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Morningstar | AMP's FVE Is Reduced, With the Royal Commission's Interim Report Hinting at Major Industry Changes

Significant further investments in systems and processes, more aggressive enforcement action against AMP by regulators, and the increasing potential for major structural changes in Australia's advice industry are our key takeaways from the Royal Commission's Interim Report. This has prompted a further downgrade in narrow-moat AMP's fair value estimate to AUD 3.40 per share from AUD 3.60.

Somewhat disappointingly, the Interim Report did not provide any interim recommendations regarding Australia's financial advice industry. Instead it posed a series of questions with a view to provoking debate to inform the recommendations in its Final Report. Nevertheless, we believe the Commission is of the view that broad structural and cultural change is required. The report suggests that the financial advice scandals that have plagued Australia raise broad systemic issues. It does not accept the frequent characterisation by organisations caught up in these scandals, including by AMP at its recent annual general meeting, that the misconduct was limited to a "few bad apples". On the other hand, it also appears reluctant to add an extra layer of legal complexity to what it regards as an already complex regulatory regime.

One likely change is more aggressive enforcement by the Australian Securities and Investments Commission. ASIC has already begun federal court action against AMP and announced embedding ASIC officers within AMP. We expect ASIC to commence further court actions against AMP, and along with the class actions it's already facing, this will keep AMP's misconduct in the public's consciousness over the next few years. In addition to higher legal costs and compensation payments, this will make it harder for AMP to attract financial advisers and investors to its products. This has motivated a further forecast reduction in AMP's wealth management assets under management to a CAGR of 3.8% over the next five years, from the previous 4.8%.

The Interim Report is highly critical of ASIC, suggesting its enforcement action did not generally reflect the gravity of the breaches identified and it did not make enough use of the court system. It indicates ASIC's position should be to always ask whether it can make a case for a breach, and if it can, then to ask why it would not be in the public interest to bring proceedings to penalise it. In contrast, the report believes ASIC's starting point is to negotiate an agreement with the offending organisation to remediate customers. More damningly, the report suggests that too often, regulated entities have been treated by ASIC in ways that would allow them to think they--and not ASIC, Parliament, or the courts--will decide when and how the law will be obeyed and the consequences of a breach. This sharp criticism and suggested new formula for enforcement is why we expect ASIC to commence further court actions against AMP.

Our view that grandfathered commissions will be abolished was also reinforced by the Interim Report. The Royal Commission clearly did not accept AMP's submission that there may be constitutional obstacles to their removal, given that it referred to these arguments as "allusions". The report also suggests the onus is on organisations that want to maintain them to provide justification. Removing these commissions will reduce the revenue earned by financial advisors, and along with the new higher educational standards, this will likely prompt more to leave AMP and the industry. These grandfathered commissions are also linked to higher fee-generating legacy products. Accordingly, abolishing them negatively affects AMP primarily via the loss of more advisors, reducing fund inflows, and by increasing AMP's margin pressures as well as potentially triggering "buyer of last resort" agreements.

While still too early to accurately identify and quantify the types of new systems changes that may be required, our reading of the Interim Report indicate these have the potential to be significant. The report found that some of the root causes of poor conduct often lie with systems, and processes. Although the exact form of system changes is unknowable until we see the Final Report and AMP's response, we believe the changes will generally require stronger monitoring of financial advisors and potentially expensive changes to platforms, software, and processes. This may include being able to monitor that the advisor is authorised to receive fees and is providing the services promised. Notably, the Interim Report expressed a concern that systems allowed platforms to automatically deduct advisor fees from client accounts, and this resulted in clients being unaware they were being charged a fee for no service, which meant they seldom complained. We also believe process changes will likely involve more regular random audits of advisor files and the facilitation of faster breach notifications and remediation of aggrieved customers, as well as stronger record-keeping processes to facilitate this.

We think part of the monitoring by licensees is likely to include ensuring individual advisors do not have more clients on their books than they could monitor or advise annually, affecting funds under management per advisor. We also believe ongoing advice agreements may need to be renegotiated annually instead of every two years. Additionally, we expect AMP to be required to provide more transparency on platform fee charges, potentially disclosing fees charged by competitor platforms. The Interim Report suggested that AMP preferred its own financial interests over its clients by continuing to charge fees more than 15% above market rates, and it was able to do this because investors did not have the ability to find out they were being charged these higher rates. Processes may also be required to allow clients to change platforms more easily, including providing in specie transfers.

We still believe the most likely outcome is that the government will not seek to completely abolish vertically integrated business models. However, given the Interim Report's expressed concerns about this model, we are less confident in this view. The report noted the "virtue" of vertical integration is the promise of efficiency that is then passed on to customers in the form of lower costs and greater access, as well as the convenience of dealing with just one institution. However, it also noted that the one-stop shop also has an incentive to promote the product manufacturer's product over others, even when this may not be in the best interest of clients. It also suggested the higher platform fees of organisations like AMP invited the question as to whether vertical integration may harm clients by protecting entities operating platforms from competition, resulting in them paying more for platform services than others.

The Report also indicated that one of the fundamental premises of the Future of Financial Advice, or FOFA, legislation was that conflicts of interest between advisors and clients should be permitted but be “managed”. To implement this premise, FOFA provisions required the licensee to have adequate arrangements to manage conflicts, a requirement to act in the client's “best interest”, and a ban on conflicted remuneration subject to the grandfather provisions. However, the Interim Report points to ASIC's recent investigations into the vertically integrated business of the four major banks and AMP, suggesting the results on their face deny FOFA's fundamental premise that conflicts can be managed. Notwithstanding, the Interim Report also makes it clear that it wants to avoid placing an extra layer of legal complexity on what it regards as an already complex regulatory regime. We believe requiring the structural separation of advice business on the one hand, and platform and investment management business on the other, will result in more complex layering of legislation, with the potential for unintended consequences.

Another potential structural change hinted at by the Interim Report that would negatively affect AMP's vertically integrated model is the prospect of advisors being individually licensed and directly supervised by ASIC. Currently, the regulation of advisors has been at the intermediary or firm level and not at the individual level. The licence entity is commonly the financial services company, and the individual advisor operates as the authorised representative or employee of the licenced entity, with the licenced entity being responsible for ensuring that individual advisors comply with the law. While this question was posed by the Interim Report, we do not think ASIC has the capacity to individually supervise the circa 25,000 financial advisors in Australia, and there is the potential for unintended consequences, such as individual advisors not having the funding to compensate clients if misconduct occurs.

However, there is the potential for wealth management organisations to require more expansive and transparent approved product lists, or APLs. The Interim Report noted that advisors may satisfy their best interest duty by simply choosing the most appropriate product from its licensee's APL. The report suggests this makes the best interest duty more akin to an obligation to do no harm, rather than a requirement to do what is best for a client.

Unfortunately, while the Interim Report poses a lot of questions, it provides few answers, but hints at the potential for material industry changes. If the Commission were to ultimately recommend changes such as the dismantling of vertically integrated business models that would materially affect AMP's fundamental value, it would likely be difficult to lobby against such recommendations. The final Royal Commission report is scheduled for release by Feb. 1, 2019, and Australia's next half-senate election must be held before May 18, 2019. This means there is significant probability that the Royal Commission's final report will be released in the lead up to or during the next Federal election. Given the significant media attention and negative fallout from the Royal Commission, we believe it will be very difficult for either major party not to accept the Royal Commission's recommendations, particularly in a heated election campaign. Consequently, this will continue to make AMP a high-risk investment in the near term.