustee in any capacity

> undertaking acts that are illegal.

Usually, an attorney must only hold the assets for the specific benefit of the appointor. Dwyer points out that some flexibility may be required to truly serve the appointor’s best interest: ‘In a lot of cases, if someone loses capacity, they will often want their spouse and their family to benefit from assets in their name so it’s important to consider, when having this type of document drafted, to add the clauses that allow the attorney to be able to have the power to benefit a spouse and children from the assets of the appointor.’

There are some situations where it is unclear at law as to whether an attorney has the power to undertake certain acts, such as:

> withdrawing sums from superannuation

> being able to confirm a binding death nomination.



Placing clear directives in a POA around these matters will give the superannuation trustee a level of comfort in allowing for those transactions and nominations to take effect.

A matter of trust No one oversees the acts of an attorney, so the client must be certain that they are comfortable assigning this level of responsibility to their nominated attorney. ‘Giving a power of attorney, particularly a very broad power of attorney, is like giving someone the pin number to your bank account or the key to your safe: you need to trust that person. You need to rely upon them that they will act in your best interests’, said Monahan.

It is also essential that the attorney has the capacity to manage the principal’s affairs, and that in areas where the attorney may have limited knowledge, they will be prepared to seek advice, or delegate to the appropriate people.

Key considerations when choosing a POA include:

> that the person acts in the best interests of the principal

> that there are no conflicts of interest (for instance, is nominating one child over another in the interests of equal distribution of the estate?)

> a back-up in case the appointed attorney is unable to fulfil their duties.

A POA can be set up as a single person, or jointly with another party (where both have to make decisions), or they can be appointed severally, which enables them both to make decisions on behalf of the appointor. Dwyer urges clients to consider the practical implications of POAs, including working relationships: ‘That can, in practice, be a little bit difficult having two people who are able to make those decisions … you’ve got to think of that bank teller, who needs to know about all those conditions and whether they’ve been met before they can actually hand the money over to the attorney, so impractical conditions can be a problem’.

Another trap to watch out for where both attorneys are obliged to sign, is that if one attorney dies, then the appointment of the surviving attorney will also fail except in limited circumstances. ‘If you do want more than one attorney, you can consider an appointment by majority for example, so I appoint three attorneys for two out of three to sign. That may be better than having joint attorneys where the whole appointment may fail’, said Dwyer.

Enduring power of guardianship Until now, the focus has been on appointing others to be responsible for the principal’s financial requirements. However, there are other areas to consider when a client loses mental capacity, such as medical and lifestyle matters.

An enduring power of guardianship is where someone is appointed to make lifestyle decisions on behalf of someone else, such as where a person will reside, in the event of their losing the capacity to make those decisions for themselves at some time in the future.

It is important to distinguish between an enduring power of ‘guardianship’ and an enduring power of ‘attorney’. In this context, a guardian makes medical and lifestyle decisions while an attorney manages financial and legal affairs. As with POAs, the laws in relation to enduring powers of guardianship vary from state to state.


http://www.publictrustee.sa.gov.au/products-and-services/enduring-attorney.html


If guardians and attorneys are going to be separate individuals, it is worth considering their relationship. In practice, guardians and attorneys work quite closely together because the guardian makes the decisions, but the attorney has to arrange payment for those decisions, so their roles require that they work closely together.

Other types of POAs Limited forms of POA can be set up, which grant appointors rights for a specific situation, such as buying property, or for a specific timeframe.

For example …

Monahan provides an example of when this may be appropriate, ‘I saw an accountant, for instance, who was going overseas for a couple of weeks. There was a particular transaction he was involved in and he gave his business partner power of attorney, limited to signing documents relating to that particular transaction’.

In some states it is also possible to set up medical POAs, which enable the appointor to make medical decisions on the appointor’s behalf. More detail on this is provided later in the article.

What happens if you don’t have a POA? Without a POA, it is possible for the government to become involved in the client’s affairs, which will usually be assigned to a state government organisation such as the Guardianship Tribunal in Victoria. The government is obligated to act in the best interests of the principal in all instances, which in some cases may be against the family’s wishes.

As Dwyer points out, the consequences of not having a POA can be time consuming and difficult: ‘While you are incapacitated, your affairs can become neglected, bills might not be paid, assets can’t be managed and that can lead to a great deal of delay, cost and potentially loss to your investments as well’.



For example …

Marriage is not an automatic POA Ngoc and John have been married for over 30 years, and own a house together. They assume that their joint Wills entitle them to have control of their joint assets upon each other’s death or incapacity.

However, when John becomes incapacitated and they need to sell their home to pay for his care, they find that the house cannot be sold without John’s permission, which he does not have legal capacity to give. This means that Ngoc is unable to sell the home until her nomination as financial manager has been approved by their state’s relevant guardianship tribunal. A government body may also be appointed to oversee Ngoc’s administration and ensure that arrangements are in accordance with fiduciary duties.

Dwyer emphasises the importance of never assuming that an enduring POA will be in place. ‘You’re left with a situation where you may not be able to deal freely with your family home or other joint assets, so it is still critical that husband and wife, even if they’ve got joint assets, have POAs in place.’

State-based differences Over the past two decades there has been significant change in relation to POAs. The concept of enduring POAs has come into operation and, as a result, most states or territories have amended their legislation, including:

> New South Wales Powers of Attorney Act 2003

> Queensland Powers of Attorney Act 1998

> Victoria Instruments Act 1958

> South Australia Powers of Attorney & Agency Act 1984

> Tasmania Powers of Attorney Act 2000

> Western Australia Guardianship & Administration Act 1990

> Northern Territory Powers of Attorney Act 1980

> Australian Capital Territory Powers of Attorney Act 2006.

While there is a move nationally to have uniform laws in this area, this is not likely to happen for several years. Monahan points out that these varied laws provide some key areas for financial planning. ‘It’s important for financial planners to appreciate there is a difference in relation to powers of attorney and if you have clients who are either interstate clients or have assets in another state, you should be aware of the fact that there’s not just the one form of power of attorney.’



Key differences in the legislation include:

> requirements to create a valid POA, enduring POA or to revoke a POA

> the actual physical form that is required for a POA (e.g. the expression to be included and statement of understanding/acceptance to be annexed to the document)

> the number of witnesses required, and the qualification of witnesses

> some POAs are required to be registered before the attorney can act on behalf of the principal.

Mutual recognition Some of the new POA legislation that has been passed by Australian states and territories provide for what is called ‘mutual recognition’. The New South Wales, Queensland, Victoria and Australian Capital Territory all recognise a POA, provided that it has met the requirements of the state/territory in which it was established. Western Australia also has mutual recognition, but a specific government department must be applied to in order to gain recognition. South Australia and the Northern Territory do not recognise POAs across borders.

According to Monahan, ‘You must look at your client’s particular circumstances, not only the state in which they reside, but the state in which they have assets and the possibility that those POAs may be needed to be used in those other states’.

If clients move across borders, Monahan suggests that caution should be exercised and a new POA should be drawn up that complies with the legislation in that state or territory to ensure that it is watertight.

Requirements Each state and territory has subtle differences in the requirements to set up a valid POA, including the number of witnesses required and where certain forms are prescribed by legislation. Figure 1 compares the requirements across the jurisdictions.

Requirements also vary in different states for revoking POAs. Both New South Wales and Victoria have prescribed forms, while other states will accept legal documents.



Figure 1: Formal requirements of an enduring POA by state and territory.

State Witness Certificate by witness

Accepted by attorney

Other requirements

NSW Registrar of local court, or legal practitioner. Licensed conveyancer, Public Trustee employee or trustee company employee, who has completed a prescribed course. May not be the attorney.

Yes Yes

Qld A justice, commissioner for declarations, notary public or lawyer. Not a relative of the principal or attorney. May not be the attorney.

Yes Yes

Vic Two adult witnesses, one of whom is authorised to witness a statutory declaration. Only one witness may be a relative of the principal or the attorney. May not be the attorney.

Yes Yes

SA The witness must be a person authorised by law to take affidavits.

No Yes Must be by deed

WA Two witnesses both authorised to make declarations.

No Yes

ACT Two adult witnesses. May not be a relative of the principal or attorney. May not be the attorney.

No Yes

NT A witness who is not the attorney or near relative of the attorney.

No Yes Must be registered

Tas Two adult witnesses. May not be a relative of the principal or attorney. May not be the attorney.

No Yes

Source: CCH Guide to Estate Planning, 2007. Reproduced with permission.

Medical matters One area of significant difference is when it comes to prescribing powers to make decisions about medical matters, with the extent of powers across states varying widely. It is a common client misconception that an enduring POA entitles them to make decisions that go beyond financials, and this misconception should always be addressed to ensure that clients understand that the legislation views these two areas as separate responsibilities.



All jurisdictions have separate documents for assigning the power to make decisions about medical issues, except for Queensland and the Australian Capital Territory, which assign these powers under one document. ‘They are still separate functions, so you appoint someone to make financial decisions for you and someone to make the lifestyle decisions, but it’s under the one document — a POA. In other states they are separate functions, generally in different documents. In some states [they are] called a medical POA, in others an enduring guardianship, so it just depends on the particular state legislation,’ Monahan said.

Figure 2: Enduring POAs and guardianship by state and territory

State Enduring POA

Power to make medical decisions Power to make lifestyle decisions

NSW Yes Enduring guardian Enduring guardian

Qld Yes Enduring power of attorney Enduring power of attorney

Vic Yes Power of attorney (medical treatment) Enduring guardian

SA Yes Power of attorney (medical)

Or enduring guardian

Enduring guardian

WA Yes Nil Nil

ACT Yes Enduring power of attorney Enduring power of attorney

NT Yes Nil Nil

Tas Yes Enduring guardian Enduring guardian

Source: CCH Guide to Estate Planning, 2007. Reproduced with permission.

In some states it is possible to draft ‘living Wills’, where a directive about medical decisions is made. Whether or not this is binding will depend on the state; for those states in which it is not binding, it may still be used as evidence of a client’s wishes for a particular treatment.

The same person may be an appropriate attorney for both financial and medical decisions, but it is important to consider the additional emotional issues that come hand in hand with medical decisions. ‘If you are nominating someone to make medical decisions for you, you’ve got to also ensure that they are going to have the time to do that and also that they’re prepared to carry out that role because it would be a very difficult role for a lot of people to perform’, Dwyer said.



Revoking a POA A POA is an important responsibility and it should be checked regularly to ensure that it is up-to-date. The physical document needs to be kept in a safe place, and notification to all relevant bodies should be made if its status changes. Appropriate bodies might include financial institutions, medical practitioners and the appointed attorney.

State legislation will vary on how powers are revoked, but an enduring POA can be revoked at any time by informing the appointed attorney and all other relevant people or agencies in writing. A POA can also simply be destroyed. However, if the POA has been registered, a written revocation of the power should also be registered. Note that registration fees and stamp duty may need to be paid to register a revocation.

Plan with care The subtle variations across Australian jurisdictions mean that care has to be taken when clients are assigning POAs.

Points to cover include:

> Going beyond the simple question ‘Do you have a POA?’ to ‘What purpose does it have? Who prepared it? May I look at it?’ Clients might not understand the importance of an enduring POA.

> Each state has different requirements and scopes when assigning permission for an attorney to make financial or medical decisions.

> The concept behind an enduring POA (that affairs should be in order for an incapacitating event) is similar to income protection or trauma-based insurances, and there may be value addressing these planning areas at a similar time.

> POAs need to be reviewed regularly, and those that are no longer appropriate should be revoked. State legislation will vary on how powers are revoked, but it is essential that there is no confusion about exactly who the principal has nominated to manage their financial and lifestyle affairs.



Consider …

What is an adviser’s role in the estate planning process?

> Estate planning in reality is a collection of risk management strategies employed to mitigate risks that may be present when a person dies or is unable to deal with their assets, e.g. as a result of incapacity.

> The risks involved could include depletion of the estate, challenges to the estate, paying excessive taxes, assets being lost from the family or inappropriate distribution of assets.

> When viewed in this way, it is much clearer as to how essential this process is to a client and how an adviser providing a full financial planning service would be obligated to address these risks.

> Advisers know they are obliged to explain the tax implications of their recommendations to a client, however, it is also important to explain the implications of these recommendations in the client’s estate plan.

> Risk-only advisers also have this obligation. At the very least, the client should be made aware of to whom the insurance proceeds will be paid; whether the nomination to this person binding or not; whether there may be a challenge to the nomination; how the funds may be protected after death; and any tax implications to the estate or beneficiary.

> It is not enough simply to recommend a product and a sum insured. Leaving the beneficiaries to deal with these issues may not only be breaching the adviser’s duty of care, it may also mean there are lost opportunities to save tax, and to direct and to protect the funds.

> This does not mean advisers are expected to be experts in estate planning, but they do need to advise their clients of the impact their financial planning recommendations will have on a clients’ estate planning objectives.

> An adviser is not necessarily required to provide solutions to all of the client’s estate planning issues and shortcomings, but at the very least they must identify the issues and refer the client to the appropriate estate planning professional.



Wrap up A POA authorises a trusted person to make financial and legal decisions for someone else, usually for a specific period of time. POAs in different jurisdictions can have a significant impact on estate planning, particularly if clients have assets that span across state and territory borders.

A POA is an instrument (a document) that enables one person (known as the ‘principal’) to appoint another person (known as the ‘attorney’) to act on their behalf. It allows the nominated attorney to sign any document or do any thing that the document allows, subject to certain legal limitations. In order for a POA to be valid, certain formalities must be adhered to. These requirements can vary from state to state.

There are two main types of POAs:

1. general power of attorney

2. enduring power of attorney.

A general POA gives permission for an attorney to make financial decisions about specific assets, but on the condition that the principal still has capacity to make decisions. An enduring POA has all the same characteristics as a general POA with the exception that an enduring POA will continue to be effective even if the principal has lost the legal capacity to act for themselves. This allows the finances of the incapacitated person to continue to be managed and made available for the incapacitated person and their family.

With the capacity of POAs varying across the different states and territories in Australia, care must be taken when preparing the relevant documentation.

References Voyce, M. Brookhouse, J. Charaneka, S. Semple, L. (2007), Guide to Estate Planning, CCH Australia, Sydney.

O’Sullivan, B. (2008), Estate & business succession planning, a practical and strategic guide for accountants, financial planners and lawyers, Taxation Institute of Australia, Sydney.


> Catherine Dwyer, Senior Estate Planning Lawyer, ANZ Trustees

> Robert Monahan, Senior Estate Planner, Australian Executor Trustees

DISCLAIMER



May 2009

Risk profiling – getting it right

Overview Financial advisers are legally required under the Corporations Act 2001 to have a reasonable basis for the advice provided to clients. Where that advice relates to financial products with an investment component, ASIC’s Regulatory Guide 175 indicates that the ‘relevant personal circumstances’ of the client will normally include their tolerance to risk.

While it is common industry practice to identify a client’s risk profile and recommend an asset allocation based on this, recent market performance and issues concerning adviser and licensee practices have again focused attention on this area of the financial planning advice process. Financial advisers need to understand the difference between risk tolerance and risk profiling, and how both are relevant to providing appropriate advice to clients.

Did you know?

During 2007, around 70% of complaints about financial planning made to the Financial Industry Complaints Service, concerned inappropriate advice.


> Define risk profiling.

> Evaluate the different approaches to risk profiling.

> Explain the importance of appropriate risk profiling to the financial advice process.

> Describe factors that influence the outcome of risk profiling with clients.


Knowledge areas This segment is relevant to the following knowledge areas:

> Generic knowledge — Industry standards and ethical considerations (15 minutes)


Risk profiling — getting it right


Risk profiling — what is it? Risk profiling has often been seen by adviser practices as a way to both meet compliance requirements and ensure that the appropriate asset allocation is selected when recommending investment products to clients. Traditionally, some advisers may have asked clients to indicate where they felt they fit on a scale from ‘conservative’ through to ‘aggressive’, while others used a short questionnaire provided by their licensee.

The role and method of risk profiling clients has been the subject of debate in the industry over many years, and has again been in the spotlight as a result of recent financial market events.

There are a number of tools and methods available to determine a client’s risk profile, but, before examining these, it’s necessary to define risk profile and risk tolerance.

> Risk profile — is used to describe a person’s investment type.

> Risk tolerance — is the degree of risk that a person is prepared to take in regard to the performance of their investments.

Wayne Stevens, Managing Director of Emohruo Financial Services, believes financial advisers usually confuse the two terms. ‘The main difference between risk profiling and risk tolerance is something that a lot of planners don’t really get. They tend to merge the two of them together. Risk profiling is more about a generic description of what someone’s risk profile is after a series of questions … but risk tolerance … goes down to individual questions and really starts to examine the individual person’s way that they feel about investments and it also goes into things like timeframe, their age and so forth.’

Paul Resnik from FinaMetrica discusses the confusion. ‘Often when risk profile is talked about in terms of individuals, it conflates three things:

1. their risk tolerance, which is a psychological construct, an innate characteristic of individuals

2. risk needed — the amount of risk needed to achieve goals

3. risk capacity — how much somebody could afford to lose without having their goals messed up.

Very often people don’t quite understand how all those things fit together.’

Paragraph 104 of ASIC’s Regulatory Guide 175 Licensing: Financial product advisers—conduct and disclosure, states that where advice relates to financial products with an investment component, financial advisers need to account for the tolerance of the risk of capital loss and the tolerance of the risk that the advice will not produce the expected benefits.

Quicklink

For a copy of ASIC’s RG 175, visit www.asic.gov.au

> select ‘Regulatory documents’ under ‘Publications’

> select ‘Regulatory guides’

> select ‘RG 175 Licensing: Financial product advisers—conduct and disclosure.



Risk tolerance Wes McMaster, Adjunct Professor with RMIT University, believes that advisers often mistake risk tolerance for emotional tolerance. ‘Risk tolerance means financial capacity to take risk. In other words, how is the financial capacity of the client affected if the investment goes down or the investment goes up, or if there’s a capital loss. What financial position will the client be placed in if any of these circumstances eventuate? That’s what ASIC is asking us to look at.’

Financial risk tolerance is often described as a continuum, with people ranging from risk-avoiders to risk-seekers. Low risk tolerance prevents many people from doing as well as they could financially. On the other hand, some of life's most unpleasant financial surprises arise because people were exposed to a level of risk beyond their comfort zone, that is, beyond their risk tolerance.

Broadly, risk tolerance can be seen as the sum of all the fear and greed trade-offs available, including trade-offs between making the most of opportunities and securing financial well-being, between regret avoidance over ‘losses’ incurred from taking too much risk, and over ‘gains’ missed through not taking enough risk, and so on.

Risk tolerance is normally distributed so that the standard statistical formulae and techniques can be applied to risk-tolerance observations. According to a report by Geoff Davey and Paul Resnik (2008):

> Males are more risk tolerant than females by about a standard deviation.

> Risk tolerance decreases with age.

> Risk tolerance correlates positively with income wealth and education, and negatively with marriage and number of dependants. However, the correlations are not strong and some researchers came up with different results.

> Test/re-test studies over periods of 30 to 120 days produced correlations of 0.8 and higher between the first and second tests. This is evidence of the stability of risk tolerance.

> Financial advisers are more risk tolerant than their clients by slightly less than a standard deviation.

> Clients need to balance their comfort level with the short-term volatility of their portfolio, and the concern that their investment portfolio balance will be less than expected in the future.

Most people only focus on the short-term risk and don’t understand the trade-off between short-term volatility and long-term performance. The more risk-averse (uncomfortable with short-term volatility) a person is, the more future growth they are likely to trade for security today. These people may not be able to see beyond today’s discomfort to tomorrow’s funding needs. They may worry about immediate fluctuations instead of realising that the investment plan is actually for long-term growth and they may not want the money until perhaps retirement, which could be many years away.

Methods of profiling A risk profile helps financial advisers to determine the appropriate risk/return trade-off for investors. Risk profiling is used for defining what an acceptable level of risk is to an investor and it helps to manage client expectations so their outlook is reasonable in relation to their tolerance for risk.



Quite often clients may also have more than one risk profile. For instance, they may have a short, medium and long-term goal. If an investor has indicated that they don’t need their investments to supplement their income and are prepared to invest for the long-term, this could indicate that they are able to bear a higher risk. These investors contrast with those who may be dependent on investment income for survival, or who are only prepared to invest on a short-term basis. Thus, the investor’s time horizon, disposition, current income requirements and lifestyle aspirations are crucial to determining the risk tolerance of an investor. The longer the time horizon, the greater time the investor will have to ride out the rises and falls of the portfolio value.

Different approaches Risk profiling is not an exact science. Arriving at an appropriate risk profile for the investor can be tricky, although there are a number of tools available to advisers. The modern versions of these tools incorporate assessment of both anxiety-based risk assessment and lifestyle requirements of the investor.

For advisers, making an accurate assessment of a client's risk tolerance is a challenge because of the intangible nature of the attitudes, values, motivations and preferences it entails, and because of the potential for miscommunication when discussing such intangibles.

There are a number of tools available to help assess a client’s risk tolerance and these include:

> questionnaires

> psychometric testing

> client education process.

Questionnaires Diagnostic questionnaires are probably the most common form of risk profiling. They can range from a few multiple-choice questions to complex questionnaires. Some advisers will give their clients the questionnaire and have them complete the assessment without them in the room, whereas others will talk the client through the questions.

Wayne Steven from Emohruo Financial Services uses this method. ‘In our case we have a series of questions under the dealer group that we’re with. We are guided by what they say, so we have to use their method of risk profiling and they have a series of 12 questions. That’s really how we come up with it and it’s just a matter of again making sure that it’s not just the overall, but going through the individual questions and making sure that when you’re asking those questions that you’re making sure that they actually understand what the questions are and how they fit, because a lot of people are going down certain tangents with what the questions might say.’

Quicklink

For an example of a risk profiling tool, click here to take FinaMetrica’s Risk Tolerance Questionnaire.



Psychometric testing Psychometrics is defined as being the science of measuring mental capacities and processes. Psychometric testing is any method, whether in the form of a questionnaire or behavioural study, that assesses an individual’s psychological profile. In the context of financial advising, a psychometric test assesses a client’s psychological acceptance of risk in pursuit of an investment objective.

Many financial advisers already use simple psychometric tests.

For example …

FinaMetrica offers an online assessment that can take place with either an adviser present or not at all. It takes about 10 to 20 minutes for a client to complete. Assets are grouped into risky and defensive categories. Clients are then provided with an illustrative tool to look at, which shows how a portfolio, made up of those assets, performed over the past four decades. The main purpose of this is to give clients a better understanding of the upside and downside risks of each asset allocation.

CEO Paul Resnik explains how it works: ‘We have 25 questions which look at employment issues; it looks at how people view words; it looks at how people might judge a particular option when losing money or making money, so we look at a broad spectrum of questions as well as asking the simple question, just to correlate back, “what do you think your risk tolerance is?” … generally we’ve found that most people get their assessment of their own risk tolerance right … within three points in a score of 100.’

However, financial advisers need to exercise some caution when using these products because the ‘know your client’ rule requires more of a financial adviser than merely conducting a test. The danger with over-reliance on any risk-profiling tool comes with assuming that if the client can cope with risk, then that risk should be taken.

One approach to combat this would involve both psychometric testing and an analysis of the client’s circumstances. For example, even if the client is psychologically accepting of risk-taking, their personal circumstances may not allow it, in which case a low-risk strategy would make the most sense.

Client education process The client education process involves talking to the client about how markets work, sharemarket volatility and the source of investment returns as well as the relationship between risk and returns, i.e. low risk low return, high risk high return. It is good practice to use both oral and visual communication tools such as discussing historic facts and using graphs and tables. Wes McMaster says he prefers this method and advises showing clients a table with different asset allocation benchmark portfolios and different asset allocations and then explaining the returns over different timeframes.



‘For instance in terms of the ratio of equity to bonds, a conservative portfolio might have 20% in equities and 80% in bonds and a high growth portfolio might have 80% in equities and 20% in bonds. We use that as a shorthand for looking at the relevant characteristics of different portfolios, so you could move through a range from conservative to high growth so you can show the client statistically, how over time on average the return will increase as you increase your exposure to equity, but so does the standard deviation, which is the measure of risk — really a measure of volatility. So the client can see the relationship between return and risk,’ he said.

After this information has been provided, the adviser might then ask the client to consider which portfolio they would feel most at ease with, given that they are now in a position to make an informed choice.

Effective risk profiling for advisers A risk profiling assessment should generally be carried out during the adviser/client fact-finding process and it should be revisited every time there is a review because clients can change. At the conclusion of the risk profiling exercise, the adviser and the client need to agree on the client’s particular requirements that categorise them as a ‘type’ of investor.

A client’s understanding of (and comfort with) risk often increases as they become more knowledgeable and more experienced in investing. They are able to see past short-term fluctuations in the investment value of their portfolio and focus more on the long-term return that higher risk growth assets can provide.

Nevertheless, a financial adviser shouldn’t rely on their intuition when determining an investor’s appropriate risk profile. It is important to ask the investor many questions about their particular goals and fears to determine whether they will be able to bear a fall in the markets without undergoing undue hardship or stress.

Adviser bias The way in which an adviser frames a question, responds to a question, or makes a statement can have an influence on a client’s response and produce a biased outcome. Wes McMaster explains, ‘I remember a case in particular where various clients of quite different backgrounds … were obviously conservative because they were retired and on the pension; for example, they didn’t have the capacity to replace any money if it was lost. Others were working and earning quite good incomes and so they had a different capacity, and yet the adviser put them all through a risk profile test and somehow got them all to come out very similar as high growth, and that could only be through adviser bias because it was clear that some people were inappropriately in that category’.

Tip: When an adviser is with a client when they are completing a questionnaire, remain neutral and silent when the client does the risk profiling assessment.

Providing clients with more information when asking questions will ensure that they have a better understanding on how the process works. This should also ensure better answers to help determine a risk profile.



Consider …

Consider the following questions:

1. If the market is going to be volatile and you lose 30% in a very short period of time, such as a year or less, what would you actually do?

2. If the market is volatile what would you do?

Question 2 is more likely to get an uninformed and quick response rather than the detail that is needed to construct an appropriate risk profile.

It can be less intimidating for the client if questionnaires and psychometric tests are given to them to do in a private office space. However, if the adviser is needed in the room, they should avoid projecting their own views and risk tolerance onto clients, particularly because financial advisers tend to be more risk tolerant, on average, than the general population.

Timing The timing of risk profiling can have a huge impact on a client’s response. The global financial crisis has affected so many investors, and confidence is at an all time low. The challenge now is on advisers to do an adequate risk profile assessment when so many clients are likely to be uncertain.

‘If you get them to do a psychological risk profile now, they’re likely to emerge as being quite cautious and conservative because of their recent experience, but if you had done the same profile test on a person in mid-2007 after they’d had several years of very strong growth, you are likely to have found a completely different outcome where because of their experience and exuberance over the growth that they’d experienced, they would likely be more risk tolerant as an outcome. So the problem is that recent experience will definitely skew the psychological profile that you produce.’ McMaster said.

Tip: When talking about sharemarket volatility, especially at the moment, be sure to present a balanced view. For example, point out to clients that before the current bear market, the bull market produced substantial returns for investors’.

The risks of incorrect risk profiling When risk profiling is not done correctly, the client ends up with an inappropriate asset allocation and inappropriate investment portfolio. Typically this leaves the investor exposed when markets fall and ultimately the adviser might find themselves in a position of having to answer some difficult questions, or even face litigation.

Wes McMaster says, ‘I’ve seen a retired couple on the age pension with assets of about $200,000 (outside their house and car). They were advised to invest in a high-risk speculative equity investment, which is entirely inappropriate for their position … Needless to say, they didn’t know that it was a speculative and high-risk investment, that’s not how it was presented to them, but they had a conservative to moderate risk profile and yet they were given this investment … it was the subject of litigation along with a number of other clients from the same adviser’.



The recent financial turmoil has highlighted how many clients have been exposed to investments that didn’t match their risk profile. The global financial crisis has also changed many investors’ perception of risk; however, that doesn’t necessarily mean a client’s risk tolerance should change. Paul Resnik says, ‘All of the evidence suggests that [risk tolerance] is a trait, not a state, so in all the work we’ve done (we’ve got about 260,000 profiles over the last 11 years) our analysis suggests that generally risk tolerance doesn’t change greatly. It changes after traumatic events, but we don’t know necessarily which way,’ Resnik said.

There is concern in the industry that many financial advisers and licensees have adopted a particular risk profiling method and stayed with it out of complacency and for ongoing compliance reasons. The current environment presents an opportunity to revisit risk profiling methods and ask questions such as:

> When was the last time I revisited my risk profiling method?

> Is the risk profiling method used still relevant?

> Is it adding value to our advice?

When it comes to explaining risk and determining a client’s risk profile, part of the adviser’s role is to educate. Wayne Stevens says risk profiling should never be a ‘set and forget’ practice. ‘One of the things that we do is go back through previous fact-finders with the client so we show them how they answered their questions … and ask “What would your answer be on this particular question?” and they’d reply and then … you can say “Well, that’s different to what you did last year”.’

The need for licensees to focus on training their financial advisers properly on risk profiling is now more important than ever and market performance has highlighted why this is the case. The current economic landscape has changed and clients have become more sophisticated and their expectations of financial advisory firms are higher. What’s now key for financial advisers is to ensure that they understand risk profiling and remain committed to getting it right, no matter what the approach.

References Callan, V. and Johnson, M. (2002), ‘Some Guidelines For Financial Planners In Measuring And Advising Clients About Risk Tolerance’, Journal of Personal Finance, August. Available from www.riskprofiling.com.

Davey, G. and Resnik, P. (2008), Risk Tolerance, Risk Profiling and the Financial Planning Process, FinaMetrica Pty Limited.

McMaster, W. (2009), Risk profiling Has the financial industry got it right? Available from www.wesmcmaster.com.


> Paul Resnik, CEO, FinaMetrica

> Wes McMasters, Adjunct Professor, RMIT University

> Wayne Stevens, Certified Financial Planner & Authorised Representative, Emohruo Financial Services



DISCLAIMER


May 2009

Fee disclosure — the basics

Overview Under the Corporations Act 2001, financial service providers are required to give their retail clients documents that disclose fees at various stages in the advice process. ‘Dollar disclosure’ rules require that fees, expenses, benefits and interest must be disclosed in dollar amounts, rather than as formulas or descriptions. Outside of its legal requirement, proper fee disclosure allows clients to make an informed decision and plays an important role in managing conflicts of interest. There is also a trend in the industry towards simpler disclosure and using a fee-for-advice approach.

Did you know?

According to data from PriceWaterhouseCoopers’ Investment management CEO survey, many adviser practices expect to move towards a ‘fee-for-service’ remuneration model in the near future.

Learning objectives After completing this segment participants will be able to:

> Detail when fee disclosure is required and what must be disclosed.

> Outline the ‘dollar disclosure’ rules.

> Explain the relevance of fee disclosure to conflict of interest management.

> Summarise some of the future trends in relation to fee disclosure.



> Generic knowledge — Industry standards & ethical considerations (30 minutes)




Requirements for disclosure Once a thorny issue for financial advisers and product providers, the requirements for disclosure of fees and commissions are now clearly set out in the Corporations Act 2001, through guidance from the regulator, the Australian Securities and Investments Commission (ASIC), and through policy and recommendations by the major industry associations and bodies.

Quicklink

To download a copy of relevant provision of the Corporations Act 2001, see www.comlaw.gov.au:

> select ‘Compilations — current’ under ‘Acts’

> select ‘Co’ from the alphabetical list

> select ‘Corporations Act 2001’.

The industry regards disclosure of fees and commissions as important for a number of reasons. As David O’Reilly, the Director of Policy and Regulations for the Investment and Financial Services Association (IFSA) says, ‘All investments involve costs and we should know what those costs are before we invest. The Corporations Act requires the disclosure of fees and costs to enable consumers to better understand the product they are investing in and allows them to compare products and to ascertain for themselves what the best value for their money is’.

As the disclosure of fees and commissions is a legal requirement for advisers, if it is not fulfilled, both prosecution and action by the client (if they suffer any loss) are possible.

Aside from the legal aspects, good fee disclosure is regarded as best practice. As Christina Kalantzis, Principal of Alexis Compliance and Risk Solutions, says, it ensures that clients are fully informed and aware of what they are paying for — both upfront, and on an ongoing basis — when purchasing financial products or advice.

To fulfil these legal and ethical obligations, it is important for Australian Financial Service Licence (AFSL) holders to understand what the requirements are for transparent fee and commission disclosure in the appropriate documentation.

Dollar disclosure Dollar disclosure rules require that various costs, fees, charges, expenses, benefits and interests be stated in dollar terms. The rules were introduced in 2005, as part of a comprehensive overhaul of the disclosure of fees and costs, in a bid to make it easier for clients to understand exactly how much they were paying for certain services.

’When we’re talking about the dollar disclosure rule, it’s about being upfront and transparent so the client has an informed understanding of exactly what the fees are’, says Kalantzis.

In a statement of advice (SOA), information needs to be provided and a dollar cost attached to this information about who the adviser acts for, the adviser’s remuneration, and any charges the client will incur if they purchase a financial product, sell a financial product, increase or decrease their interest in a financial product.



In a product disclosure statement (PDS), the dollar disclosure requirements cover the benefits that the holder of that product may become entitled to, as well as the costs of the products and any periodic costs or commission that may be deducted from the investment.

Quicklink

For a copy of ASIC’s regulatory guide relating to dollar disclosure, see www.asic.gov.au:


> select ‘Regulatory Guides’

> select ‘RG 182: Dollar Disclosure, June 2008.

RG 182 sets out how ASIC administers the dollar disclosure provisions of the Corporations Act 2001, and ASIC’s policy for granting relief from the rules.

Disclosure at various stages of the advice process Essentially, there must be fee disclosure that is clear, concise and effective at all stages of the advice process. This includes:

1. When a client is seeking a financial service, they must be provided with a financial services guide (FSG).

2. When a client is seeking financial advice, they must be provided with an SOA at the time, or soon after, they have been provided with the advice.

3. When the client is considering purchasing a financial product, they must be provided with a PDS.

Disclosure in the financial services guide (FSG) The Corporations Act 2001 requires that an FSG must be given to a retail client as soon as practicable after it becomes apparent that a financial service will, or is likely to be, provided to that client. The FSG must be given before a financial service is provided. O’Reilly says, ‘In an FSG, the primary fee disclosure that’s required is disclosure of the remuneration, including commissions and other benefits that the adviser may receive’. This includes, for example, any upfront commissions, trailing commissions and ‘soft dollar’ commissions or benefits to which the adviser may be entitled.

Kalantzis says, ’When we are looking at the FSG, there are a few things to focus on. One is the remuneration structure that the adviser has. The next one is the fees that they charge the client in the provision of advice. Whether that is fee-for-service or whether that is on a sliding scale depending on funds under advice’.

Also required is statement on commissions — whether upfront commissions or ongoing trail commissions, or a combination of both. Lastly, any other benefits that might be received in lieu of income are to be included.



Disclosure in the statement of advice (SOA) When personal advice is provided to a retail client, an SOA must be provided to the client at the same time as, or as soon as practicable after, the advice is provided.

The SOA should normally include information about all remuneration, commission and other benefits that the financial services provider will or reasonably expects to receive for the advice, both upfront and on an ongoing basis. As the ‘dollar disclosure’ rules apply to SOAs, this information must be stated in dollar amounts.

O’Reilly adds, ‘You need to disclose any direct or indirect pecuniary interest that you may have in the financial product that you are recommending and you’re required to disclose any associations that may influence your recommendation’.

Most importantly, as the SOA is a personal document that is given to the client, the disclosure must be tailored and customised specifically to the advice provided.

Kalantzis says, ‘You talk about what the fees are with respect to the advice that was given, and also what the fees are to actually execute the advice from a product perspective. So good fee disclosure would include the product fees, the management expense ratios as well, any platform or administration fees that you have, and also the fees that the adviser charges, articulating what the fee structure is for the AFSL and what the fee structure is for the adviser. It doesn’t stop there. You have the ongoing fee as well, and this should be disclosed in percentage terms as well as dollar terms. What’s more important is it needs to be disclosed in total amounts as well’.

Disclosure in the product disclosure statement (PDS) The PDS is the point-of-sale document that sets out the significant features of a financial product. PDSs for superannuation products issued after 1 July 2005 and for managed investment products issued after 1 July 2006 are required to include a fees and costs template. As in the SOA, fees, charges, benefits and interests must be stated in dollar amounts in a PDS.

Schedule 10 of the Corporations Regulations requires that the PDS include a fees and costs template and it also requires an example to be provided of the annual fees and costs that the holder of the interest will incur. ‘That annual fees and costs statement is based on a $50,000 balance with an annual $5,000 contribution being made to a balanced or default fund’, O’Reilly says.

Industry support for disclosure Industry associations such as IFSA and the Financial Planning Association (FPA) strongly support full fee disclosure.

Fee disclosure is clearly addressed in the FPA’s ‘Rules of Professional Conduct’, with Rule 6 stating that in any written recommendation, the adviser must disclose:

> ’Remuneration, fees, commissions, or any other pecuniary or non-pecuniary benefit whether direct or indirect, received or receivable by the member, the member’s principal or an associate in connection with the financial planning service.

> Any other benefit reasonably capable of influencing the making of the recommendation.

> Any benefit that a third party may receive in connection with the recommendation.



> Any other costs borne by the client, should they accept all or part of the recommendation.’ (FPA, 2008)

These amounts must be stated in percentage terms, at a minimum, and in dollar terms where required. Where financial planning services are provided orally, these amounts must still be disclosed.

Quicklink

For more information on the FPA’s Code of Ethics and Rules of Professional Conduct, visit www.fpa.asn.au:

> select ‘About us’

> select ‘Profile, vision and priorities’

> select ‘Code of Ethics’ in the text under ‘Profile’.

Conflict of interest management Disclosure is seen as a key tool in the management of conflicts of interest.

In 2006, the FPA introduced four ‘Principles to manage conflicts of interest’. Principle One is:

‘The cost of financial planning advice should be separately identified as a financial planning advice fee in the statements of advice provided by FPA members to clients, and the total fees paid for ongoing advice should be disclosed to clients on a regular basis.’ (FPA, 2006)

A requirement for separate identification began in 2006 and an ‘ongoing advice’ disclosure requirement began in January 2008, which required that all ongoing advice fees (in other words, trail fees) must be disclosed to the client on a regular basis through client advice statements.

Both the FPA and the Association of Financial Advisers (AFA) have been focused on encouraging transparency, as well as identifying and disclosing any conflicts of interest.

David O’Reilly outlines IFSA’s approach to fee disclosure and management of conflict of interest:

‘In terms of management of conflict of interest — and it is an obligation under the Corporations Act to manage any conflicts of interest — disclosure is a primary tool for management of those conflicts. If a client is fully informed, then the potential for conflict is very much reduced’.

However, there is still a requirement, even when there is full fee disclosure, that any conflict be managed.

IFSA has a Code of Conduct and Ethics for all its members. That Code of Conduct and Ethics requires members to:

> safeguard their client’s interest

> provide clear, concise and effective disclosure

> act with integrity and make ethical decisions.



O’Reilly adds, ‘When you’ve got all those elements within a regime which is based on full disclosure to clients, the potential for conflict of interest and damage to the client’s interest is minimised’.

Quicklink

For more information on the IFSA’s Codes of Ethics and Conduct, see www.ifsa.com.au:

> select ‘Standards & Guidance Notes’

> select ‘Standard No 1 — Code of Ethics & Code of Conduct’.

Trail fees and soft dollar commissions Trail fees and soft dollar commissions have both been contentious areas within the financial planning industry and the broader community in the past, and in both areas full disclosure requirements apply.

Trail fees Part of an adviser’s remuneration following the sale of a financial product, trail fees are paid by product providers as a smaller ongoing fee. While the concept behind trail fees is that they remunerate investment advisers for periodic reviews of a client’s investment portfolio, these types of payments have often come under attack.

‘The major criticism of trail fees is that the fee is paid after the product has been purchased and there is no ongoing advice being provided in some cases’, O’Reilly says.

Kalantzis acknowledges that the ongoing, and often heated, debate about trails generally centres on whether they represent a conflict of interest, from a legal and regulatory perspective. As such, the issue is not whether a fee-for-service model is used for adviser remuneration in preference to trail fees, but whether any fees that are charged are transparently disclosed to the client.

Some in the industry have argued that Principle One of the FPA’s ‘Principles to Manage Conflicts of Interest’, with its ongoing advice requirement, has the potential to cause difficulties in relation to trail fees. For example, Encore Group Managing Director Graham Peatey asserted that while a majority of advisers have the right systems in place to disclose fees to core clients, adherence with FPA Principle One would mean dealer groups would also have to send advice statements disclosing trail fees to ‘low value’ and legacy clients, even though they were not necessarily ‘active clients’ of the dealer group or adviser. (Baltazar, 2008)



Quicklink

For a copy of ASIC’s regulatory guide relating to managing conflicts of interest, see www.asic.gov.au:


> select ‘Regulatory Guides’

> select ‘RG 181: Licensing: Managing conflicts of interest’.

‘Soft dollar’ commissions Another area of debate in the past has been ‘soft dollar’ commissions. ‘Soft dollar’ refers to any indirect fee or benefit that has the potential to influence an adviser to choose a certain product, platform or service.

‘In a wholesale context, it could be free research being provided to sell a financial product or use a financial service. In a retail context, it could be free or subsidised conferences. It has no direct impact in terms of the service or advice, but it’s an encouragement or an inducement for the person to actually sell that particular product or provide that particular service,’ O’Reilly says.

The disclosure requirements mean that any benefits of this type must also be disclosed to clients in the same manner as other fees and commissions.

Future trends With full disclosure now mandatory, the focus is on how it can be made simpler and more easily understood by clients. For example, the Federal Government has created a Financial Services Working Group that is developing financial services disclosure documents which are brief, simple and allow consumers to easily compare products. That group is presently examining PDSs sector by sector, beginning with the superannuation sector.

O’Reilly believes continuous improvements by service and product providers looking for better ways to inform their clients will lift the standard of fee disclosure. These improvements may be found through the more widespread use of technology, such as electronic calculators, end benefit statements and projections.

‘I think the industry will encourage clients to use those for the purpose of determining how much they need to save for their retirement, for example, and what impact fees and costs may have on that end benefit that they might receive’, O’Reilly says.

There are also signs of a growing move towards fee-for-service, as a way of increasing clarity about the cost of advice. For example, in January 2008, NAB Financial Planning indicated it would be moving its financial advisers to a fee-for-advice approach for all new clients seeking personal investment and superannuation advice.

The results of the Investment Management CEO Survey, conducted by PriceWaterhouseCoopers and released in 2008, revealed that the majority of chief executives indicated they would be changing their ‘adviser incentivisation’ model over the next few years, predominantly towards fee-for-service. (PriceWaterhouseCoopers, 2008)



Transitioning to fee-for-service Before an adviser practice decides to move to a solely fee-for-service model, there are many considerations that need to be taken into account. Clients do not necessarily prefer the fee-for-service model — those clients who are used to being charged commissions, may prefer this structure as they understand it better. Some adviser practices use both fee-for-service and commission models.

When charging via a commission structure, the advantages are:

> it is easier to administer

> it may be easier for the client

> some clients would prefer this method

> familiarity – for advisers who have been using this model since starting their business

> the unlikelihood of incurring bad debts.

The disadvantages of a commission structure include:

> the product provider is determining the price

> this method is progressively falling out of favour with regulators and some professional bodies

> the adviser is only paid if the client proceeds with the recommendations

> there is the perception that this structure is less professional than other methods of charging fees

> this makes client segmentation more difficult

> there may be conflict of interest issues.

When charging via a fee-for-service structure, the advantages are:

> transitioning to this method provides an opportunity to review a client portfolio

> an adviser’s awareness of business operations is raised

> the value of the business may be enhanced in the long term

> this method easily allows for client segmentation

> the adviser is able to provide non-product based advice, for example, budgeting, debt management and basic estate planning

> there is the perception that this method is more professional

> a fee-for-service structure seems to be increasingly favoured by the regulators and some professional bodies

> the adviser can be paid for the advice regardless of whether the client proceeds with the recommendations

> the adviser is able to determine their own fee and their own worth

> the perception that the adviser receives payment only for services provided.

The disadvantages of a fee-for-service structure include:

> there may be difficulty in placing a value on the service

> there are many variations of the model that can be used



> it may be difficult to transition to this method with significant planning required

> it may be difficult to change the mindset of clients

> there may be a requirement to purchase new software

> other resources, such as time and effort to change, are required

> there is a higher chance of bad debts so there will need to be systems in place to monitor and follow up payment of fees.

Final advice on disclosure According to O’Reilly, the most common area of complaint by clients around fee disclosure is that they don’t understand the fees; for example, they might find the fee template in a PDS confusing.

‘Really it’s an opportunity at that stage to explain a bit more fully how those fees and costs impact the client, what they are and how they will impact the financial return,’ O’Reilly says, ‘Don’t be afraid of fee disclosure. A fully informed client is a happy client. Clients need to take responsibility for their decisions. The job of the financial adviser and the financial services provider is to provide as much information and explain that information as comprehensively as possible to the client, so that the client can make an informed investment decision’.

Kalantzis also advocates ensuring the client understands exactly what fees they will be paying, ‘You need to understand it and your client needs to understand it as well, so if the fee disclosure goes for more than one page, we may have some issues in terms of adhering to the concise, effective and transparent disclosure rules. If you can explain it in an easy format, where the clients know exactly what the total fees are and what the ongoing fees are, then you’ve done a really good job’.

Aside from fulfilling legal obligations, transparent and effective disclosure may also provide protection from action by clients on fees and commissions.

‘If you read current Financial Ombudsman Service (FOS) complaints and determinations arising from complaints, you’ll find that the rules of the Financial Industry Complaints Service (FICS) and FOS are such that if a client complains about the level of fees and commissions that were charged, FOS and FICS review it to see whether the fees were disclosed. If the client is saying that they were excessive, the complaint gets thrown out because it’s not an issue as to how much you charge a client — the question and your obligation is whether or not they were disclosed to the client. If you didn’t disclose the fees and commissions to the client and the client was unaware of what the true cost was, then that is a potential claim’, Kalantzis says.

Wrap up Under the Corporations Act 2001, financial service providers are required to give their retail clients documents that disclose fees, commissions and other benefits at various stages in the advice process. The documents this particularly affects are the FSG, the SOA and the PDS.

On top of these requirements, ‘dollar disclosure’ rules exist that require the fees, commissions and benefits be disclosed in dollar amounts, rather than as formulas or descriptions. Aside from its legal requirement, proper fee disclosure allows clients to see exactly what they are paying for and this plays an important role in managing conflicts of interest. There is also a trend in the industry towards simpler disclosure and a fee-for-advice approach.



References Australian Securities & Investments Commission (2007), ‘Regulatory Guide 168 — ‘Disclosure – Product Disclosure Statements (and other disclosure obligations)’, Australian Securities & Investments Commission, Sydney.

Australian Securities & Investments Commission (2007), ‘ Regulatory Guide 175 — Licensing: Financial product advisers — Conduct and disclosure’, Australian Securities & Investments Commission, Sydney.

Australian Securities & Investments Commission (2007), ‘Regulatory Guide 182 — Dollar disclosure’, Australian Securities & Investments Commission, Sydney.

Baltazar, M. (2008), ‘New era in fee disclosure’, Financial Standard, 5 August.

Financial Planning Association of Australia (2006), ‘Principles to manage conflicts of interest’, Sydney.

Financial Planning Association of Australia (2008), ‘Rules of professional conduct’, Sydney.

PriceWaterhouseCoopers (2008), ‘Investment Management CEO Survey 2008’, PriceWaterhouseCoopers.


Christina Kalantzis, Principal, Alexis Compliance and Risk Solutions

David O’Reilly, Director, Policy and Regulations, Investment and Financial Services Association (IFSA)

DISCLAIMER

This document was prepared by and for Kaplan Education Pty Limited ABN 54 089 002 371. It contains information of a general nature only and is not intended to be used as advice on specific issues. Opinions expressed are subject to change. The information contained in this document is gathered from sources deemed reliable, and we have taken every care in preparing the document. We do not guarantee the document’s accuracy or completeness and Kaplan Education Pty Limited disclaims responsibility for any errors or omissions. Information contained in this document may not be used or reproduced without the written consent of Kaplan Education Pty Limited.

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