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Self Managed Super Fund (SMSF) Article
Real cost of planning often hidden

By Tony Negline.

This article may be out of date.

1st December 2010

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All superannuation investor needs to understand how much they pay for financial services because these costs have a direct impact on net worth and retirement lifestyle.  This week I'm going to look at financial planning fees.

This is an area which successive Governments have tried to fix but have all failed.  It is now the Gillard Government's turn and like everyone before him Bill Shorten, the current responsible Minister, will find it hard to deliver a solution that leaves all parties happy.

In many ways financial planning grew out of the old life insurance sales culture where for decades complex high cost life office products were peddled to clients who typically didn't understand them.  Life agents and brokers were paid commissions (often very high) when they had made a successful sale.

In the bad old days adviser commissions were carefully hidden in the life insurance company's costs and did not have to be disclosed to clients.  These commissions were paid on all life insurance policies including those with an investment component.

This system predominantly exists today for life insurance contracts without any investment component (called term life insurance contracts).

Life insurers and the financial planning industry have always argued that term life insurance policies are sold and rarely voluntarily bought.  They have also said that Australians are under-insured.  Joining these two arguments together they reach the conclusion that without life policy commissions the under-insurance problem would get worse.

In my view it is true that many Australians don't have adequate death and disability insurance.  However to argue that this problem will become worse without commissions is doubtful.  Life insurance companies have been making these arguments for decades and the problem is not going away.  Perhaps the problem has another solution.

The financial planning industry is currently split into various factions about how they charge clients for their services.

Many financial planning firms want to keep the status quo.  Typically they have a business model which extracts a good ongoing revenue stream out of their client base.  They find the current complex regulatory regime around providing financial advice a hassle but know it keeps competitors away because of the significant entry barriers.  They also don't mind the current cost disclosure regime which permits costs to be explained in percentage terms not dollars and cents.  They especially want to charge clients a percentage of assets each year via fund manager commissions, technically for ongoing advice, even if they have little contact with a client after the first product sale.

The impact of this charging structure shouldn't be under-estimated and is best explained by an example.

According to Australian Prudential Regulation Authority statistics in June 2004, there was $638 billion in total super assets.  The total cost of administering these assets, including investment management costs, was $4.4 billion.  By June 2009 total super assets had increased to just over $1 trillion which cost $8.8 billion to administer.

It's important to understand what's happening here.  In this five year period total super assets increased by 70% yet the costs to administer them increased by over 100%.  Even during the global financial crisis total super assets declined yet administration costs did not decline.  The APRA statistics show that the raw costs of administration (accounts, filing, banking etc) have not been declining but the costs of investment management have been going up.

What is the direct impact this cost structure has on a client's retirement funds?  Suppose you have $10,000 to invest and a financial planner tells you it will cost 2.5% per annum to invest this money.  This sounds like a small fee so you accept this offer.  In reality this is $250.

Suppose after ten years your money has grown to $20,000.  Your financial planner is still receiving 2.5% of your money or $500.

Has double to work been performed?  Most likely not.  Regrettably most people when presented with percentage fees do not understand the long-term impact.

The bottom line is that disclosing and charging fees in percentages is good for financial planners and financial product businesses because it painlessly provides an increasing ongoing revenue stream and saleable businesses.

The next type of financial planning firms wants to directly charge their client fees but want to be able to charge these fees as a percentage of assets under management.  This has the same flaws as the payment of commissions using percentages.  Clients simply don't understand it and it is often dependant on selling the client something and keeping it in place.

The final group of financial planning firms want to charge clients professional fees in much the same way most other professionals charge clients.  That is, with reference to the services provided performed not the amount sold.

The approach has been proposed by the Accounting Professional and Ethical Standards Board in a draft standard.  Their proposal has met stiff resistance from many areas of the financial planning community.

Investors should never allow their financial planners to disclose their fees in percentage terms.  They should insist that all fees have to be disclosed in dollars and cents for each year over an investment timeframe.  Professionals deserve to get paid for their services.  But you should be prepared to negotiate and ask for a discount.  You can't negotiate if you don't understand what the real cost is.

The government could significantly reform financial services by legislating the disclosure of all costs in dollars and cents for every investment year by fund managers, super funds and financial planners and other market participants.

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