As regulatory reform for financial services moves along slowly here in the US, half way around the world in Australia a new set of regulatory reforms entitled the "Future of Financial Advice" are now being implemented. The changes will include a ban on all investment commissions, and a fiduciary duty for those giving financial advice, not unlike similar reforms scheduled in the UK under their Retail Distribution Review (RDR) set to take effect in 2013. Notably, though, while Australian reforms may have leapfrogged past the US, the Australian marketplace looks more like the US did nearly 20 years ago, as approximately 80% of advisors work under a small number of dealer groups and there are almost no independent firms. With Australian firms required to adopt fee-only models, including AUM, retainer, and hourly, within a year, the evolution of business models in the US may provide a glimpse to what is coming for Australia. Yet while the US offers Australia a glimpse of fee-only business models, Australia may provide US a first glimpse at how financial services shifts in a fiduciary, fee-only environment - providing a live, real world environment to evaluate questions like whether the less affluent marketplace really is served effectively without commissions, and whether there's still a place for broker-dealers in a fiduciary world.
The inspiration for today's blog post was my recent trip to Sydney, Australia for a speaking engagement, where I had a chance to see first hand how financial advisors are reacting to the recent "Future of Financial Advice" (FOFA) reforms that are in the midst of being implemented. In many ways, the somewhat smaller Australian financial services industry is "behind" the US in the evolution of how financial advisors work with the public - but thanks to their reforms, which have come what may be several years ahead of the US, the Australian market may catch up quickly. In the same way that the US may provide hints for Australians about how the industry will evolve in light of the recent FOFA reforms, in the coming years Australia may provide some guidance about how proposed US regulatory reforms might play out.
What Is FOFA?
The FOFA reforms in Australia first took effect "voluntarily" on July 1st of this year, and became mandatory on July 1st of 2013. The 1-year voluntarily phase-in period is intended to give the Australian financial services industry time to adapt to the changes.
The FOFA major reform changes include:
- A ban on commissions for investment products. Commission trails on previously implemented products are still allowed, but not on new sales after the FOFA mandatory effective date. Notably, some exceptions apply, including basic banking products, and general insurance (including life insurance) as long as the insurance is not being bought inside a Superannuation fund (which is an Australian retirement account with flexible investments similar to IRAs in the US, but contributions are mandatory similar to Social Security). Other "conflicted remuneration" arrangements, like many types of soft dollar payments and shelf-space agreements, are also banned.
- A statutory fiduciary duty that financial advisors must place the best interests of their clients ahead of their own when providing personal advice to retail clients. Advisors can demonstrate adherence to the rule by taking "reasonable steps" to ensure proper due diligence, including making "reasonable inquiries" to obtain client information (recognizing that clients may not always be forthcoming with full information) and conducting a "reasonable investigation" into relevant financial products.
- A two-year opt-in renewal requirement for recurring fee arrangements, requiring clients to affirmatively complete and sign a form every two years to continue to renew their ongoing management arrangement, along with an annual disclosure detailing fees paid and services rendered in the preceding 12 months.
- A limit on AUM fees to apply only to unleveraged investments, preventing advisors from earning additional fees by taking on margin or other loans to increase the amount of investment dollars under management.
In response to concerns that these limits may make it difficult to obtain limited scope advice on specific issues (what we in the US often call "modular planning" and the Australians call "scaled advice"), upcoming FOFA guidance is anticipated that will clarify how to meet a best-interests fiduciary duty when providing scaled advice.
Australian Delivery Of Financial Advice
Notably, unlike the US, in the Australian marketplace the delivery of financial advice has remained heavily concentrated in dealer groups (roughly the equivalent of wirehouse broker-dealers in the US); advisors in Australia indicated to me that approximately 80% of all advisors there work for one of four major dealer groups.
Notably, this means that the distribution of financial advice in Australia looks more similar to the US in the early 1990s, before the rise of independent custodians and the emergence of RIA firms outside of institutional or ultra-high-net-worth money management. Although in practice, it may be more accurate to characterize most Australian advisors in a form of hybrid broker-dealer/RIA model, as I found it was relatively common for advisors to run a business that generates a blend of ongoing AUM fees, ongoing fees from trailing commissions (similar to A-share or C-share trailing fees from mutual funds in the US), and some segment of upfront commissions.
Nonetheless, the ban on commissions in Australia will rapidly force the Australians there to adapt to a purely fee model - some blend of AUM, retainer fees, or even hourly fees (which appear to have almost no presence in Australia yet).
US Implications For The Australian Marketplace
Looking at how the financial advice marketplace has grown in the US, particularly over the past two decades, provides a great deal of insight about how the new FOFA reforms may play out in Australia.
One of the most notable distinctions between the current US and Australian marketplace is the dearth of independent firms in Australia. To some extent, this appears to be due to licensing requirements that make it significantly harder for one to "simply hang a shingle and open for business" in Australia than in the US. At the same time, though, I suspect that much of the difference has to do with what is still a relatively heavy focus on commissions for at least some part of advisory business revenue, which in turn limits how large advisory firms grow, and how much they're willing to take the risks of going independent and building out their own staff and infrastructure. By contrast, in the US firms that have grown on a recurring revenue basis, with far greater revenue and profit stability, have driven much of the independent movement, making the space lucrative enough for new business to emerge that support the independent industry, and in turn allow it to be profitable for an ever-wider range of independent firms.
This progression in the US has become an ongoing challenge for the broker-dealer community, arguably exacerbated for many of the largest wirehouses due to tarnished brands after the 2008 financial crisis. But even without the 2008 crisis, broker-dealers have already been struggling with ever-more-compressed profit margins, as the firms struggle to justify their infrastructure costs and the segment of revenue they keep from their representatives. Increasingly, firms are "doing the math" and realizing that at a certain size, it's simply more profitable to go independent and, through a combination of hiring and outsourcing, replace the key services the broker-dealer previously provided.
While the growth of recurring fee (AUM) models emerged slowly in the US, the FOFA reforms will force the evolution to occur rapidly and suddenly in Australia. Initially, I suspect that many advisors in Australia will be inclined to cling to their dealer groups through the transition, seeking guidance and insight from the parent company about how to transition their business models effectively, and implement new systems and processes to meet everything from the new fiduciary requirement to the new business model itself. Although FOFA does allow any form of fee arrangements, I strongly suspect that most advisors will migrate quickly to an AUM model, rather than a retainer fee or hourly model, both because it is likely more familiar to the advisor, and because I suspect that in Australia the typical retail client is even less accustomed to the saliency of retainer and hourly models than they are here in the US.
The next change in the Australian marketplace is likely to be driven by the dealer groups. In the near term, FOFA may be an effective test of the role that commissions really did play in advisor recommendations - will investment activity decline without commission incentives? And if so, what will that do to the profit margins and health of the dealer groups? Perhaps more significant, though, is the question of what such a shift may do to the dynamic between dealer groups and their advisors.
After all, my impression is that one notable difference between the US and Australian marketplace is the relative dearth of direct-to-consumer options for Australian investors. Firms like Charles Schwab, ETrade, Scottrade, TD Ameritrade, etc., do not have a comparable presence down under. Which means it's entirely possible that some dealer groups decide the best way to continue distributing their financial services products may be to skip the no-longer-incentivized advisors altogether, and go directly to the consumer! I wonder if we won't see the Australian Securities and Investments Commission (ASIC) struggling in a few years to rein in aggressive direct consumer financial products advertising?
Once the initial shock of the transition has worn off, I suspect the real challenge in the Australian marketplace will be for the dealer groups to continue to justify their value proposition - carrying their "old" infrastructure and legacy - to advisors that are now growing almost exclusively AUM-fee practices. This will create tremendous opportunities in the Australian marketplace, especially for third-party providers to serve advisors that want to transition away from dealer groups - everything from portfolio management software to client relationship management software to trading platforms to independent custodians. In the US, the independent support infrastructure has grown slowly and taken years to gain momentum in drawing advisors away from the broker-dealer environment. In Australia, as the transition to the AUM model is accelerated, it may also accelerate an explosion of providers seeking to draw advisors away from dealer groups to a simpler, more efficient, more profitable business structure.
Australian Reform Implications For The US Marketplace
Notwithstanding what Australia might learn from how recurring fee business models have changed the advisory landscape here in the US, I suspect that in the coming years there will also be a great deal than the US financial advisory world can learn in seeing the regulatory reforms play out in Australia.
Just a few interesting questions to examine in the next few years will include:
- Will advisors be able to adapt to the new reforms and adopt viable business models? Or will there be attrition in the number of advisors in Australia?
- Will consumers be willing to adapt to the new advisor business models? Will investors tolerate a more salient pricing structure from advisors, or turn to direct-to-consumer alternatives to meet their needs?
- Will Australian advisors be able to create "scaled advice" (i.e., modular planning) businesses, such as the Garrett Planning Network here in the US, to serve less affluent consumers? Or will the elimination of commissions reduce access for the less affluent to financial advisors (which some groups have suggested may occur with a fiduciary duty here in the US)?
- Will a fiduciary duty change advisor behavior? How will the fiduciary duty be overseen and regulated? Will the fiduciary duty be a moot point in light of the ban on commissions, or will ASIC find additional oversight concerns for non-commissioned fiduciary advisors?
- Will FOFA create an accelerated independent trend in Australia, or will the ban on commissions successfully force dealer groups to reform their own infrastructure to retain and serve advisors in a cost effective manner? Will dealer groups in Australia provide a template for US broker-dealers about what "life beyond commissions" can look like, or will the ban on commissions prove that broker-dealers are not financially viable without high-margin financial products to distribute?
- Will some dealer groups decide that it's more profitable to go directly to consumers and skip working with advisors no longer incentivized to sell products, rather than retool their businesses to serve AUM-based advisors?
- Will segments of the financial services industry find loopholes in the FOFA reforms? Will we gain any insights about how to implement and oversee a uniform fiduciary duty in the US based on whatever struggles emerge as ASIC tries to oversee the fiduciary duty for Australian advisors?
Notably, the reality is that Australia is not the only place in the midst of major regulatory reforms. In the UK, the "Retail Distribution Review" (RDR) reforms set to take effect at the end of 2012 will also enact similar changes to FOFA in Australia, including a ban on investment commissions and the implementation of a "client's best interests" (i.e., fiduciary) duty.
In one regard, the fact that such financial reforms are happening in many other developed financial services markets before the US suggests that the United States has fallen behind in the evolution of regulating financial advisors. On the other hand, the fact that reforms are moving forward first in Australia and the UK may provide a revealing glimpse of the consequences, both expected and unintended, that result from the application of a ban on commissions and a fiduciary duty for advisors. Notably, Section 913 of Dodd-Frank is driving the US towards a uniform fiduciary standard for advisors, but unlike Australia and UK, the currently proposed reforms would not ban commissions but merely subject recommendations to a fiduciary standard (regardless of how implementation is compensated). Will the results in Australia and UK reveal that that is the wrong approach, or show that it may actually be a better way to ensure a wide range of consumers are served?
So what do you think? What insights from the US marketplace do you think will apply as Australia (and the UK) implement their advisor fiduciary duty and a ban on investment commissions? Do you think there will be unintended consequences? What lessons would you hope to learn from the US perspective to inform future regulation here?