07 – The valuation of renewal commission rights
The LIF changes taking effect from 1 July 2016 will ‘cap’ the level of trailing commission at no more than 20% of the premium. Assuming that the life offices agree to pay this figure, and they will (none of them will want to reduce an already reduced figure) most advisers will who receive commissions will start to receive a trailing commission of 20% of renewal commissions.
This is actually an increase on the current standard level of trailing commissions, which is between 10 and 15%.
In terms of medium term cash flow, this change will not fully compensate for the reduction in the maximum permissible amount for upfront commissions, which are in many cases being halved. However, there is a ‘silver lining:’ the increase in trailing commissions will lead to an increase in the value of renewal commission rights held within an adviser’s ‘commissions book.’
If the commissions increase, the value of owning the right to receive these commissions must also increase.
Typically, the valuation of renewal commission rights applies a multiple to the amount of trail to be received. The multiple will be a function of the nature of the policies to which the commissions relate. Books with low historic renewal levels will receive a lower multiple. Books with more robust renewal rates will attract a higher multiple.
The multiple will also be a function of the state of the book-buying market: if there are more buyers than sellers, the multiple goes up; if there are more sellers than buyers, the multiple goes down.
Regardless of the state of the multiple at any given time, basic maths tells us that the higher the level of trailing commissions, the larger the book value. Any multiple applied to a larger trail figure will be higher than that same multiple applied to a lower figure.
So, to an extent advisers should ignore the market and the multiple it delivers. This multiple is outside of the adviser’s control. What is more within the adviser’s control is the level of trail commission to which the market will apply that multiple.
That said, the amount of trailing commission for any given policy will be limited to no more than 20% of the amount of the premium. So, the most reliable way to increase the total trailing commission will be to increase the number of clients for whom commissions are received.
Selling commission rights has a number of things going for it. Firstly, doing so converts a future income stream into current cash. The ‘time value of money’ means that money received today is inherently more valuable than money received tomorrow. This is all the more so if the money received is invested in some income generating/cost saving way.
Secondly, selling renewal rights represents an asset sale. Therefore, the amount received is a capital gain, rather than ordinary income. It is taxed accordingly – which means it is taxed preferentially. In summary, as long as one quarter of the gain is rolled over into a superannuation fund, it is usually possible for a small business to sell an asset such as the renewal rights on trailing commissions tax-free. This is explained in more detail here.
This tax treatment in turn increases the impact of the time value of money.
The LIF changes will skew commission income away from upfront commissions and towards trail commissions. This will see the book values of trailing commissions become higher than they otherwise would have been.
Even better, if and when the rights to these renewal commissions are sold, the sale can usually occur tax-free.
The LIF reforms will reduce the amount of commission payable on a policy by about 20% over the life of that policy. This is a straight out reduction. However, the LIF reforms will also increase the relative size of trail commissions. Selling these commissions can bring forward the point in time at which they are received, as well as give the adviser access to more preferential tax treatment.
Selling the trail is one way in which the intelligent adviser can reduce the impact of the LIF reforms on his or her practice.