The Canadian Securities Administrators are exploring the elimination of embedded compensation that mutual fund manufacturers pay to dealers and advisors as one of their major policy focuses for 2013.
This is a passionate argument that I thought long and hard about, On the one hand, consumer advocates claim that this compensation structure creates a conflict of interest when advice is given; on the other, those in the financial advice industry argue that by banning this compensation method, advice will be restricted or eliminated for many clients of financial services — especially lower-income investors.
This issue is really about a question of transparency and choice. In order to get a closer look at the arguments involved on both sides of the equation, it’s prudent to explore the recent changes that have taken place in the U.K.
This past Jan. 1, the U.K.’s Financial Services Authority (FSA) banned commission payments to financial advisors in favour of upfront fees paid by consumers to advisors for advisory services. The following arguments made for and against this new compensation system in the U.K. correlates well to the Canadian debate:
- Many analysts argue that spelling out the cost of financial advice — even spread out over a number of years — will cause financial consumers to put off getting advice.
- Rostrum Research found that nine of 10 financial consumers would pay up to ₤25 an hour for financial advice compared with the benchmark of ₤50-₤250 an hour fee expected in the review.
- Graeme Bold, director of U.K. retail (retail distribution review) with Standard Life PLC, said: “The requirements to disclose advisor charges in cash terms puts a definite price tag on financial advice. Asking someone to pay what might be a few thousand pounds [sterling] a year is, psychologically at least, quite different to quoting a 1% ongoing charge.”
- According to management consultancy Deloitte Touche Tohmatsu Ltd., 5.5 million people will either choose to cease financial advice or no longer have access to it.
- A report by Bestinvest predicted that millions of people, unable or unwilling to afford fees for advice, will go it alone and use Internet-based “execution-only” services rather than financial advisors
In contrast, the FSA and consumer advocates stood firm that financial consumers will be better serviced with independent advice and that the system will adjust itself over the long run.
The jury is still out on this experiment in the U.K., but the initial data show that, indeed, many advisors have left the industry while the remaining advisors are adjusting to the new regime.
Why is this issue important to financial planning? The reason is that, in many cases, financial planning is subsidized by embedded commission fees in which financial planners use a variety of business models, such as:
- Fee-only advice, no product sales.
- Refundable advice fees if the client purchases product solutions containing commissions from their financial planner.
- Free financial plans subsidized by product commissions.
In reviewing this issue in the context of transparency and choice, financial consumers should have a choice in how they pay for advice. The question is whether we can design a system in which independent advice can be delivered in a cost-effective and transparent manner.
A few years ago, I interviewed an Australian advisor on how their new advisor compensation system works, which came into full effect July 1. The main learning for me is that all conflicted compensation — including commissions, volume payments and soft-dollar benefits — is now banned.
Thus, all fees must be approved by the client upfront and the advisor may charge the client directly or include the charge through the products recommended. Furthermore, the advisor must get a client agreement and justify ongoing fee charges as substantial. Finally, although product manufacturers will have reduced costs through not paying commissions, some of these savings will be offset by advisors’ new product charges.
This is an interesting potential model for Canada, considering product manufacturers are already funding advice through commissions; perhaps, we just need a better advisor and financial planning compensation distribution model like Australia.
In conclusion, the most important part of this debate is to ensure Canadians have independent, affordable and accessible financial planning advice and services. Using an effective compensation system to balance the needs of financial consumers and the financial advice industry through transparency and choice is paramount. This will only be effective if the securities and insurance regulators harmonize compensation structures across their jurisdictions.