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).
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