Decision to allow financial advisers to keep taking a cut is a backward step
The chance of New Zealanders getting a fair deal from the financial advisory sector took a step backwards last month when Commerce Minister Simon Power said the Government had no plans to ban advisers from taking commission.
New Zealand's stance on dealing with this fundamental conflict of interest is in sharp contrast with that of Britain and Australia whose regulatory bodies have set a timetable for completely banning the taking of commissions. Even India is banning commissions.
The New Zealand approach instead is to introduce a new regulatory framework which would require full disclosure of commission.
The Commerce Minister says: "I am confident that transparency of commissions, along with various other standards, will ensure mum and dad investors can make informed decisions about whether to use a particular financial adviser and will ensure that advisers act in their best interest."
That might sound reasonable, but it is not that simple, Simon.
Disclosure of fees is not the answer to solving the widespread problem of inappropriate financial advice and restoring the faith of the public in investment advisers. There are numerous problems with disclosure.
Firstly, not many non-expert investors are able to tell whether they are getting a fair deal or not because there is no requirement to disclose the relative cost of the advice or indeed that there may be a cheaper and more appropriate option. Nor is there any requirement in New Zealand, unlike Britain, to put the best deal in front of your client.
In New Zealand an adviser might disclose that he is getting a 0.25 per cent trailing commission and a 3 per cent initial fee to a client but the client will not necessarily know that there are other products available with initial fees a third of that level and paying no trailing fees.
That is just the start. Recent United States research points out some major problems with disclosure itself.
According to a Carnegie Mellon study, compulsory disclosure can, and often does, induce other actions on behalf of the person doing the disclosing and the person receiving the disclosure. Disclosure does not happen in isolation. The key findings of the study are as follows:
Firstly, a financial adviser selling managed funds exclusively from provider ABC which pays him/her higher levels of commission is much more likely to embrace disclosure as the lesser of two evils as it generally involves minimal disruption of their business model.
For example, most doctors will prefer disclosing paid holidays from pharmaceutical companies rather than not going on the free holiday.
Disclosure also offers another benefit to advisers and policy-makers: it diminishes those party's responsibilities for adverse outcomes.
An example is the warning labels on cigarette packets - a great victory, consumer advocates said at the time. But since the labels first appeared the tobacco industry has fended off smokers' lawsuits by citing the labels as evidence that smokers should have known the risks.
Secondly, for disclosure to be effective the recipient of the advice must understand how much the conflict of interest has influenced the adviser and be able to correct for this.
The Carnegie study showed that "people generally do not discount advice from biased advisers as much as they should even when conflicts of interest [COIs] are honestly disclosed". People tend to think "X is a great guy and he wouldn't rip me off".
Lastly, experiments conducted as part of the Carnegie study showed that "disclosure can increase the bias of advice because it leads advisers to feel morally licensed and strategically encouraged to exaggerate their advice even further".
The professors conclude that disclosure may fail to solve the problems created by COI and may even make matters worse.
The inappropriateness of the commission model can be appreciated if one is aware of the difference in remuneration available to advisers from different products.
Low-cost exchange traded funds, investment trusts and direct investments in government bonds pay no commission or trailing fees.
The adviser recommending these products must instead charge a fee and this fee, in most cases, will need to be shared with a member of the stock exchange who will arrange the transaction.
In contrast, higher cost instruments allow advisers to be remunerated in many different ways besides just commission and trailing fees. The inducements to sell some products, commonly associated with insurance companies, are over the top.
The disclosure statement of one advisory group I saw had a template for its disclosure statement as follows: "I also receive a commission of x per cent for each investor who subscribes for units in the ABC managed fund. I receive an additional commission of x per cent for each of these subscriptions, the value of which exceeds a certain amount.
I also receive certain benefits for giving investment advice in relation to these products whereby in addition to fees and commission I get a free trip for myself and my wife to the value of $x. If I achieve other targets in addition to the fees, commission, etc, I get access to research and gifts including consumer goods, travel and accommodation."
Now, faced with those inducements, how many commission-based advisers are going to put you into a genuinely low-cost managed fund which pays no commission, no free travel, no trailing fees, etc?
Despite the disclosure, because mum and dad may not know about the low-cost alternatives, they will not be in a position to determine what sort of a deal they are getting.
In Britain advisers will soon be required by law to do the best thing by their clients. That is a far more rigorous threshold to cross. It is unrealistic to think that a disclosure statement and a code of professional conduct is going to stand in the way of making $1000 from a deal versus $100.
Finance company debentures (FCDs) are a great example of commission-driven bad advice. While FCDs are fixed-interest investments, they are high-risk junk bonds, so they have no legitimate place in a balanced portfolio of bonds, property and shares.
The risk element of the portfolio is represented by the property and share components, whereas the bond portfolio, to provide diversification benefits, needs to be resilient in the face of an adverse economic environment.
The bonds thus need to be low-risk; for example, government bonds. Under the disclosure rules, a financial adviser could sell finance company debentures to a client, whereas if they were required to do the right thing by clients, as in Britain, they could not.
It will be embarrassing to backtrack but the Government needs to revisit the question of commission before the inevitable next major mis-selling event forces its hand.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
