What is switching?
The term ‘switching’ refers to personal financial advice that recommends the full or partial replacement of one financial product with another. Superannuation funds are, of course, financial products. Therefore, whenever an adviser recommends that an existing super fund policy be fully or partially replaced, the rules regarding switching come into play.
The replacement aspect is the crucial one here. Adding a new super fund to super funds that are already in place is not a ‘switch.’ A switch only occurs when an existing fund is completely or partly replaced.
The disclosure rules on switching
The SOA should state that the client’s existing product has been considered, and should include information about:
- the cost of the recommended action (i.e. the disposal of the existing product and acquisition of the replacement product);
- the potential benefits (pecuniary or otherwise) that may be lost; and
- any other significant consequences of the switch for the client: s947D(2).
Note: The SOA should include information about:
- the exit fees applying to the withdrawal;
- the loss of access to rights (e.g. insurance cover) or other opportunities, including incidental opportunities (e.g. access to product discounts) associated with the existing product (also including rights or opportunities not presently available to the client but which may become available in the future); and
- the entry and ongoing fees applying to the replacement product.
These rules are limited to the ways in which the switching of financial products must be disclosed to the client. In this article, we will also discuss those things that need to be considered before it comes time to present a client with an SOA.
As this article is devoted to superannuation, we will restrict the discussion to this type of financial product.
Why these special rules exist
The special disclosure rules for switching exist as a way of minimising situations where financial advisers recommend that new super funds be joined up purely to gain access to an increased commission. Historically, advisers who recommended superannuation investments could be paid a percentage of the amount invested as a commission. Initial and trailing commissions were available.
In some cases, this incentive did have the effect of encouraging advisers to switch super funds for no reason other than to gain access to commission payment. This process was known as ‘churning.’
Not all switching is churning. Churning is a pejorative term specifically used to describe switches that are recommended solely to gain an increased commission payment for the adviser. Churning is a switch that is not in the client’s best interests but from which the adviser benefits through increased revenue.
But not completely. Since 1 July 2013 advisers can only accept fees as remuneration for superannuation advice. Some superannuation funds now allow the fees for financial advice to be paid using . This can create an incentive for an adviser to recommend a switch to a fund that allows fees to be paid in this way. Especially for clients who cannot afford to pay fees out of their day to day cash flow, this can make the advice more affordable and thus increases the amount that the adviser can be paid.
If the only reason for recommending a switch to a particular superannuation fund was to allow the adviser to access higher fees that are paid by the fund, this would still constitute churning. It would be a switch made to benefit the adviser, not the client.
The rules regarding switching and its disclosure were developed specifically to discourage churning. The idea is that, by requiring the adviser to provide written justification for switching, advisers would find it more difficult to churn super funds. Any switch would need to be shown to be in the client’s best interests.
Even before the tightening of the disclosure rules (the precedents to RG 175 were released in 2003), it would be fair to say that it was only very naïve advisers who participated in churning. This is because there are various risks inherent in the practice. These risks far outweigh any short term benefit of an increase in cash flow for the adviser.
The risks apply to all super fund switches. But the risks are mitigated when the switch is being done for genuinely client-centred reasons.
These risks are discussed in the next section.
The risks of switching
Loss of ancillary benefits
This is the main risk to an adviser recommending a switch of super funds.
As a result, many managed super funds provide risk insurance benefits to members. This is often done on a basis, where all members who meet certain thresholds are entitled to stated levels of insurance. The premiums for these insurances are deducted from member balances.
When a member rolls their superannuation benefits out of a given fund, they will lose access to any ancillary benefits being made available through that fund.
When a member rolls their superannuation benefits into a given fund, they will gain access to any ancillary benefits being made available to that fund.
The main risk of switching from one fund to another is that the new fund might not provide the same level of ancillary benefits as the one that is being closed. For risk insurance benefits, this may mean that the client loses some or all of their insurance cover.
This raises the prospect of an insurance event happening for which the client has become non-insured due to the change of fund. By recommending that the previous fund be discontinued, the adviser may have placed himself or herself in the situation where a client suffers some loss arising from their advice.
This raises the prospect of some form of action being commenced against the adviser.
At this point it is worth remembering that the main time at which clients take action regarding insurances is when a claim fails. Clients typically do not take action at the time the super fund is switched. It is not until some event occurs, for which the client thought himself or herself to be covered as an ancillary benefit of their new fund, but which is then rejected by the fund’s insurer as not being covered by the policy, that a client will typically take action.
That is to say: there will often be little or no indication at the time of the switch that the adviser has done something risky. This is why it is only the naïve advisers who participate in churning. More experienced or knowledgeable advisers simply know better.
What this means, of course, is that a recommendation to switch super funds becomes a recommendation to change default insurance providers. It is, therefore, a recommendation to switch insurance policies. The switching of insurance policies – and especially the risks inherent in doing so – is .
Anyone contemplating recommending a switch of super funds should read this article.
The benefits of switching – why it should sometimes be done
Given the risk, it makes sense that a switch would only take place where there are clear benefits to joining a new fund. There are, of course, times when such a change is clearly in the client’s best interests.
In terms of identifying these benefits, the process is much the same as the process used when choosing any super fund. The only difference is that the selection process must include the existing fund – with all of the ancillary benefits that it may have accrued over the years – as one option.
In fact, Dover’s principle of conservatism dictates that the ‘starting point’ when contemplating a change of fund is that the existing fund should be retained. Switching should only take place when there is another fund which clearly better meets the client’s needs.
Typically, the features that see one fund being selected over another include:
Coverage of insurance policies available within the fund
From Dover’s point of view, this is a very significant factor in determining whether one fund is better than another. The starting point should always be that the fund whose policy has the best coverage is a preferred fund. Once this has been established, then other factors such as price can be included in the calculation. But the starting point must be coverage.
Specifically, super advisers should be very cautious about switching to funds with policies with more limited coverage. Doing so can negate the very reason for having insurance in the first place. Is also increases chances of a later claim being rejected. This is bad news for the client, obviously, but it can also be bad news for the adviser if it is found that the adviser did not properly address this factor when recommending the alternative fund.
Coverage also refers to the way in which an insurer might define an insured event. For example, in March 2016 it was revealed that Comminsure, a large provider of risk insurance through super funds, was using a of a heart attack when determining whether policy holders were entitled to insurance benefits. So, advisers can include an insurer’s track record regarding definitions and their application to claims when considering the coverage being offered.
Everything else being equal, lower price is a benefit to clients. Typically, super funds charge clients a mix of set administrative fees, which tend to be flat, and percentage-based management fees, which vary according to the amount of benefits within the fund and also according to the investment strategy being implemented.
Most super funds invest in the same or similar investment markets. Therefore, for a given allocation between growth and conservative assets, most super funds achieve similar investment results. Attaining a lower price for the management of these investments can make good sense.
When it comes to the cost of risk insurance being provided within a fund, price can again be a guide. But we do urge some caution here: when comparing two or more policies the lower premium is only a benefit if the policies are the same (or the cheaper one is better). It is not so simple as to say that lower price is always better.
To understand this, think about what the insurer is doing: it is setting a premium at a level that it thinks will allow it to pay out all claims and still make a profit. If an insurer is setting lower premiums, then it is either (i) more efficient; (ii) prepared to accept a lower profit; or – very importantly – (iii) anticipating paying out fewer claims.
If an insurer is calculating that it will face fewer claims, this may indicate that its policy is more restrictive. If the relatively lower expected claims lead to lower prices, then the cheapest policy is not necessarily the best. This is especially the case if the policy is so restrictive that a client has a greater chance of having a claim refused. Remember, the main risk to an insurance adviser becomes apparent at claim time, not at the time the policy is established.
Some funds are easier to deal with than others, either at the time that a member joins a fund or at some later time when the member needs something from the fund. Choosing a fund with a preferred administrative system is a valid decision.
Communicating the Switch
As establishes, when recommending a switch the SOA must demonstrate that the adviser has considered the existing fund, with all of its inherent advantages, and still found that the new fund will be of greater benefit to the client. This is not the same as simply saying that this is the case. Nor is it a matter of simply .
The additional benefit that the new fund entails must be made abundantly clear.
Summary Points: Switching Super Funds
The following points should always be borne in mind when contemplating a switch of risk insurance policy:
- Start with the assumption that the existing fund is the best and should be retained;
- Identify the ancillary benefits of the fund. This typically means identifying the risk insurances that may be being utilised.
- Itemise the features of the existing risk insurance policy;
- Review these features against the features of any and all other policies within other super funds being considered;
- Make sure that the existing features are at least matched – and preferably bettered – by any new fund being recommended;
- Make sure that the client understands – and document this – that they have a duty of full disclosure with regard to risk insurance;
- Make sure the client otherwise understands the risks of switching funds; and
- Make sure all of these things are clearly communicated to your client via an SOA, as well as recorded elsewhere in your client file.