Brent Sheather: Keeping financial advisers honest

About a month ago we looked at a paper by the Securities Commission which detailed its thoughts on how financial advisers might be better educated, qualified, regulated and supervised.

This was a response to the widespread incidence of poor investment advice over the past five years.

This column concluded that while the commission's efforts were going in the right direction, it was easy to be cynical as the authors of many of the horror stories in recent years have apparently been qualified financial planners.

The conclusion, therefore, was that either advisers were being taught the wrong stuff or they were ignoring the lessons. The article noted that the fundamental weaknesses of the financial advisory business remain.

Many financial planners are remunerated by commission and are thus given an incentive to sell whatever has the highest fees at the time rather than having regard to what the client should own, and reality is that higher-risk products pay the highest commission.

The suggestion was that commission should be abolished and advisers work on a fee basis, whereby an adviser charges the client a set percentage of the funds to be invested.

Under the fee-based model, a financial planner will be disinterested as to whether he or she sells bonds, property or shares and can focus on what is good for the client, rather than what maximises income.

The removal of commission and trailing fee payments by product providers would change the investment advisory landscape in an instant and do more "to promote the sound and efficient delivery of financial advisers and to encourage public confidence in the professionalism and integrity of financial advisers" than any legislation ever could.

Coincidentally, this also seems to be the latest thinking of the leading British regulatory authority, the Financial Services Authority (FSA), which published in late June a paper that proposes to abolish all types of commission within the investment advisory industry by 2012.

New Zealand could do worse than copy the British initiative. This week we will look at the FSA's recommendations.

The document in question, "Distribution of retail investments: Delivering the RDR" (www.fsa.govt.uk), is a 100-page monster.

The report begins by describing the scene in Britain, which in terms of competition between investment managers, is "aimed at persuading advisers to recommend their product rather than marketing the efficacy of products to consumers generally. When providers compete it tends to be on features such as past performance, reputation and the level of fees."

In this case, though, the FSA is saying the higher the fee the more competitive the product. The FSA noted significant commission bias, that investors did not know what they were paying in commission and that many were under the impression that the fund manager paid the initial fee rather than them.

The FSA noted the development of platforms and their potential benefits but was more concerned with the platforms' charging structure, complexity and lack of transparency.

Sound familiar? It looks a lot like what happens here. So let's see how the FSA plans to sort out its dysfunctional market.

The FSA proposals have three prime objectives:

To address the potential for adviser remuneration to distort consumer outcomes.

To improve the clarity with which firms describe their services to consumers.

To increase the professional standards of advisers.

The most significant of the three is the abolition of commission payments from product providers (fund managers) to financial advisers by December 2012. The FSA will also ban advisers from recommending products that pay commission including soft commissions paid in non-monetary form.

Financial planners must set their charges in agreement with clients and will have to meet new standards regarding how they determine and deduct these charges.

The FSA appears to be doing its damnedest to put to rest the old system, which falsely implied that initial fees were being paid by the fund manager rather than the client. As part of this proposal the FSA will make sure that adviser charges don't vary unreasonably depending on the type of product used where this product is readily substitutable. For example, investment in life assurance bonds should not produce higher fees than in investment trusts.

The FSA also proposes to knock trailing commission, or rather, its fee-paying equivalent, on the head unless it is part of a regular review of client portfolios - that is, a quarterly monitoring service. It looks very much like the end of the free lunch for British financial planners.

The other major initiative is to allow investors to clearly discriminate between independent advice and "restricted advice"; that is, advice which is limited to the product sold by a certain fund manager or bank.

This is going to get a bit tricky as a number of advisers can potentially advise on all sorts of products but in reality choose only to sell some. A while back in New Zealand, a firm which recommended only a limited number of high-cost products (most of which seem to have gone bust) got into a bit of strife when it called itself independent. If it tried that in Britain post 2012, it would almost certainly "go directly to jail".

According to the FSA paper, "Our rules and guidance will ensure that firms that describe their advice as independent genuinely do make their recommendations based on comprehensive and fair analysis, and provide unbiased, unrestricted advice. Equally, where consumers choose to use a restricted service - such as a firm that can only give advice on its own range of products - this will be made clear."

Just where this will leave "platforms" is unclear but the FSA has said that it may regulate these as well because of problems with complexity, transparency and the fact that many platforms promise the earth but in reality do not provide "unrestricted advice".

The FSA also plans to increase the professional standards of advisers in the same way as is planned by the Securities Commission in New Zealand.

Just where these changes will leave the British financial planning industry is anyone's guess. Their effect will be far reaching. Some experts reckon up to 50 per cent of financial planners will leave the industry, that investors with small sums to invest will find it hard to get advice (a cynic would say that that is the present situation as far as good advice is concerned) and that the changes will encourage vertical integration.

This latter effect could happen as fund managers who used to generate sales by paying high commission react by buying the investment advisory businesses to guarantee distribution. This would mean fewer "independent" advisers.

For the British investment advisory business it looks like "the end of the world as they knew it". It's a reasonable bet that consumers will end up "feeling fine".

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free.