Britain’s Financial Services Authority, characteristically ahead of the curve in its approach to retail regulation, is now confronting the idea that commission revenue may be naturally incompatible with independent advice.
The FSA is spurring evolution in Britain’s retail distribution market with a project that aims to defuse the inherent problems it sees in the segment, namely:
> consumers who are often un–sophisticated;
> products that are unnecessarily complicated;
> unaligned interests of firms and their clients;
> an industry that often favours production volume over quality advice;
> prevailing compensation structures that create risks, such as bias;
> advice that isn’t particularly professional.
The fundamental problems the FSA sees with retail distribution in Britain are little different from the ones that afflict Canada or, indeed, any well-developed retail investment market. The issues the FSA aims to combat aren’t country-specific; rather, they are basic market failures.
In an effort to tackle the issues, the FSA launched its retail distribution review a year ago. The first discussion paper generated by the effort was published at the end of June. As part of the review, the FSA looked at the retail markets of other countries, including Canada, to determine whether any country has solved the problems. It concludes that no one has yet found a solution.
“If an ideal distribution system is one in which all consumers take educated financial decisions off the back of sound impartial advice, then it is straightforward to conclude that none of the countries considered have achieved this,” the FSA reports. “While other countries have experienced similar problems and investigated solutions, none has yet arrived at a distribution nirvana.”
Whether such a paradise exists or not, the FSA maintains that no country has had a more high-profile debate about the sustainability, impartiality and quality of retail investment advice than Britain. And this latest initiative takes the effort a step further. Based on ideas culled from five groups comprising senior industry executives and consumer representatives, the FSA aims to solve some of the retail investment industry’s core problems by coming up with cost-effective ways to make financial advice more widely available, improve industry professionalism and enhance consumer outcomes.
To do so, the FSA proposes several ideas, the core one being that the regulated investment advice market be divided into two parts: primary advice, a regime under which firms would offer straightforward advice on simple products; and a professional financial planning and advice channel, which would serve clients with more complicated financial needs. Within the more professional channel, firms would be subdivided into those that negotiate their compensation directly with clients and those that collect commissions from product manufacturers. Only advisors that agree with the consumer directly on compensation could call themselves “independent.”
Currently, British advisors, in order to call themselves “independent,” must be able to source products from anywhere in the market and not be restricted by their firms to a handful of providers. As well, they must, at the very least, offer fee-based services — although they can still be paid by commission.
Eliminating commissions for advisors that call themselves independent would be a significant step, but the role commissions play in distorting advice is an issue that cannot be avoided if the goal is to solve some of the retail market’s inherent problems. Whenever people are being paid on commission, there’s a temptation to favour one product over another, favour products from a particular provider and sacrifice quality for volume. In sum, being paid by commission creates the risk of bias in advice, raises questions of suitability and sweetens the appeal of churning, among other things.
The FSA is questioning whether those risks can be tolerated in advisors who want to hold themselves out as being truly independent.
“Can commissions — an effective way, if properly controlled, of incentivising a sales force — really be reconciled with the provision of advice?” asked FSA chairman Callum McCarthy in a speech to the regulator’s retail distribution conference at the end of June. “Is it really in the interest of product producers, who have so much riding on their brand reputation, to continue to use commissions as an incentive when [this] so clearly risks inappropriate consequences?”
It looks as if the FSA is willing to conclude that, in fact, traditional commissions cannot be reconciled with the provision of advice — at least, not scrupulously independent advice.
@page_break@In Canada, provincial securities regulators have been reluctant to intervene directly in industry compensation methods, preferring instead to rely on disclosure to consumers. The last time regulators really tackled the issue of compensation-led bias was in the mutual fund sales practices rule of the late 1990s, which — in an effort to ensure that clients get unbiased advice across funds — prohibit certain types of compensation.
The Ontario Securities Com-mission’s fair-dealing model toyed with the idea of eliminating trailer fees after its research found that advisor compensation, rather than investors’ best interests, was driving asset-allocation decisions. The OSC also questioned whether disclosure was effective.
Ultimately, however, the OSC dropped the idea of regulating compensation directly. The FDM project has itself effectively been abandoned in favour of more modest reforms to the registration regime.
In Canada, of course, the regulatory landscape is different from that of Britain, and innovation is tougher to achieve here. But that doesn’t change the fact that financial advice isn’t as valued, professional or available as it should be.
Indeed, the FSA reports that it looked to markets in the U.S., Canada and Australia to discern how financial planning models work in those countries. What the FSA found, however, was “that nearly all intermediaries in these countries call themselves financial planners, almost regardless of the type of service they actually offer. Comparatively few actually offer true financial planning services.”
Several years ago, the OSC did try to regulate who could call themselves a “financial planner” as a precursor to the FDM project, but the effort was killed by industry lobbying at the provincial level.
In Britain, the FSA indicates that it would prefer that the industry address the market’s problems for itself, but it acknowledges that there is a role for regulation, too. Indeed, it recognizes that it is hard for a firm to take the high road and abandon commissions voluntarily, when its competition chooses to promote itself as being independent while still operating under a different and potentially flawed compensation paradigm.
For the industry to lead change, the first move has to come from its biggest players, which have the scale to absorb a significant shift in practice. Last year, a few of Australia’s large banks did voluntarily eliminate commissions as a way to address some of that industry’s credibility issues and create a market value for advice.
Similarly, in Canada, the move toward lower mutual fund costs has been driven by a few of the industry’s largest players. CI Investments Inc. pioneered the move to fixed expenses, while RBC Asset Management Inc. has initiated some fee competition by voluntarily cutting management fees on certain funds.
Cutting fees is quite different from fundamentally changing the way people are paid, however, and that’s why there is a role for regulation in ensuring a level playing field.
Along with the FSA’s plan to segment advice and restrict the use of the word “independent,” the regulator is contemplating a handful of other changes, such as raising proficiency standards for all advi-sors and adopting risk-based prudential requirements as a way of encouraging firms to offer higher-quality services. Firms that decide to stick with commissions could face higher capital requirements to account for the greater risks of a commission-based system.
All these ideas are out for a six-month comment period, with detailed proposals expected early next year.
If the FSA finally succeeds in cracking the fundamental failures of the retail investment market, Canadian regulators may yet have to take notice. IE
Improving retail distribution
Britain’s Financial Services Authority aims to diffuse inherent problems
- By: James Langton
- July 31, 2007 July 31, 2007
- 09:39