Abstract

This research note seeks to quantify the historical and future change in the potential share of Australians who could be classified as ‘sophisticated investors’ in accordance with the definition legislated by the Corporations Act. 

These changes arise as a result of the failure of the legislation to index the $250,000 gross income and $2.5 million net wealth tests in the Corporations Act’s sophisticated investor definition, which were legislated in 2002, to the increase in both income and wealth over the 20 years since the definition was introduced.

 
Clearly the share of Australians earning $250,000 in gross income over two consecutive years, or those with more than $2.5 million in net assets, has changed dramatically over the last two decades because of income and asset price inflation. 

In reality, meeting the requirements of the sophisticated investor definition is unlikely to guarantee that an investor is immune to poor investment choices or being misled by shady deals. The Corporations Act and the Future of Financial Advice Laws (FOFA) have evolved to provide greater protections for retail investors but much less so sophisticated investors. 

The absence of income and asset price inflation indexation in the Corporations Act has driven a shift of more and more Australians out of the FOFA’s retail protections and into the much more unrestricted sophisticated investor world. 

Consideration of unscrupulous behaviour uncovered in the Hayne Royal Commission or sub-prime lending that led to the 2008-09 global financial crisis or the collapse of Storm Financial Limited should give pause for thought to the potential for all types of investors to be deceived. 

This research considers the definition of sophisticated investor and tracks the share of the population who meet this definition through time. Projections are also provided under reasonable economic assumptions of potential income and wealth projections. 

We find that the share of persons who could be defined as sophisticated investors has grown very substantially since the legislation was first introduced in 2002. The potential sophisticated investor share has increased from just 1.4 per cent of all Australian households (104,000) in 2002 to 9 per cent (853,000) by 2018 as a result of income growth and asset price inflation. 
 
By the end of the 2020-21 financial year, we project that the sophisticated investor share had increased to 11.3 per cent (1.09 million) of all households. Applying RBA and Treasury income growth and asset price inflation assumptions and projecting forward, we arrive at a median estimate of 34 per cent (4.24 million) of all households that could be classified as sophisticated investors by 2041.  Moderately stronger growth in wages and wealth could see this share rise to around 49 per cent of households by
2041. Moderately lower growth would still see the share increase to around 21 per cent by 2041. 

If we consider individuals rather than households, we find that the per cent of adults who satisfied the sophisticated investor test in 2002 was 1.9 per cent (285,000) of adults. By 2018, this share increased to 12.1 per cent (2.37 million) of adults. By 2031 the share increases to 29.1 per cent (6.78 million) of adults and by 2041 that share is projected to increase to 43.6 per cent or 11.5 million.

Regardless of the appropriateness of the definition of sophisticated investors, it is clear that the circa 11.9 per cent of Australians that could be defined as such today is dramatically different to the 1.9 per cent that parliament had in mind when it created the definition in 2002. And this problem will only grow over time: by 2041 it is entirely possible that half of all households could lose the benefit of retail investor protections.

Quite clearly, the lack of indexation of the original definition’s income and wealth assumptions mean that ordinary, or ‘retail’ investors are shifting into the sophisticated class. This continued creep has considerable implications for these investors and their livelihoods, for the way that advisers and institutions potentially organise themselves to exploit these changes, and, more broadly, for the integrity of the Australia’s financial system. 

We have not identified any prior research efforts to empirically quantify the proportion of the community that has shifted out of the retail and into the sophisticated investor definitions over time, nor attempts to forecast future changes in the number of individuals and/or households that fall into these two cohorts.

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