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Painful transition to FOFA will pay off in the long term

The Future of Financial Advice (FOFA) reforms have overhauled the way financial advisors operate, to the long term benefit of financial advisors and the major banks. FOFA came into effect on 1 July 2013, and aims to reduce conflicts of interest within the financial planning and investment advice industry. The legislation has fundamentally changed the way financial advisors are remunerated for their services. Consequently, some advisors have come under significant pressure, while others have capitalised on opportunities to strengthen their business models and emphasise value propositions. Meanwhile, the major banks are following developments closely, ready to pick up the pieces – as they tend to do when a part of the financial sector is set to disintegrate.

The basics of FOFA

FOFA has introduced a ban on commission payments. Previously, financial advisors would receive a commission on the sale of retail financial products, such as investment schemes and insurance policies, to retail clients. This commission would be paid by the product provider. Thus, retail customers themselves did not have to pay directly for financial advice. Rather, the financial advisor would inform them on a product, sign the clients up and receive a commission from the upstream institution. Essentially, the advisors were part of the upstream cost structure and were incentivised to push through as many products as they could, regardless of a client’s financial situation. The ban on commission payments, along with the introduction of a fiduciary duty, has changed this. Subject to grandfathering on some existing payments, financial advisors now have to receive upfront payments for their services directly from clients, and it is now law that they act in the best interest of clients.

The fundamentals of financial planning and investment advisory operations have not changed. The success of these businesses is still underpinned by the quality of advice and the established relationships between clients and advisors, and between advisors and financial institutions. The FOFA reforms only apply to advisors working with retail clients — that is, clients that are not classified as wholesale or sophisticated investors. What has changed is the remuneration of retail advisors. The model will now largely move towards a salary-based package for advisors. The days of cap-free and trailing commissions are all but over.

Effect of fee-for-service

Financial advisors have had over a year to adjust their platforms. In early 2012, the Federal Government announced that the reforms would be compulsory from July 2013. Many firms implemented the fee-for-service model much earlier (notably NAB, which began implementation in 2008). The performance of advisors that introduced a fee-for-service model before FOFA became mandatory suggests that demand is unlikely to plummet due to the reforms. However, the demographics of the markets for financial advisors are expected to change, and the long-term effects of the legislation on the financial planning and investment advice industry remain unclear.

The reforms create an opportunity for savvy advisors with established reputations. The legislation improves the quality of financial advice because it removes the patent conflict of interest that existed previously. It also attracts clients previously put off by the feeling that a financial advisor was just another salesman. Overall, IBISWorld expects the industry to continue its healthy growth path over the five years through 2018-19.

The changing pay structure is spooking some advisors, who have turned to the big banks for security. The banks have started to consolidate their financial planning businesses by acquiring smaller boutique advisories that depended on the commission structure. The Big Four banks are still able to offer free financial advice as part of their overall value proposition, spreading the related costs across their traditional products. Furthermore, some advisors with strong ties to particular institutions, such as superannuation firms or insurance underwriters, have been able to find refuge with these establishments. The FOFA reforms offer the banks an opportunity to further diversify their businesses and reduce their dependence on mortgage lending.

Although it may be painful, FOFA demands higher professionalism, improves client confidence and presents opportunities for the banking sector and reputable advisors. The cleansing effects of the legislation are expected to outweigh the costs in the long term, especially as the wealth of the general public continues to grow.

Andrei Ivanov is Industry Analyst, IBISWorld, and Tim Stephen is Industry Research Manager, IBISWorld. IBISWorld is Australia’s best-known business information corporation. Related industry reports include K6419b Financial Planning and Investment Advice.

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