Commissions: the industry strikes back – with disengenuous nonsense
Stung by the strength and frankness of the FSA’s rebuke of the long-terms savings industry at Gleneagles (see Commissions: you’re going to have to help yourself), Stephen Hadrill, DG of the Association of British Insurers, struck back at a Labour Party fringe meeting in Manchester. “Carry on churning” said the headline in the advice industry rag MoneyMarketing reporting his reposte.
This exchange between industry and regulator illustrates well the subtlety of the market failure in the commission-based distribution model. Were it not so subtle, 25 years of regulation or competition from better business models would have seen it off. But it’s not so subtle that outsiders, by which I mean customers, cannot be helped to see that churning in this industry is not a healthy sign of competition or innovation, as the ABI disingenuously asserts.
A key No Monkey Business insight is that the persistence of the commission model is intimately linked to the performance myth. Together, they destroy wealth. The big message in the No Monkey Business clearing is: you don’t have to allow this unholy alliance to destroy yours.
Carry on churning
Stephen Hadrill said in Manchester in defence of the industry: “It does seem to be the only market in the world where a degree of churn is not seen as a good thing. If you talk about telephone services or electricity services, you argue there should be competition that should lead to people switching from time to time. And that should happen in the financial services industry just as much as in any other market so I reject what lies behind Callum McCarthy’s thesis.”
Since Sir Callum came to the FSA from the Office of Gas and Electricity Markets, where he had been Chairman and CEO, the comparison was a particularly disengenuous one: appealing on the outside, hollow inside. Indeed, Sir Callum had drawn on his expertise in his Gleneagles speech for one of two examples (the other being incentives to ship owners for transporting convicts to Australia in the 18th century) of how misdirected incentives produce predictably bad outcomes. He referred to the opening up of the energy markets to competition in the late 1990s. “In practice this was done by door to door salesmen and women, on commission. Originally, all the energy companies paid their sales forces against signed contracts to buy gas and electricity, with the result that there were numerous abuses: forged signatures, signatures from children, incorrect claims of the savings from benefits, disputed contracts. Eventually (and with some regulatory encouragement), all the energy companies changed to paying commission against signed contracts only after they had been subsequently confirmed by the customer, and abuses essentially stopped – not because door to door salesmen and women had become more ethical, but because it was not profitable to cheat.”
Because I have covered commission bias and the enabling role of active management in their own areas of the site, I am only summarising the key observations relevant to the battle of words between these two leaders.
Poor product persistence rates
Churning destroys value when the product creation and sales costs that might otherwise be amortised over long periods have to be clawed back over a shorter period. Many insurance-linked savings plans, including personal pensions, have this characteristic. Sir Callum in his speech said poor persistence rates for long-term contracts are partly due to customers’ circumstances changing and partly to advisers recommending a new set of products or arrangements.
Poor agent persistence
We can further separate the agency affect into i) existing agents advising switches and ii) new agents advising different arrangements. The first is potentially subject to Treating Customers Fairly regulations, if the adviser has not properly justified the costs incurred. The second is not so easily subject to objective value tests, as there will be a new appraisal and interpretation of needs and possibly also an expectation on the part of a customer disappointed with a previous adviser that the products chosen should change. In either case, the tests for value are nothing like as straightforward as a gas price contract. I think I could come up with an argument, and supporting mathematics, for almost any course of action if I had to. It’s not usually that black and white.
Clearly, churning arises as a result of product dissatisfaction but is magnified by agency switches. Why these occur so often is that advisers do a poor job of differentiating the value of the relationship from the value of the products and so when products appear to be going wrong they have no control over the agenda. Switching is what customers expect but there is only so much switching before the customer twigs it is the adviser not the products they need to switch. Which means another agent will then switch the products. And so it goes on. The heart of the problem is poor relationships with people, not products.
If, every time you switch a product, you pay a front-end loaded commission for the sales or advice process, you reduce the investment return that would otherwise be available. Theoretically, the value of these initial commissions could match the timing and costs of advice which you value, in which case they are directly equivalent to a fee for advice. In practice, however, there are usually alternative courses of action or alternative products with lower or no sales commission that would provide better expected outcomes, or better fit the investor’s ‘utility’, that would be a more rational choice even if paid for by a cheque for advice.
The example the FSA most frequently gives is that paying down debt is better advice than investing in a savings product. In his speech, Sir Callum clearly thinks it is a sign of commission bias that only a third of advisers (when tested) offered this option.
I have suggested a more subtle form of bias, in the shape of packaging risky and low-risk investments to create product at the low-end of the risk spectrum which costs the customer much more in expected outcomes than separating the risky and risk-free exposures and dealing with each at the most competitive market cost. Not only are they unnecessarily expensive but they also often fail to find in practice the spot on the risk spectrum the sales pitch emphasised. I explained this in an FT article called Product safety claims don’t hold water.
The product the FSA has found is most prone to commission bias is ‘investment bonds’. Provided by insurance companies, they are attractive to advisers because of the ludicrously high selling commissions (up to 7%). But regulations at least mean that advisers have to believe they can justify the additional costs. In another example of the greyness of financial advice, the tax treatment of these bonds, though usually overstated as a justification and frequently mis-stated, provides the cover the advisers need. The supporting maths, which logically are about ‘relative advantage’ expressed by net present value calculations, are rarely provided to support the recommendation.
The bias towards them arises also from their use as an administrative wrapper, because they can provide access to different funds of different managers and free or low-cost switching arrangements. To the possible capital gains tax advantages for the investor are added a potential IHT advantage but these also need to be quantified relative to the additional costs.
For the adviser, these have a value that does not necessarily equate to the customer’s. The bond wrapper is effectively a solution for outsourcing back-office administration to an insurance company trading and custody platform. In this case, however, outsourcing does not reduce the customer’s costs. It is more likely to increase them.
There has been a gradual shift in advice business format from serial transactions, often reactive to need, to portfolio stewardship, which should be proactive and continuous.
In the IFA community this is rarely conducted as ‘discretionary’ management of portfolios of funds. The knowledge threshold is generally understood to be higher for discretionary than advisory management of portfolios but this is clearly nonsense. With knowledgable clients, it is obvious that a recommendation requiring a response will be more tested than an explanation of one of many decisions after the event. The FSA had noted that there has been no commensurate increase in portfolio skills in the adviser industry to underpin the otherwise welcome move to portfolio stewardship as the business format.
The revenue format is the key driver of this shift. Here at least we can see competition at work and it is the internet that made it happen.
Online discount brokers (such as Hargreaves Lansdown) provide a means of buying and holding funds in a nominee name, with complete and timely online visibility, with reduced or no front-end sales commissions. Their revenue model is usually a combination of trail commissions, almost always 0.5% pa, and a fixed transaction charge. They have exploited the universality of the trail commission arrangement to position themselves competitively with direct purchasing from providers.
This only worked because providers will not sell products direct to self-directed investors without a sales commission even though the sales commisison is there to pay for the provider’s own new-business costs and the third-party advice costs which, in the case of a self-directed investor, are either absent or much lower. Why will they not discount for direct purchases? Because the IFA industry, on whom they depend for the bulk of their distribution, has put the squeeze on them.
Sir Callum had a message for industry leaders on this subject in Gleneagles: “I understand well that many are frustrated by what they describe as the “commission stranglehold” that the advisory community enjoys, but so long as providers continue to compete over the attractiveness of their commission proposition, the fundamental flaws in the present business model will remain.”
With competition gradually undermining sales commissions and the public gradually absorbing the sales pitch that continuous stewardship might be a better idea than occasional transactional advice, it can look on paper an attractive proposition to convert an advice business from dependence on sales commissions to regular income from trail commissions. The trail is based on a percentage of the portfolio value and is collected by the providers, so there is no need for a billing or collection process, no bad debts and far less pressure to justify the value proposition. After all, the trail is paid for out of the provider’s annual management charge and if you can’t avoid it you may as well get some value for it.
In practice there is a short-term cost in converting, as trails will not immediately make up the loss of sales commissions but, if an adviser is confident about the retention rate, the higher net present value of the income stream can justify the short-term drop in earnings. Regular income also has a higher value when a business is sold than transaction income. With so many IFA firms controlled by principals close to retiring age, full conversions are less common than phased ones, combining both sales and trail commissions – more greyness.
When your revenue model is fees based on the market value of a base of assets (such as an investment portfolio under advice), the name of the game is simply gathering more assets. This exposes the customer to many of the biases listed above in relation to sales commissions.
Biases in the asset-gathering model
An asset-gathering model biases towards riskier investments because equity-based products are most likely to carry the 0.5% trail.
Even if an adviser scrupulously avoids bias to changing the desired location on the risk spectrum, the model biases (as we have seen) against selecting lower-risk assets (cash, index linked gilts, National Savings certificates) which can be dealt in or held for free (or at most very cheaply) and towards assets or portfolio combinations that aim to occupy the same overall location but attach a fee to all of the exposure. In doing so they also introduce uncertainty about the actual risk location.
It biases against index-tracking funds and towards active management because the former will not (in most cases) generate any (or as high a) trail commission. This is the most subtle and most pernicious of the biases, as has been noted by many independent reports, because of the very low probability of making up the higher costs. This critical insight was the subject of a chapter in my book, called The Cost Wedge. You can download the whole chapter.
The move from sales to trail commissions has not significantly diminished the bias to active management because continuous re-selection of active managers becomes one of the few visible signs of activity that the stewardship model needs if it is to justify itself in the customer’s eyes. What a mistake that ‘justification’ is.
Understanding what ‘fee-based’ means
To reduce the risk of consumer harm from all of the forms of commission bias listed above, the FSA introduced in 2004 a requirement that so-called ‘independent’ advisers had to offer a choice between fees and commissions as the basis for paying for advice and, if they charged by commission, they had to show a ‘menu’ of their rates and comparison with typical industry rates as published by the FSA.
This black and white world is also too good to be true. The reality is much greyer. If an adviser
charges a fixed rate (which could be fixed as a monetary sum, an hourly rate or a percentage of portfolio-value)
offsets commissions received and
rebates any excess of commissions received over the agreed fee
then this fee-based’ arrangement does not give rise to a requirement to provide a menu of cost comparisons.
Fee-based says nothing about independence
Fee-based advisers are not necessarily any less biased than commission-charging advisers. This insight is critical to self-protection in this tricky business. Like many No Monkey Business insights, it is simple but not immediately obvious.
If an adviser is not confident they can persuade a client to pay a fixed fee for independent advice, which is all about their confidence in the value of their service to the customer, then they will try to have the best of both worlds. They will appear independent, by offering a fee-based arrangement, but will actually be dependent on recommending commission-generating products to cover the fee. If there is no actual change in the business model, the biases will remain the same.
The FSA can hardly come out saying the menu failed to deal with commision bias, even though it was not on Sir Callum’s watch. But if it didn’t deal with it, why is he telling the industry different incentives are required to encourage a change in business model?
The initial proof of a new or prospective firm’s independence is their confidence about the value to you of writing a cheque.
The confirming proofs are revelations (in the analysis of needs, the presentation of solutions and the specific recommendations of products) of a set of alternatives that, when you think about it, would yield very different profitability to a commission-based adviser, whether depending on sales or trail commissions.
Are these instances hard to come by? No, absolutely not. As fee-charging advisers we have a constant flow of items that we can offer as compelling proof of both the presence and value of true independence.
When I wrote the book as a ‘self-protection guide’ in 2002, I said ‘don’t wait for the FSA to fix problems for you’. You have to be your own fixer. I am sorry to say, the FSA lived up to my scepticism, because I do believe more could have been done to change the misdirected industry incentives. But the FSA is also constantly telling you, and helping you, to take more personal responsibility for your own financial future. That message does deserve support.