The commission system seems to be behind many cases of bad investment advice
KEY POINTS:
With memories of investment disasters like Feltex, finance company debentures, CDOs and Vestar fresh in the minds of so many New Zealanders, there won't be many people around who would deny that the local retail investment advisory business is in need of some big changes.
In New Zealand
the Securities Commission's efforts to improve matters rely primarily on improved levels of disclosure - spelling out to Mum and Dad the costs and nature of the advice they are getting and who is paying who so that people can assess their adviser's independence or otherwise.
For the financially literate, and those investors with common sense and the inclination to do the research, these changes should herald a big improvement in financial decision-making. But just because the information is there doesn't guarantee that it will be read, much less understood.
Furthermore, those people with the greatest need for good financial advice - that is, those with the least money - often rely on other less formal information sources in making their choice of investment adviser.
A cynical view is that, while full disclosure is necessary, as long as there are different rates of remuneration for different products, and advisers are paid by the people selling the product rather than those buying it, many will be biased in the advice they give.
Indeed, the commission system seems to be behind many of the most recent local cases of bad investment advice.
Britain, too, has had its fair share of retail investment disasters but the chief regulatory authority over there, the FSA, reckons commission payments are fundamentally incompatible with the provision of independent advice so it is going about addressing their financial advisory industry's problems in a very different way to New Zealand.
Britain has required high levels of disclosure from investment advisers and fund managers for quite some time but it is the FSA's view that further radical changes are necessary. Last month the FSA released its latest thinking on the retail financial advisory industry. The "retail distribution review" is designed to ensure that consumers have more confidence in the industry and will thus want to use its products and services more frequently.
To achieve this the FSA says "we need an industry that more clearly acts in the best interests of its customers and treats them fairly".
One of the key initiatives in this report is a proposal to split the financial planning industry into two groups - those that do the right thing, as defined by the FSA, and those who do not. The former group will be allowed to call themselves "advisers"; everybody else will be called salesmen/women.
The FSA is proposing to make a clear distinction in the market and the minds of the public between people who can provide independent investment advice and those who just have something to sell.
One unstated but pretty clear implication of the change is that advisers will be able to charge a higher rate than salesmen/women and that commissions for those operating in the "sales" space will be a good deal less than they are now.
It appears that many financial planners will miss out on the benefits of being an "adviser". Banks look likely to be particularly hard hit by the new legislation in that in Britain bank advisory staff typically offer only their own company's products and are paid by way of commission. The FSA sees this as being a sales role rather than advisory in terms of being able to truthfully say "this is the best product for you".
In order to earn the title "adviser", financial planners must be able to show that they operate remuneration arrangements agreed with customers and determined without input from product providers, show that they are truly independent and be able to recommend products from across the whole market. In respect of the latter requirement the FSA advised that it has not yet firmed up just how this will work in practice, particularly as regards firms which limit their clients to just those managed funds which are available on their platform.
In New Zealand and Australia, product providers often compete to have their product on a popular platform and the process of just how they get there often isn't transparent.
On the face of it this sort of situation does not seem to fulfil the FSA's "whole of market" requirement.
People calling themselves investment advisers will not be able to receive commissions or any other remuneration from product providers - no brokerage, no sponsorship of financial planner conferences, no volume bonuses, no free trips to rugby games, etc.
This is probably the most significant aspect of the retail distribution review.
In Britain, as in New Zealand, higher-risk/higher-return products have been able to pay higher commissions to advisers and thus ensure that advisers start selling that product.
This fact is behind the recently observed local phenomenon of every client of certain financial planning firms owning high-risk products irrespective of their risk profile.
CDOs are a good example: the product had a high-risk/high-return profile which let it pay much higher fees than other fixed-interest products so everybody owned it.
The FSA's proposal would mean that the advisers would be paid by Mum and Dad rather than the product provider.
CDOs, finance company debentures, Feltex shares and the like would not get to the front of the sales queue just because they paid higher commissions.
The Ministry of Economic Development, which is responsible for policy around securities law, advises that it has looked at the changes in Britain as part of the development of the Financial Advisers Bill being considered by the finance and expenditure select committee.
Liam Mason, general counsel of the Securities Commission, commented that part of the new legislation is designed to ensure investment advisers don't engage in misleading advertising which will include strict policing of the word "independent". That is going to be interesting.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.