This company was founded because we had the vision of offering independent financial planning services without conflicts of interest. The subject of conflicts of interest has been extensively discussed for many years with a widespread industry consensus emerging that it is practically impossible to operate without conflicts of interest, and the industry’s recommended model is one of disclosure rather than avoidance.
But is it unreasonable to expect that the advice given to you by a financial adviser or planner should be untainted in any way by conflicts of interest? Is disclosure really the only way to deal with conflicts? How did we get here, and are conflicts of interest really a big deal anyway?
An independent financial planner is an adviser that operates free from biases and conflicts of interest. A “conflict of interest” is a situation where an adviser has to make a decision where his own welfare (usually financial) is at odds with that of the client.
A classic example would be the adviser who is remunerated by any form of asset based fee structure (including both commissions and percentage of assets) who knows that the best advice for the client would be to pay off a debt, but if the adviser gives such a recommendation he would not be paid, because paying off debt does not increase the portfolio size. This is a common situation, faced by nearly all financial advisers because nearly all financial advisers charge an asset based fee structure.
It is our contention that the existence of conflicts of interest are bad not only for clients, but for advisers also. We feel it is fundamentally unfair that honesty and integrity would be handicaps in doing business, and feel that any time an adviser is obliged to take a pay cut in order to do the right thing by their client, or to put their clients’ interests behind their own in order to earn a good living, not only is the client disadvantaged but so also is the honest adviser.
We assert that only the elimination of conflicts of interest is optimal, and that mandatory disclosure of conflicts of interest will never offer the same protection as the absence of conflicts of interest, in part because it is virtually impossible for the client to figure out whether the advice has actually been comromised, or simply may have been.
In short, we feel that removing incentives to do the wrong thing is more likely to reduce bad behaviour than simply warning the client that such incentives exist.
There are various conflicts of interest, but the major conflicts of interest exist when there are ties to product providers and remuneration structures with the potential to create biased advice.
Ties to product providers
When you go into a Holden dealership, you are generally going there because you want to buy a Holden. The salesperson is employed by Holden, paid by Holden and gets incentives to sell you a Holden. If a Ford would be a better option for you, you wouldn‚’t expect a Holden salesperson to tell you this because they have a duty to their employer before any duty to you. The salesperson is paid for selling you a Holden, not for giving you advice on the best car for you.
This isn’t a problem as long as the customers are aware of this and know not to rely on a single brand car dealer for impartial advice on which brand of car to buy. Even if there are a handful of models from other manufacturers around the showroom, customers generally know or suspect that the dealer will have a preference for selling the in-house product. Therefore, people rarely rely on car dealers for impartial advice and try to read as many car reviews as they can, go on plenty of test drives and ask lots and lots of questions. In the end their decision might be motivated by something as trivial as liking the car’s colour, but few people buy a car without any research based solely on the first recommendation made by the first car dealer they meet.
In the financial services business the situation is similar to the auto business, but the problem is that it isn’t as obvious and people tend to place a lot more trust in financial advisers, assuming that the adviser’s recommendations are based on research. Basically, many people go to advisers precisely because they don’t understand research and expect that a skilled professional can do this research on their behalf.
That wouldn’t be a problem if the research process was impartial and balanced, but in many cases customers do not realise that their advisers are no more able to offer impartial advice on investments than the car dealer, and even worse yet many customers do not realise that the independent-sounding firm they have approached is simply trading under a brand name which obscures the fact that the firm is owned by the very same company that makes the products the adviser sells.
The majority of financial advisers work for dealer groups owned by the same institutions that create the funds and insurance policies that the products these advisers sell. Unfortunately, these dealer groups operate under a plethora of brand names and it is only seldom obvious to the uninitiated what the relationship between the adviser and a product provider is.
How is this a problem? Well first of all the term “adviser” tends to imply that advice is being given and a reasonable person would assume that there is some kind of research behind that advice. In a situation where the adviser is restricted to recommending only a narrow range of products, most of which are manufactured by the owner of the adviser’s company this research has to be called into question. In many cases the adviser’s impartiality is not much different to that of a car dealer when talking about the single brand of cars they sell.
Seldom advertised to the public, but certainly well known in the industry that the majority of large dealer groups associated with product providers operate at a loss or at best only a nominal profit. Advisers for these dealer groups pay a relatively small split of their fees and commissions to the dealer compared to the splits which are paid to unaligned dealer groups. The reason for this is that the tied dealer groups are not intended to be profitable businesses in their own right. The parent group is quite happy to make a loss on their adviser business provided they make a profit elsewhere. That profit of course is generated from the product manufacturing side of the business, turning advisers into nothing more than a product distribution channel.
No matter how skilled and ethical the individual adviser, they will always be operating with one hand tied behind their back if their primary goal is to give the best advice they can give, to research a wide variety of products and especially to shop around for products with reasonable fee structures. When competing products are added to recommended product lists, it is quite common for the lists to include only competing products with relatively high fees, seldom products which show up the in-house product as overpriced.
Commissions and asset based fees
There has always been a great deal of controversy over advisers being paid commissions, but there are many who argue that commissions are a perfectly valid way for an adviser to be paid. Some even argue that there are significant advantages to this.
To understand what is wrong with commissions and asset based fee structures, imagine what it would be like if other professionals were paid this way. Consider for instance what would happen if judges operated on a commission basis.
What if judges were not paid a salary, only paid a “sentencing fee” when they found someone guilty, and the amount they were paid was proportional to the severity of the sentence they passed. The court, prosecutor and all lawyers would of course be paid a percentage of this amount, and would receive nothing otherwise.
If this system had been going for a while we are sure it would attract both strong support and strong criticism.
Supporters of the system would argue that it is a very fair way to conduct justice, because it would be an efficient “user pays” system which costs nothing to the non-guilty. It might also be expected to help cut down on long court cases by giving all involved an incentive to get the proceedings over quickly and get on with a new case. Costs might be expected to be reduced and speed would be increased. Furthermore, there would be no complaints about overly lenient sentencing. All in all, say its defenders, this would be quite an acceptable situation.
But there would be one flaw in the system: there would be a strong financial incentive for all involved to find defendants guilty, regardless of whether they actually were guilty or not. There would always be a lingering doubt about whether the person was really guilty on the evidence, or whether the judge just wanted to buy a bigger boat. Naturally defense lawyers would play the “judge was biased” card during appeals, and public distrust of the legal system would be very high.
Apologists would have an answer to that as well: professionalism. Such a system would be fine so long as all participants were morally and ethically flawless. They would be highly trained, highly regulated and told to think of themselves as “professionals” who put the common good ahead of their own. In short, the answer to this conflict of interest would be to just hope that everyone would simply overcome their conflicts of interest by acting professionally.
Returning from our legal analogy to the financial services industry, the “professionalism will save the day” argument is in fact the standard argument used by industry lobby groups. Whether feigned or genuine, nothing inspires an angrier outburst of righteous indignation from an industry spokesman or non-independent adviser than the assertion that many advisers are not professional enough to just do the right thing all the time even when they have strong financial incentives not to.
Commissions create a conflict of interest in several ways. First of all, advisers reliant on commission income will have a strong aversion to using products that don’t pay commissions, or a strong bias toward products that pay higher commissions than lower ones. It is our belief, backed up by research of a wide variety of products, that there are many products out there that would simply shrivel and die from lack of inflows if not for the commission incentives offered to salesmen. If commissions weren’t paid on these, the products would be seen as simply pointless.
Secondly, and this flaw applies to asset based fees for service models as well as commissions, if remuneration is simply linked to the size of the investment portfolio there is little incentive for advisers to do a good job with the broader aspects of financial planning. While advisers who restrict themselves to investment advice only arguably could charge a percentage based fee, this just isn’t logical for financial planning.
When a financial planner is criticised for the poor performance of a recommended portfolio, the reply is almost always that the main value of a financial plan is in the strategy they provided. It is in the tax saved from the tax planning advice, in the extra social security received due to the social security advice, the peace of mind from the estate planning and the reduction of risk exposure from the asset protection and insurance advice where the most value is added.
We agree… so why do the majority of those same advisers have a fee structure directly linked to one factor only, the portfolio size?
How did we get here?
There are many features of the way the financial advice industry operates that perhaps would not exist if the industry were recreated from scratch today. Like any system which has been in place for a while there are certain parties who have a vested interest in maintaining the previous order.
The modern financial planner is a direct descendent of the insurance agent of the past. Insurance agents were salespeople who worked for insurance companies. Initially most were agents for a single insurance company, though multi-agents and brokers became common over time. The role of these individuals was set by the insurance companies, who hired and fired them solely for their ability to sell product, and paid them only for sales.
The concept of advice was limited to figuring out which of the products the salesman was selling would be most useful to the person he or she was selling to. That is of course the type of advice you get from a car salesman, and that is fine when people recognise a sales pitch for what it is, but dangerous when people think the salesman is in a position to be impartial when making statements about how good the product is.
During the 1990s, and since then, financial planning has emerged and developed into something quite different.¬† Financial planners today really do see themselves as advisers rather than salespeople, and the public for the most part sees them that way also.
The problem is that even among these advisers many of the trappings of the salesperson remain. Commissions are still paid by product providers for selling product. This remains the case even though financial planning has for the most part moved away from a product-centric approach to an advice-centric approach.
What is the difference?
An advice-centric approach looks at a person’s goals and investigates all the different strategies for achieving those goals. These strategies may include products, but often they will not. Paying off debt, drawing up budgets, advising on asset protection issues and estate planning are all vital and common parts of the financial planning process which don’t involve products at all.
While these are all integral to the financial planning process, the product-centric approach to financial planning tends to reduce these subjects to little more than a generic paragraph or two at the back of the statement of advice with no customisation whatsoever. This makes sense for the adviser, who has little incentive to spend much time on things which don’t make him or her any money.
Whether you want to call most financial planners “adviser-like salesmen” or “salesmen-like advisers” is largely a matter of opinion, but it will always be one or the other until advisers are no longer paid sales commissions by product providers or set their “fee for service” with a direct tie to products sold.
Why aren’t there more independent advisers out there?
According to http://www.independent-advice.com.au, a registry of independent financial advisers maintained by actuary and compliance consultant Brett Walker, there are less than 20 independent advisers in Australia as at the start of 2008. There are tens of thousands of non-independent advisers, so the chances of bumping into an independent adviser at random are slim.
There are several reasons why there are so few independent advisers out there. The first is simply because the Corporations Act restricts the use of the term “independent” in a way which is inherently difficult for advisers to live up to. Little consideration is given to materiality, the definition basically prohibits use of the term “independent” or “unbiased” or any similar terms if the adviser, or any of their associates, receives any commissions at all without crediting them back to their clients.
This is a much bigger obstacle than it might appear at first glance, because the majority of financial products do pay commissions, whether the adviser wants them or not. While an increasing number of products have a “dialdown” feature which enables the adviser to rebate commissions at the product level, these are only present in a minority of products. If an adviser wants to work on a strictly fee for service basis, it is just a fact of life that the adviser will need to develop a system for accounting for commissions and crediting them into clients’ accounts. This is a major undertaking because there is no standard format for commission statements and many providers send commission statements out only on paper, meaning at the very least the process of entering all of the commissions into a spreadsheet or database takes a substantial amount of time.
It is possible of course for the adviser to simply not recommend any products which pay a commission, but this restricts options greatly (not all commission paying products are lousy). It also doesn’t help clients who bring existing accounts with them which pay commissions which they would like the adviser to collect on their behalf and credit against their financial planning bills or rebate back to them.
Tellingly, there is also a common perception that an independent advice model is less profitable than a biased one. This is completely false if all advisers are acting solely in their clients’ best interest and charging commercially reasonable fees, but it is unfortunately true that commission based remuneration models do allow less scrupulous advisers to charge their clients a lot more money. The reason for this is simply that a fee for service adviser needs to negotiate a dollar fee with their clients, a discussion which inevitably results in clients thinking about the value for money they are getting.
Commissions are a highly suitable form of remuneration for any adviser wishing to avoid getting into discussions with clients about how much they are to pay for advice. Product disclosure statements are often vague about points such as where the entry fee goes (it usually goes to the adviser, as an up front commission) and trailing commissions are sometimes disclosed as if they are just a standard unavoidable fee which everyone pays. It is thus possible for example for an adviser to take a 4% commission on a $1,000,000 superannuation rollover for an unsophisticated investor, in situations where the client would never say yes to a $40,000 fee for service. Commissions work well for the unscrupulous adviser because many investors do not know about things like dialdown features, or the fact that it is normal for advisers to reduce up front fees, sometimes to zero, for larger account balances.
The argument that commissions aren’t a concern for investors because they are paid by fund managers, so the investor gets their advice for free also gets used a lot, even though it just isn’t true.
Assuming that the adviser actually wants to rebate commissions, and is willing to go through the heavy administrative burden of tracking all the commissions and crediting them back to their rightful owners, the definition of “independence” ties the adviser’s ability to call themselves “independent” to the independence of their colleagues. Essentially it isn’t just the single adviser who must be independent, but all of the other advisers in their dealer group as well. It thus isn’t a decision which an individual adviser is able to make, the decision must be taken at the highest level of the adviser’s dealer group and enforced throughout the organisation.
Since most mid-sized and large dealer groups make all, or a substantial fraction of their profit from in-house products or tied distribution deals, sponsorship and shelf space fees, few have any interest in converting to the independent model. Thus, the handful of independent advisers out there all work for small independently owned dealer groups with only one or two advisers each.