The arrangement between a consumer and a financial adviser is the classic principal-agent problem: an informed agent (financial adviser) transmits information to an otherwise uninformed principal (consumer) who then must make a decision. Consequently, this relationship is beset by adverse selection and moral hazard problems, particularly given that the financial adviser’s interests are strongly aligned with those of the product providers from whom they receive payment.
A consumer is typically not equipped to evaluate the quality of an adviser in advance and must make use of a range of proxies to infer quality. These proxies can include the brand of the company, referrals from friends or family members, the titles and qualifications of the advisers, and pricing policy. For those consumers with little ability to accurately assess quality, there will be a tendency to make poorer selections. Since financial advice is a product that is infrequently consumed, and tends not to be subject to comparative shopping, many consumers defer to convenience, whereby location or integration with existing financial services becomes the determining factor.
Consumers can insure themselves against making a poor selection of their financial planner by limiting their exposure – and the research does show that scepticism about planners’ remuneration is an obstacle for some consumers.
In the market for financial advice, there is also a glaring disconnect between supply and demand. ASIC noted that one-half of all consumers want simple advice or a DIY option. In contrast, the business model of many financial planning firms is to assume that most consumers need comprehensive advice provided by way of a full financial plan, with the onus on the client to request a less holistic approach. Even though the majority do offer scaled advice, five in eight do not explicitly promote it to their clients.
A conscious effort to place all clients into higher-margin (and higher-cost) holistic strategies and products is the epitome of moral hazard. Moral hazard arises because of the inherent conflicting incentives for financial planners: on the one hand consumers expect that they will be advised on what is best for them (although this is not currently a legal requirement); while on the other hand planners need to generate revenue by selling financial products. This generates a bias towards promoting more expensive products. Behavioural economics and choice theory tell us that this need not be in the form of a hard sell; menu selection and a default option would be effective nudging mechanisms for passive or uninformed consumers, à la the predominant strategy adopted by licensees.
As a result, the financial planning industry has been ambivalent at best about intra-fund advice and scaled advice more generally and increasingly out of step with consumer demand.
For years financial planners have argued consumers will not pay upfront fees, when of course the real problem has been the quantum of the fee and the scope of the service. A majority of consumers increasingly prefer one-off transactional advice for which they are willing to pay a few hundred dollars. Until now, the solution has been to conceal the real cost of advice through commissions and percentage-based ongoing advice fees.
This has created a further moral hazard in the use of deferred payments, specifically trailing commissions and ongoing advice fees. Consumers with high discount rates (relatively measured, vis-à-vis advisers) will have a tendency to prefer the exchange of upfront costs for an ongoing payment. Since high discount rates are correlated with financial illiteracy, the use of trailing commissions and ongoing advice fees invites the unscrupulous to take advantage of some consumers.
The FoFA reforms – and in particular the prohibition of conflicted remuneration, the opt-in provisions and requirement for transparent pricing of advice – will put an end to the practice of concealing the cost of advice through ongoing advice fees and the commercial reliance on inertia and information asymmetry.
At that point, the financial planning industry can transform into a profession. Until that point financial planners, as well-intentioned as the vast majority are, will continue to be regarded as sales agents.
*Note: All surveys, figures and relationships referred to are from ASIC’s Report 224 Access to Financial Advice in Australia (December 2010).
David Whiteley is chief executive of Industry Super Network (ISN).
Good points made below. In summary, QInvest have exactly the same advice model as the Industry Funds, which is pretend ‘fee for service’, subsidised by all members. This arrangement is reinforced by the FOFA reforms and will continue, whilst independent advisers are put out of business. This is the opposite outcome to that suggested by David Whitely in his article.
Agree with you Tim. My wife is a member of QSuper. She doesn’t have choice due to a legislative carve out – how many non-industry funds have members that are unable to leave them.
We visited a financial planner at QInvest for some advice in relation to her DBF. The cost of the SOA was to be $300. I commented on how cheap this was and that on that basis they’d be making, at best $30 per hour. The planner commented that the QInvest was subsidised by QSuper so we might as well take advantage of it.
My wife had been suppporting QInvest for 20+ years. Never once had an adviser rung her for a review. Never once had an adviser offered to ask her to opt-in to continue paying the ongoing fees. Furthermore, regardless of the opt-in legislation, my wife has no choice but to continue to be a member of a sub-par fund and pay for financial planning that she is not using.
Great comment Tim, but I’d like to bring focus to Davids first two paragraphs.
Have a read of them again, and just insert ‘ISN’ before the term ‘financial advisor’. If they get license to provide advice on their products, that’s exactly what they’ll be, ISN Financial Advisors.
So with the ISN working towards offering advice themselves? wouldn’t this amplify any principal-agent problem? receiving advice directly from the product provider, limited only to that product, with no capacity to explore or advise on where the use of that product fits within the client overall requirements?
Mr Whitely, I have read your articles in this magazine for months and find many of them full of loose information and targetted ‘surveys’, used to hypothesise and produce inferences and outcomes to suit your obvious agenda. Your lack of understanding of ‘real’ financial planning is obvious from your comment in the latest edition: “In contrast, the business model of many financial planning firms is to assume that most consumers need comprehensive advice provided by way of a full financial plan, with the onus on the client to request a less holistic approach”.
I have worked in 3 major Licensees in the past few years and for all it is a required compliance assumption that the client is offered full advice and only the client can limit the scope of advice sought. What you are proposing is that this assumption is based on a need to make sales. I suggest you actually talk to some Compliance Managers in Dealer Groups other than IFFP, so you can get an understanding of how ASIC regulations are interpreted and complied with, in the real world. Let’s face it, IFFP is really a tied sales force much like the Life Insurance agents of the past, as it is well known that the fees they charge do not completely cover salaries, bonuses (for meeting sales / FUM targets), expenses and overheads. In effect, this shortfall in costs is subsidised by the funds they represent, paid from the funds under management. In effect, isn’t this a commission-based system, rather than a true ‘fee-for-service’ system? The ‘crisis of confidence’ you spoke of in a previous article lies I believe in the Industry Fund network as if they (and you) were really serious about their members getting good advice of their choosing, then they would be able to pay me from their super fund balance for advice I provide to them specifically about their Industry Fund. In the numerous times that I have advised clients about their Industry Fund, the cost is either subsidised by another investment holding they have, or they have had to pay me with an after-tax personal payment, which their Accountants have had issues with. Unfortunately, Industry Funds seem to only work in the interests of their executives, IFFP, ISN, the TV networks/Advertising companies and sporting clubs/venues. I guess that’s why they are ‘not-for-profit’, it’s all spent on indulgences. Now, how much was spent on sponsorships and advertising (including Professional Planner mag!!) last year?? Surely that should be disclosed to members shouldn’t it, or is their a crisis of confidence??
Regards