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.