Is commission equal to fraud? In Australia, the Netherlands and UK the answer is yes, and more countries look likely to join their ranks. Inherent to the commission system was a tremendous conflict of interest, right at the heart of financial advisory, due to the fact that advisors used to be paid by the suppliers of the financial products they sell to clients. Thus, financial advice has been ‘free’ of charge until recently.
The proverb ‘if it’s free, then you’re the product’ applies well to the situation above within financial services. By acting the middle man between investment providers and consumers, financial advisers found themselves in a sweet spot, where they often received a form of ‘kick-back’ from the provider, a share of the return on the consumer’s investment, or both.
The Retail Distribution Review (RDR) created by the FSA came into effect in the UK on December 31st 2012, and aimed at making advice independent by banning the commission practice and make transparent pricing structures a requirement for the industry. Furthermore, the RDR introduced a higher minimal qualification for financial advisors: previously, the equivalent of A-levels was the benchmark, now it is the equivalent of a first-year undergraduate course at university. Since the RDR was implemented, a few pitfalls have emerged (from The Investment Management Association (IMA)’s 11th annual Asset Management Survey):
1. Less access to advice: Many consumers could be priced out of receiving advice, because they now must pay the price for advice if they want it.
2. Multiple share classes: The creation of multiple share classes to accommodate different charging structures could emerge as an issue. Large fund distributors have tried to provide ‘super clean’ share price deals with fund groups, to sell funds at a discounted rate compared to competitors.
3. ‘Dumbed down’ funds: RDR could lead to too many “plain vanilla” outcome orientated products, which do not generate significant levels of alpha, and further cause excessive conservatism, due to investors having insufficient experience in taking calculated risks.
4. Advice gap: The survey expressed concerns that an ‘advice gap’ will result due to changing charging structures, creating greater numbers of unadvised, low-to-middle net-worth retail investors. Unadvised investors might favour execution-only platforms or go direct as a consequence of the new pricing structures. The concern is not unfounded, seeing as several providers of advice have culled their financial adviser workforces, including HSBC, RBS and Barclays.
5. Consolidation: Finally, one of the unintended consequences of RDR could be a more polarised fund management industry.
Despite the warnings and red cards from people in- and outside financial services, the RDR is widely considered a necessary and beneficial improvement to previous practices. The abovementioned problems are largely solvable by refining legislation, and by letting the pieces fall into place, until advisers find the high-net worth market so saturated that they explore downwards. Initially, however, a lot of consumers will most likely exit the market for financial advice entirely, based on the discrepancy between willingness to pay and cost of advice: 91% of UK consumers will not pay more than £25 for an hour of financial advice (survey conducted by Rostrum Research in 2012).
According to unbiased.co.uk, cited by the Telegraph, “the latest costs of commonly sought financial advice add up to £500 for initial financial review and report. Advice on where to put £200-a-month pension contributions would also cost £500. Help setting up a £10,000 Isa would cost £400, whereas advice for investment strategy for a £50,000 inheritance would cost £1,500. Advice on how to use a £100,000 pension fund to buy an annuity and withdraw a lump sum would cost £1,500.”
This trend has not been limited to the UK, and is likely to spread beyond the current scope. In Australia, the FOFA (Future of Financial Advice) framework went live on July 1st 2013. As in the UK, the idea is to improve the quality of financial advice for consumers and abolish the commission practice, making fee structures transparent and publicly available. In the Netherlands too, a ban on commission-based financial advice was implemented in January 2013. It is expected that digital advice will become more prevalent, and that the provision of low-cost advice will increase. Prices for online advice will probably be €2,000 – €3,000, which is still much more than Dutch consumers are willing to pay (i.e. nothing).
According to Dutch Rabobank director of private banking, Pim Mol, investment costs will fall by 25% for clients thanks to the new legislation. Rabobank has moved almost $3bn into cheaper index funds, since managers of more expensive funds will no longer be able to offer commissions (openly called ”kick-backs” in the Netherlands). The landscape of financial services is likely to change more broadly in the near future, as the obvious conflict of interest inherent in current commission practices becomes exposed and experiences of first movers like UK, Australia and Netherlands emerge.
