Danish storyteller Hans Christian Andersen, beloved by generations of children, was a keen observer of human nature. In his fairy tale The Emperor’s New Clothes (published in 1837), he tells a simple tale of childhood innocence. Its deeper meaning reveals a common human failing in which the majority of a group publicly aligns with an accepted norm, even though they privately reject it. Social psychologists call this phenomenon “pluralistic ignorance”. It helps to explain a related phenomenon known as the “bystander effect”, where onlookers fail to act because to do so might lead to ridicule and banishment from the group.
The short history of the financial planning industry is a case study in these phenomena. I have had countless conversations over the decades in which intelligent and otherwise ethical industry leaders have privately acknowledged the principal cause of the industry’s poor behaviour and reputation, namely conflicted remuneration and misaligned incentives. However, they have refused to recognise the problem publicly or change their practices, lest they be criticised or lose some commercial advantage.
This failure of leadership has had major consequences over the decades, mainly in the form of unnecessarily complex and costly government regulation. To make matters worse, most of this regulation has been ineffective because it has been in the form of workarounds and political compromises. That is, the approach to industry regulation has been to leave most of the conflicts in place and simply require their disclosure.
This has allowed industry leaders to disingenuously argue that responsible consumers who read the documents placed in front of them have the opportunity to understand the advice, behaviour and motives of their advisers. And those who don’t read the documents are irresponsible consumers who get exactly what they deserve.
Eventually, after decades of increasingly complex and ineffective disclosure-based, box-ticking regulation, government took a new approach with the introduction of the Future of Financial Advice laws (FoFA) in 2012. This legislation retained disclosure but went further, by banning certain forms of conflicted remuneration, mainly commissions on managed investment products.
Unfortunately, FoFA was still a political compromise and failed to introduce a comprehensive ban on all forms of conflicted remuneration. As a result, the industry simply replaced commissions paid by third parties (illegal) with commissions paid by clients (legal). Much of the industry, including its powerful lobby groups, now brazenly insists on referring to the latter form of commissions (asset fees) as ‘fees for service’; whereas in reality, asset fees are just another form of commission, little different in structure to commission paid to real-estate agents out of the proceeds of the sale of a property.
Then, in 2015, as a response to perceived shortcomings in the selling of life insurance, government introduced the Life Insurance Framework (LIF), slated to commence on January 1, 2018. This is an extraordinary and unprecedented scheme that imposes what amounts to regulatory controls over the remuneration arrangements of financial advisers. Indeed, it is reminiscent of the Whitlam Government’s short-lived Prices Justification Tribunal, which was a knee-jerk political reaction to perceptions of consumer rip-offs through aggressive pricing in times of rampant inflation.
I’m certainly not suggesting that no action was needed to improve the practices of the life insurance industry but I am suggesting it is regrettable that government, not the industry, controlled the reforms. As a result, the LIF pleases few, is unlikely to improve behaviour and will become more complex and costly as government realises its fundamental flaws, particularly the retention of commissions.
The latest initiative by government, in its endless litany of well-meaning but flawed, regulation and reform of the financial planning industry, is the Financial Adviser Standards and Ethics Authority (FASEA). Its principal roles are to establish compulsory educational requirements and to mandate (from 2020) a code of ethics for advisers. No doubt, the elevation of educational standards is worthy of support; however, in terms of improving industry behaviour, the mandatory code of ethics is by far FASEA’s most important task.
The risk here is that the code will amount to little more than a statement of broad ethical principles, thereby allowing the industry to continue its product selling activities and sustain its conflicted culture without impediment or reform. The sad case of the accounting profession’s attempt in 2012 to introduce genuine and comprehensive reform of conflicted remuneration for accountants offering financial planning services may well be a sign of things to come should FASEA pose a threat to the industry’s dominant culture.
If that is what happens, FASEA will have amounted to another expensive and ineffective exercise in government intervention with little improvement in the lot of consumers. After that, it will just be a matter of time before more regulation follows. The political process will demand it.
And the industry will have missed yet another opportunity to do what most of its leaders know is necessary, but are afraid to enact – that is, the elimination of all forms of conflicted remuneration. This would curtail much of the poor behaviour, create trust between planners and their clients and reduce (if not remove) the need for complex and costly government regulation that has achieved so little.
As for the immediate future, the activities of financial planners are about to be forensically examined as a part of the government’s Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. According to its terms of reference, the commission “must enquire into…the nature, extent and effect of misconduct by a financial services entity…any conduct, practices, behaviour or business activity that falls below community standards and expectations…or is otherwise not in the best interests of members…whether any findings…are attributable to the particular culture and governance practices of a financial services entity or broader cultural or governance practices in the industry…whether any further changes to the legal framework, practices within the financial services entities…are necessary to minimise the likelihood of misconduct.”
The challenge for the royal commission is to identify clearly the causes of the poor behaviour it is investigating. The hope is that it will be assisted in that task by considerable personal and harrowing evidence from aggrieved members of the public who have suffered at the hands of financial planners whose actions were driven by conflicted remuneration and misaligned incentives. In that sense, we already know what the outcome of inquiry should be.
The question is whether the industry’s leaders will prefer to be silent by-standers (or, worse still, hypocritical apologists arguing that bad behaviour is a thing of the past) or have the courage to publicly support the comprehensive ethical reform that most of them privately acknowledge is in the best interests of the public that the industry claims to serve. This is not the time for financial planning industry leaders to engage in pluralistic ignorance or stand on the sidelines for fear of ridicule by their peers. The royal commission presents the opportunity to comprehensively, permanently and genuinely reform the industry into a profession of which its participants can be proud.