AFCA defends ‘counterfactual approach’ to advice complaints

According to investments and advice lead ombudsman Shail Singh and senior ombudsman Alex Sidoti, the Australian Financial Complaints Authority’s (AFCA) approach to loss calculation simply aims to provide “fair, consistent and legally sound compensation outcomes”, including through the use of a “counterfactual approach”.

Despite being the standard process for understanding how a financial advice failure has impacted a client’s position since before AFCA existed, the so-called “but for” test has become a hot topic in recent months.

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Infocus Wealth Management’s Darren Steinhardt raised the issue on an ifa webinar in November last year, railing against the ability for a client that “might have actually made some money” to receive compensation because different advice could have received more.

“To me, that sounds like a zero-cost option. There is always risk in everything that you do. By putting things in place and taking away that risk, what happens when the return that I get my client is well and truly beyond the ‘but for’? Do I get that paid back to me?” Steinhardt said.

“So, I look at these sorts of settings, and for me, they are wrong.”

Even more galling for many within advice is when hypothetical losses make their way to the Compensation Scheme of Last Resort (CSLR), which sees the rest of the profession bear the costs of compensating the impacted clients.

Speaking at a media briefing during the Financial Advice Association Australia (FAAA) Congress last year, for instance, chief executive Sarah Abood said “certainly from our perspective, it seems completely unfair, but also obviously unsustainable”.

“That a compensation scheme of last resort should be paying, basically an income guarantee to those clients. So, the floor is not you’ve lost money. The floor is maybe you could have done a bit better in the Vanguard balanced fund, so here’s $150,000, and that’s where the anger is,” Abood said.

Why does AFCA use this approach?

In an article, Singh and Sidoti argued that there is a strong need for this kind of approach when dealing with advice complaints more broadly, leaving the CSLR implications to the side.

AFCA, the pair noted, are “required to determine direct financial loss arising from a breach” and rely on a range of methodologies to deal with the often “complex” calculations.

“One of the key methods AFCA employs is the counterfactual approach. Broadly, a counterfactual is when you consider what should have happened (others may call this a ‘but for’ test),” they wrote.

While it appears the complaints authority is looking to move away from the “but for” phrase that has become so hotly contested, it is used within AFCA approach documents, including one released in January 2024, and on calculation tables in determinations.

“In some cases, AFCA applies a ‘no-transaction’ counterfactual. This assumes that, had the client received appropriate advice, they would have taken no action at all,” they added.

This comes into play when the client has been moved from a stable, regulated product; the advice to sell the original investment was clearly unsuitable; or the advice to invest elsewhere led to significant losses.

“Let’s say a client was advised to switch from an APRA-regulated superannuation fund to a self-managed super fund (SMSF) with most of the assets placed in a high-risk product,” the ombudsmen said.

“Having found the advice to be inappropriate, under the counterfactual scenario AFCA would compare the performance of the original APRA fund to the actual performance of the SMSF investment to calculate the loss.”

Alternatively, there can be situations in which this approach “doesn’t make sense”, in which case AFCA considers the client’s risk profile and an appropriate market benchmark.

“Let’s say a client had an SMSF, with actively managed investments, over many years. In this situation, AFCA would evaluate the client’s risk profile and use a market benchmark – for example, the Vanguard Fund, a passively managed portfolio – to estimate the returns the client should have reasonably achieved with that level of market exposure,” they said.

“Using a benchmark like the Vanguard Fund ensures compensation reflects not just potential rewards but also market risks. If the market rose (and the Vanguard Fund with it), the client is compensated for the returns they missed out on; if the market (and therefore the Vanguard Fund) declined, the client still bears that risk.”

In terms of only calculating the actual capital loss, Singh and Sidoti said that while this approach may be straightforward, it “ignores the market exposure the client should have had and therefore does not account for potential gains or losses in other, suitable investments”.

“We do use this approach, but rarely. If there is a scenario where we can’t determine what the client would have been invested in, we may award capital loss,” they said.

“Some people might assume that having a capital loss approach would mean lower compensation, but it very much depends on the circumstances.

“Historically, AFCA receives more advice complaints in market downturns. At these times, a counterfactual approach usually results in lower compensation than a capital loss approach. That’s because it factors in the market risk people would have borne even with appropriate advice.”

Ultimately, they said, utilising this counterfactual approach can prevent either over- or under- compensation that have been impacted by short-term market fluctuations.

“Taking a counterfactual approach is consistent with relevant case law and it doesn’t ask advisers to ‘underwrite’ the market, with compensation based on likely market exposure – whether that realises risk or return,” Singh and Sidoti said.

“By focusing on counterfactual scenarios and market-based benchmarks, AFCA aims to provide fair, consistent and legally sound compensation outcomes.”