“I’m gonna free fall out into nothin’
Gonna leave this world for a while
And I’m free (fallin’, I’m-a free fallin’)”
— Tom Petty
Advising through rate increases
As Australian mortgage holders fall off an unprecedented “fixed rate cliff”, and the cost of living rapidly rises due to embedded inflation, some of your ongoing advice clients will need to offload assets to stay afloat as they slip into cashflow deficits and/or negative equity. Others may be able to ride out the cashflow challenges ahead, but with reduced discretionary spending.
For advisers who provide advice to clients about borrowing to invest in real property, or advisers whose clients have existing property gearing arrangements in place (whether individually, via a discretionary trust, or an SMSF), the fixed rate cliff is going to rapidly and dramatically change advice conversations.
AFCA itself is aware of the issue of mortgage stress, and at Assured Support we are now starting to see client files like one I reviewed recently:
The increase in interest rates (assuming all loans at 5.60%) these clients are facing in August 2023 will mean an extra $2000 or so in repayments per month (only partially tax-deductible).
At the prior annual review in July 2022, the clients had a cashflow surplus of $10,000pa. Clearly, as of the annual review in July 2023, the clients were about to lose their cashflow surplus (all other things being equal) and in fact enter a material cashflow deficit.
Setting aside the shock, confusion and horror that clients may be experiencing, the fixed rate cliff provides several risk and opportunity points for your advice business.
1. Check your terms of engagement
Cashflow is clearly going to be king in the coming months. Clients that can weather the cashflow challenges of higher LVRs and interest payments will not urgently have to make changes, but some clients may be suffering or about to suffer from cashflow deficits and may need to act now.
If your Terms of Engagement contain woolly terms such as “monitor your cashflow” or “assist with cashflow”, ensure that there is sufficient clarity around your obligations to your clients. Finding 861140 from the Australian Financial Complaints Authority (AFCA) indicates that when it comes to a dispute, the written service agreement is a key method of defining the legal relationship and determining the services you are obligated to provide to your clients.
For the clients in the example above, both were very concerned about their cashflow and wanted to sell their investment property to ensure they were not living a stressful life in cashflow deficit. The adviser discussed the various options with the clients and then provided an updated Statement of Advice (SoA) to reflect their new relevant circumstances, goals and objectives.
This met the adviser’s requirements under the relevant Terms of Engagement, which included a reference to assistance with cashflow.
2. The insurance ambiguity
Does your “Terms of Engagement” with an ongoing advice client incorporate insurance? Is there a clear expectation of an insurance review?
This is an area that is frequently unclear in client files, partly because the insurance advice may be paid for via commissions rather than via an ongoing advice fee (which would be reported via the Fee Disclosure Statement process). Clients may believe an insurance review is included in their advice package, whereas advisers may believe this is optional (opt-in) as an insurance commission is not (technically) a fee.
Remember that when recommending financial products, advisers need to consider the affordability of the strategy and relevant financial products. In the case of the fixed rate cliff and cash flow deficits, are the financial products the clients are paying for still affordable – including life and income protection insurance? If not, what advice are you providing them to address the affordability issue?
Relying on an assumption that insurance advice is opt-in rather than opt-out at an annual review is a recipe for problems ahead.
3. The buck stops with … YOU!
The “responsibility for the advice provided” buck doesn’t always stop where you think it should. You may have scoped the prior advice (e.g., a past SoA) to the effect that “your accountant has recommended…”, but if you have facilitated and implicitly approved of the strategy, for example by assisting with a rollover from a retail super fund to an SMSF, then the responsibility may well lie with you. AFCA case 676803 indicates that you need to have exercised due consideration of clients’ relevant circumstances before implicitly or explicitly recommending gearing. This is particularly the case where there are associations or arrangements that can create conflicts of interest: accounting support (SMSF or family trust); lending assistance (property), links to property development companies and so on.
Therefore, at annual review, it is in everybody’s interests to thoroughly review the client’s relevant circumstances. If the client is in a precarious position in terms of debt and cashflow, the time for a frank and fearless discussion is… now.
4. Everything is up for review
Interestingly, where you have recommended a client gear into residential property, adverse consequences from this can potentially be heard as a complaint through AFCA, even though residential property is not a “financial product”. AFCA Case 856680 provides an example where a recommendation to gear was made “in preference to shares or other asset classes” and hence the recommendation was made “with the intention of influencing the complainants to make a decision about investment in financial products or classes of financial products…”. This shows that making recommendations in your clients’ best interests is key to protecting yourself from a complaint; if you give strategic advice about gearing, it is imperative that it is supported by strong cashflow analysis and ongoing review of the strategy.
5. A great way to cement relationships
Putting aside the risks detailed above, the fixed rate cliff is in fact an opportunity to help clients avoid the pitfalls of cashflow crunches, and to be proactive in their strategic financial positioning. There may be difficult conversations in the coming months, but it will also be a one-off opportunity to cement a long-term relationship where clients understand what you can offer them beyond simply investment advice and insurance.