Follow the money

Experts are human, and humans respond to incentives," say the authors of the book Freakonomics: A Rogue Economist Explores the Hid­den Side of Everything.

“How any given expert treats you, therefore, will depend on how that expert’s incentives are set up,” they say, before showing why a real estate agent is not properly incentivised to achieve the maxi­mum sale price for a property.

(The extra time and effort involved in attaining, say, an additional $5,000 for you may only be worth $150 to them, so they don’t bother.)

Freakonomics reveals that the way real estate agents behave when they sell their own proper­ties is quite different to the way they behave when they act on behalf of clients (agents keep their own properties on the market for longer and achieve a higher price).

If you’re a client of a financial planner who’s pushing a certain suite of products, it may pay to ask them a rather pointed question: Where do they invest their own money? I’d wager that the average percentage commission paid on funds owned by financial planners is much lower than that paid by their clients.

If you’re a regular Professional Planner reader then it’s a fair bet you’re already a convert to the fee-for-service approach. It’s a rational decision to free oneself from the corrupting influence of commis­sions and kickbacks (especially the hidden variety).

But, as any number of behavioural studies demonstrate, humans aren’t always rational. And just as large parts of the financial planning industry remain desperately hooked on a commission-based business model, I’m not convinced that consumers are ready to change either. Just because something is demonstrably beneficial doesn’t mean it will be automatically embraced.

My father had a heart attack at the end of the last financial year. He’s a diabetic, and knows that he should stop eating so much sugar and fat. Yet he continues doing both, because the damage he is doing is largely invisible. Financial planning advice isn’t that different.

Excellent advice is not just costly, it requires the client to open his or her wallet. However, given the choice of signing a $2,000 cheque up-front or paying $2,500 in annual commissions out of their returns (but never having to physically hand over the money), many clients would opt for the latter. Like a clotted artery, we simply don’t notice the missing $500.

So, as much as I’d love to see it happen, I’m not convinced that the financial planning industry at large will change any time soon. Between the advis­ers hopelessly addicted to the current arrangement, and consumers’ distaste for paying an appropriate level of up-front fees, it’ll be an uphill struggle. But it is a change worth striving for.

The incentives provided to financial planners are crucial but they’re only half the battle. Next month, by way of illustration, I’ll pose a question: Would you rather be advised by an appropriately incentivised half-wit or someone with a razor sharp financial sense who charges rapaciously?

That will take us into the area that billionaire investor Warren Buffett terms your “circle of com­petence”. And I’ll relate this specifically to my area of expertise: direct share investing.

The problems with the financial planning industry are fixable but, as your answer to the above question may reveal, they’re also complex.

Greg Hoffman is Research Director of The Intelligent Investor, which provides independent sharemarket research for Australian investors. See www.intelligentinvestor.com.au for more details.