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Royal Commission 3: A ban on all percentage-based fees?

In Round 1 of the Royal Commission mortgage broking interviews, the Commissioner asked why the industry does not operate on a flat administration fee paid by the client. This would address the broker incentive to push the borrower into the largest loan and potentially fudging financial statements. Brokers are paid a commission by the bank based on the size of the loan, normally about 0.6% up front. There is usually no cost to the borrower of using a broker.

The idea immediately gained traction. Westpac CEO Brian Hartzer suggested mortgage brokers should charge clients directly, and Westpac would “tighten up” on its processes and transparency on commissions, fees and costs. The Commission found that CBA CEO, Ian Narev, had noted in February 2017 that broker incentives “lead to poor customer outcomes”.

A ban on commissions paid by banks to brokers (similar to the FOFA ban on product manufacturers to financial advisers) would have an enormous impact on mortgage broking and banking, as brokers originate half of all home and investment loans. The industry is already under stress as the banks tighten their lending criteria, with implications for house and apartment prices across the country.

Across a range of financial services, the Commission will make recommendations on fee calculations, who pays them and what incentives are created. How much further could this extend into wealth management?

Fees for fund administration platforms

What’s the equivalent in financial advice and asset management? There was a revealing moment which the media has overlooked in its excitement about charging fees to dead people.

Linda Elkins (LE) is an Executive General Manager at Colonial First State. She was examined by junior barrister Mark Costello (MC) who asked about platforms and their fees. This is a long extract to show how issues sneak up during questioning. Make a note at the point when Commissioner Kenneth Hayne interrupts.

MC: All right. So all consumers that invest through a Colonial First State platform will pay, as a general rule, an investment fee and an administration fee?

LE: Yes.

MC: And the fund manager’s fee would ordinarily be calculated by reference to funds under management?

LE: Yes.

MC: And is the administration fee calculated in that way?

LE: Yes, it is.

MC: And what’s the relationship between funds under management and the administration expenses that the platform operator might incur?

LE: So the main relationship between those things is the – I guess the risk we carry in relation to the unit pricing function that we carry out, and there can be a relationship, although it will vary, between the amount of service that would be required on the account if  the account balance is higher, there can be additional servicing needs, but I would say it’s predominantly the risk in relation to the higher amount.

MC: All right. So you’ve mentioned risk and servicing. Can I deal with risk first. What’s the risk that you’re exposed to?

LE: If we get – the unit pricing is incorrect, then we would be responsible for the remediation of that.

MC: Does that happen often?

LE: No, it doesn’t. We – we – we are – obviously, there is audit functions that are carried out with our external auditors, and we perform at – or we believe we’re at industry best practice.

MC: And explain to me the other vagaries that create the pricing risk?

LE: If we made an error, if we got it wrong.

MC: In the division?

LE: Or in – you know, things like the withdrawal of the administration fee or in the recouping of expenses, wherever it might be.

THE COMMISSIONER: You charge more against the prospect that you might do something wrong? 

LE: We – the question you asked me was what’s the relationship, so no I wouldn’t – I wouldn’t say that that is the relationship. And I would also agree that it is industry practice that these fees are asset-based.

MC: But you would also agree that you’re pricing in your risk of miscalculation which might result in a requirement for remediation, and that affects the price the consumer pays?

LE: Yes.

MC: And that’s the risk component. And the other component was the serving component?

LE: And, again, that’s not necessarily a direct relationship, but it is a factor that it can be. And I would agree that using asset-based fees is the common method that’s used in the industry.

MC: What type of services are contemplated by the servicing fee?

LE: So the servicing fee covers the administration of the account. So the application process, any redemption process, call centre activity reporting, and so on.

MC: All right. And the administration fee will generally be charged by reference to funds under management?

LE: Yes.

MC: And is there any relationship between the administrative tasks that Colonial would undertake and the amount of funds under management?

LE: As I said, it would – it would vary. I mean, no, this is the standard method that the industry uses.

Are platforms a likely target?

The two reasons given for charging administrative fees – possible costs of remediating the client and to cover the services provided – are not the major reasons for the fees. Remediation is minor, and services provided are generally a fixed cost and do not vary materially according to size. Someone with $10,000 on a platform receives the same reports and service as someone with $100,000, so why should the latter pay 10 times as much?

The main reason is to make money. As account balances grow, so do fees. A person with $500,000 at an administration fee of 0.5% pays $2,500 each year (in addition to the investment and advice fees). It’s a scale business where profits are highest on large balances.

Kenneth Hayne is focussing on how financial advice and funds management can address problems with product sales and commissions. He may argue administration in its many forms across the industry should be charged at a flat rate to remove the incentive to grow the account when it might be preferable, for example, to pay off debt.

Furthermore, there is an incentive for a vertically-integrated model to refer larger clients to a platform with a percentage-based fee than one with a fixed fee or a lower cap. There are wrap platforms available which cap the fees or have a low 0.1% fee above a certain amount. Many independent, fee-for-service financial advisers use these wraps to force down the client cost, but an adviser in a large integrated business would be less likely to offer this option.

Or maybe the Commission missed this target. Mark Costello moved off the subject quickly, did not raise the issue of the availability of cheap alternatives, and did not question the two reasons given for charging asset-based fees.

Although the capped or low-cost platforms are already available, it would be a massive change if commissions and asset-based fees were replaced by fixed fees or low caps. Investors paying hefty platform fees on large amounts should shop around now, not wait for the change.

The argument that the industry has not passed on the benefits of scale is not new in funds management. Fiona Trafford-Walker, director of consulting at Frontier Advisors, has been arguing for changes in fee structures for a decade. For example, in an article called Alignment of Interest, written in 2016, she said:

“As the Australian superannuation industry has grown, there has not been enough capture of that scale through reduced costs. We also know that fund manager margins remain very, very high (and if anything, many have expanded since the GFC), especially when compared to any ‘normal’ industry. This desire to capture the benefit of scale is now a significant focus at many funds.”

The Royal Commission will lead to a greater separation between how financial advisers are paid and their choice of products, and there’s a potential for this to extend into other parts of the value chain.

 

Graham Hand is Managing Editor of Cuffelinks.

 

10 Comments
Toby
April 30, 2018

I can't understand why there wasn't a mention the need for institutions to be compensated for the capital employed. Ms Elkins may have covered this but not been reported. We all want well resourced financial service providers and the technology and human resourcing required means substantial capital and a requirement for it to achieve an adequate return.

Michael
April 30, 2018

Thanks for the summary regarding % of assets based admin fees - I wonder if the Royal Commission will be interested in the fact that many (if not virtually all) super funds (including industry funds) now also charge admin fees that are based on a % of money invested? This means that SG contributions are effectively being charged on this basis - is this a good look for a compulsory system? The only large funds that do not do this (to my knowledge) are HostPlus and AustralianSuper.

Many years ago I looked at this issue for super funds and concluded that no more than only a few basis points could be justified and this was because the only admin costs that related to % of assets were some trustee insurance costs (eg trustee liability) and the APRA levy. All other costs have no relationship to funds under administration. This may have changed since then, but I doubt it has changed much if at all.

It will be interesting to see if the grilling that CFS received will also be applied to any super funds.

Jimmy
June 02, 2018

I read through an industry fund PDS the other month and its running costs are at least 1% p.a. from what I could see, however you had to read three different documents and put it all together to work it out.

Paul
April 29, 2018

Many wrap platforms have caps on total
Admin fees already. Generally around the $3500 mark. We are a 16 yo planning practice and a client with a million will pay approx 0.7% for advice platform fee and manager fee with our model portfolio, less than many industry funds AND with advice built in. We run on asset based advice fee and it has worked fine. Every part of the advice chain is reducing costs except for the fund manager . At one thousand or one million fund managers charge the same ICR. It’s about time that they share the load. ....

Phil
April 30, 2018

I agree you can run that pricing model Paul. And agree the active fund managers must come down. My question with your pricing model and it's a genuine question, something I grapple with - for the most part I would prefer active management, but the pricing you've indicated which I agree is a good target, sort of forces you to index costs. I find this makes you almost persuade yourself that index is ok, even if your philosophy is active. i.e. it's another conflict really that drips down to your investment process, sometimes by stealth. Hence, the problem that comes with all forms of vertical integration, you can end up forming a policy to suit the business model.

Peter C
April 29, 2018

Thanks for a great summary regarding the recent events of the Royal Commission. Hopefully it will remove commission based remuneration for financial advisors where there is a clearly a conflict of interest. No wonder genuine financial advisors have had difficulty separating themselves from second hand car salesman.

As an individual trying to find quality information, I had a lot of difficulty getting much regarding wrap platforms. Most google searches turned up websites marketing to financial advisors - I was suspicious. Reviews from the government’s Money Smart and Choice were not particularly supportive of wrap platforms for the indvidual investor. Rather it seemed a technology to make the job of the advisor easier while inconspicuously taking a percentage of assets under management.

I eventually moved everything to Vanguard. My advisor still charges a percentage but has reduced it and gives me a bill. While the difference in fees I pay is probably minimal, it is transparent and I think the financial advisor now has to justify the fee rather than hoping I just leave things as they are.

I am more than happy to pay for quality unbiased advice and hopefully changes from the Royal Commission will be the start for professionals from the financial industry earning back the trust from their clients!

John Ashton
April 27, 2018

In 1231The King of Sicily, Ferdinand II, legislated in the Edict of Salerno to make illegal the physician and the apothecary being the same. He could see the clear conflict of interest.This separation became the model for Europe and the rest of the world. The financial industry has some catching up to do.

Jimmy
April 26, 2018

"There are wrap platforms available which cap the fees or have a low 0.1% fee above a certain amount"

Most wrap platforms now have caps on the maximum fee and offer family fee aggregation across couples & some associated entities. I'm interested to understand if Graham means that the platform only charges 0.1% of the entire balance or if it's only 0.1% once the balance gets above a certain level...

Graham Hand
April 26, 2018

Hi Jimmy, without knowing the fee structure of every wrap, I mean only 0.1% once the balance rises above a certain level. One genuine IFA told me he has negotiated a full-service wrap for his clients with a cap even for multi million dollar accounts, and an upper tier cost of 0.1% before the cap. His business then charges an hourly fee-for-service with no additional percentage-based fees. So my question is: how many aligned financial planners will put clients into a structure like this?

Phil
April 30, 2018

Hi Graham,

I think there are quite a few Wrap's with fee caps, and quite a few without them. It's probably more a question of whether the cap is too high. I think you would need quite a bit of FUM to negotiate a special price with a platform.

 

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