“There is inherently a conflict between manufacturing a product and supplying a product but then having an advice network or advisers who are supposed to be providing advice in the best interests of the clients.”
Former ASIC Deputy Chairman Peter Kell.
In theory, it’s possible to manage the fundamental conflicts at the heart of vertically integrated businesses. In practice, as the Banking Royal Commission has found, the clients’ interests simply don’t seem to matter.
The Banking Royal Commission has highlighted the consequences of getting your financial advice from the people who make, distribute and ultimately profit from the financial products they also recommend.
While criticism of vertically aligned advice businesses has shone a light on alternative business models, many commentators and journalists have been using the term ‘independent’ to describe any adviser who isn’t aligned with a bank or financial institution.
Most people use ‘independent’ to describe someone or something not subject to outside control and able to act without influence.
Removing the control of ownership or association removes some of the direct conflicts that exist between your interests and your adviser’s, but there are other less direct, but possibly more insidious, influences that need to be called out.
Significant conflicts of interest arise when a product manufacturer pays your adviser.
Conflicted Remuneration and Independence
Payments such as commission from financial products (‘conflicted remuneration’) can influence your adviser’s recommendation just as much as when the product maker employs them directly and pays their salary.
For this reason, as well as restricting ownership and association, the law restricts the term ‘independent’ to those advisers who avoid commission, volume bonuses (paid for recommending large volumes of a particular product to many clients), gifts or any benefits that may reasonably be expected to influence their advice.
Unfortunately, the term ‘independent’ is misused, misunderstood and frequently misrepresented.
When you consider how difficult it already is for people to work out how they can get unbiased advice, I don’t think it’s unreasonable to say this is alarming.
Australian Financial Review reporter Jennifer Hewett recently wrote about advice she received from an ‘independent’ adviser who recommended she set up a self-managed super fund (SMSF) and borrow large amounts of money to invest in an attempt to accelerate her journey to a comfortable retirement (and no doubt boost the adviser’s remuneration) .
Ms Hewett had no money to pay her adviser.
She reports that she was assured that any advice costs would be covered by commission from her portfolio. While this seems to have set off alarm bells, they weren’t loud enough to dissuade Ms Hewett from proceeding. She lost much of her retirement savings when the global financial crisis hit.
While the advice may have been sound (in hindsight, I doubt it was), Jennifer Hewett may have made a different decision had she understood just how much more the adviser was to profit by providing the advice to borrow and leverage her portfolio. When the adviser’s interests are better served by a strategy involving more risk, how confident can Ms Hewett be that the risk is necessary and in her best interests.
Clearly, this adviser was not independent under the definition of the law – a law designed to protect people like Jennifer Hewett.
The GFC exposed the significant cost of allowing conflicted remuneration to be paid or accepted. In my opinion, the terrible advice that cost so many Australians their financial security was provided to line the pockets of advisers at the cost of their clients.
The Government promised to address these failures by introducing new consumer protection measures and by imposing a ‘best interests’ duty. Unfortunately, the Future of Financial Advice reforms were watered down after intense lobbying by the financial services industry.
Direct and Indirect Remuneration
While it’s no longer possible to receive commission from investments and superannuation, many advisers still apply asset based fees and charge you ongoing costs based on the value of your portfolio. Essentially, asset based fees, charged as a % of your portfolio, are simply another form of commission.
Commissioner Hayne has stated in his Interim Report on the Banking Royal Commission that he believes “value-based remuneration conflicts directly with customers’ interests”.
An asset based fee is presented as a way to align your interests with the adviser’s interests as your adviser should, in theory, be more motivated to grow your wealth if their fee increases as your portfolio does.
But, more often than not, an asset based fee simply protects the adviser’s financial interests. Asset based fees allow your adviser to earn more without any more work. Worse still, they can influence your adviser to recommend you take on more risk than is appropriate by borrowing funds to invest, further inflating their fees. Logically, if you’re paying more as your portfolio grows, you’d expect the service you receive to change too. But it seldom does. In fact, the size of a portfolio often has little impact on the level of service you need.
“…value-based remuneration conflicts directly with customers’ interests.”
Kenneth M Hayne, Banking Royal Commission
While the stream of commission payments may have slowed to a trickle for investments and superannuation, it’s still possible for advisers to receive other types of conflicted remuneration from their investment recommendations. This can be a particular problem for Self-Managed Superannuation advice. A recent ASIC review showed that 90% of SMSF advisers failed to demonstrate they had prioritised the client’s interests over their own. 10% of advice reviewed showed the client would be significantly worse off in retirement due to the recommendation.
The same ASIC review identified a growing use of ‘one-stop shops’, where the adviser has a relationship with a property developer or real estate agent whose investments are recommended. Often, advice firm’s who promote SMSFs make money from several different sources related to the SMSF, including the SMSF set up and ongoing management, insurance commissions, asset based fees plus commission from a property purchase and the mortgage required to finance the acquisition. Costs may be disclosed, and often are, but disclosing financial conflicts of interests is not as good as avoiding them entirely.
As a result of this conflict, people are often persuaded to enter into complicated and unnecessary SMSF strategies on the basis that there are few direct costs.
I’ve seen many cases where clients have spent upwards of $40,000 in indirect costs to implement a SMSF with as little as $200,000 superannuation.
As I have said previously, if you are not directly paying your adviser for their advice (and they make money from other sources related to their recommendation), then you cannot be sure their advice is in your best interests.
I appreciate it can be complicated for consumers to understand the conflicts of interest that exist in every business. It can be equally difficult to grasp the fact that ‘free advice’ is never free (and ‘cheap advice’ is often never cheap). But, the best way to minimise the chance you’ll receive self-interested advice is to pay your adviser a flat fee, upfront.
Complexity and Remuneration
Ms Hewett wrote that she couldn’t fully grasp the advice presented to her and blamed herself for not being an expert.
While her adviser may not have picked up on, or processed, her lack of understanding (she was a journalist with the Australian Financial Review so one could assume a higher than average level of knowledge), I wonder whether the adviser embraced complexity to profit from her trust.
When they profit from additional structures and product, I believe advisers often recommend overly complex solutions to increase their remuneration.
Is Independent Advice a Solution?
Conflicted payments such as commission, volume bonuses and other sources of indirect remuneration can negatively impact your advice and, for this reason, I believe you should seek an independent adviser who meets the strict standards set by the law.
I’m not saying independent advisers are free from conflicts or any less profit-driven. Their main advantage, and the compelling benefit for their clients, is that independent advisers won’t compromise their client’s interests to receive financial or other benefits from the Banks, Insurers or Funds Managers.
But you need to go beyond the standard of independent financial advice set down by the law and check your adviser’s fee structure is directly aligned with your interests and the value they provide.
Given the potential for conflicts in any business relationship, I’m personally more comfortable doing business with someone who’s paid by me and who doesn’t stand to profit from a source or pricing model that may persuade them to put their interests ahead of mine.