Insurers say ‘no commission bias, OK?’
No, not OK. The Association of British Insurers have published a report proposing changes to the commission basis for distributing financial products in the UK. I’ll come back to their proposals in another entry but first let’s focus on what they say about commission bias. So-called independent research “found some limited commission-related bias towards particular companies and product types but no evidence that commission was inducing advisers to sell where no sale was appropriate”. If true, it would be quite a coup for the industry. But the truth is the research on which it is based cannot possibly support any conclusions about bias to riskier products, to more expensive products than necessary or even to product sales where another course of action altogether would be better advice.
The Association of British Insurers (ABI) has sensibly responded to obvious consumer mistrust of the way long-term savings and investment products are sold on commissions and of the way independent advisers use commissions from product manufacturers to get paid for advising the public. ‘Depolarisation’, a series of regulatory changes introduced last year, was supposed to deal with this problem but the ABI knows many people think the public won’t buy it. Common sense strongly supports the notion that independence of advice and financial independence are inseparable, so the public’s misgivings need no great intellectual debate to inform them.
The industry, on the other hand, needs some intellectual weaponry to counter commonsense. Enter Charles River Associates (CRA) – the ‘independent’ economic analysts commissioned by ABI to report on commission effects. CRA virtually invented a clever new market niche in the wake of financial service regulation: gaming the regulatory consultation procedure. Knowing that, I tend to look extra closely at the scientific rigour of their research, regardless of whether they are working for the FSA or industry groups. These are well-qualified people but they are not independent in the way academic researchers can be.
It was CRA who put the Association of Independent Financial Advisers (AIFA) up to doing their own ‘cost benefit analysis’ (CBA) of depolarisation and ‘getting it in’ before the FSA’s. They spotted that the FSA’s CBAs (a statutory requirement whenever they came up with changes in regulations) tended to shape the direction, momentum and outcome of the consultation process – rather like having an expert witness in court but for one side only. Thanks to some outrageously speculative forecasts by their own expert witness, CRA, AIFA succeeded in spooking the FSA into dropping a key element of its original depolarisation proposal: that advisers could only call themselves ‘independent’ if they were paid by the customer direct, not by the product manufacturers.
What resulted was a compromise: advisers could still call themselves independent provided they offered customers a payment ‘menu’ including a choice of fees or commissions, with some tabulated comparisons to illustrate both differences between the payment methods and differences with ‘market-average’ rates. This report from the ABI shows it is alert to widespread misgivings that this will make a confusing situation even more confusing. But the requirement to fix this problem once and for all is in fact about commission bias, because that is what confusion masks. The claims made by CRA in its new research, trumpeted by the ABI, are therefore very important in conditioning the scope of the debate. The claims are in fact a nonsense, though possibly not a malevolent one.
Opponents of commissions, including both Ron Sandler and the House of Commons Treasury Committee, argue that they lead to a bias against courses of action not requiring the sale of a product (such as using savings to pay down debt instead of new investment), towards riskier products (because these typically carry higher commissions) and towards less rational products (such as those whose cost structure including commissions makes any risk-adjusted benefit improbable) and against stakeholder products and index-tracking funds. These are more subtle forms of bias than higher sales of equivalent products carrying the highest commissions – the form of bias that was found by CRA in its earlier research for AIFA and is confirmed in this new report.
To try to isolate some of the more serious instances of systematic bias in this report for the ABI, CRA conducted a ‘mystery shopping’ test. It separately identified two samples of firms: commission-based and fee-based. Its assumption was that advice biases would show up as correlated differences in the advice given, as between the two samples, and these could then be subjected to statistical tests of significance. Their conclusion was that there were no significant differences in the advice given between the two samples, therefore no evidence of bias.
This approach relies entirely on the difference in charging approach defining the samples being significant in explaining the advice given. This is asserted by CRA but not supported or tested – hardly rigorous analysis! Conclusions about the presence or absence of bias are meaningless unless you can first establish whether a so-called ‘fee-based’ adviser has a viable revenue model that allows it to give unbiased advice and is economically indifferent to the customer’s preferred payment method. If there is the same pressure on a firm offering commission-offset to collect some or all of their fee via commissions as there is for pure commission firms, common advice is not a sign of lack of bias.
What industry insiders know is that most firms who quote fees but also offset commissions against the invoiced amount cannot get fees to stick without partial or full offset by commissions. It is of course possible for a fee-charging firm to have well-informed customers who value the genuine independence provided by a fixed fee and who also appreciate the advantage of recovering commissions that would otherwise be lost. (I have an interest to declare here, because No Monkey Business Limited seeks just such customers.). Such a firm might be able to command fees without depending on commissions to reduce or offset them, though offering offset, and could therefore be free of commisison bias. But without a lot more information, outsiders would be unable to tell whether a firm calling itself ‘fee-based’ was one type or the other. I certainly would not expect researchers to know.
This is not the only flaw in the CRA argument. Because there are so few fee-based firms with the same indifference as a fee-only firm, and hardly any of the latter, it is impossible to know whether the industry’s preferences when giving advice are conditioned by knowing nothing else or are more cynically biased. When a single general way of doing business comes to dominate, practice could be explained by either.
I try to be generous in attributing part of the bias to the conditioning that comes from one dominant business model. I note that Ron Sandler also granted that the industry-wide biases to riskier products and to higher-charging active products might be a reflection of the collective ignorance of the true nature of the bets, reinforced by inadequate examination and poor internal training, rather than entirely a cynical business agenda. The Treasury Committee was not at all generous.
Knowing how IFAs work the fee-based sleight of hand, and how many business consultants are selling services that rely on it, naturally colours my assessment of the menu approach introduced by the FSA. An unbiased revenue model absolutely requires well-informed customers. To be well-informed they must know for each payment method the cumulative cost in monetary amounts for a product’s realistic holding period – in other words, a comparison of the present value of two alternative cost streams. Challenged on this very point by the Treasury Committee, Tyner and McCallum of the FSA agreed and said they understood the menu would show absolute cumulative amounts. They understood wrong: it does not. The prescribed cost comparisons, limited to rates but not cumulative outcomes, will in fact give a misleading impression which arguably makes the situation worse. Hence the scope for businesses to consult on how to game the new disclosure rules.
I shall read the rest of the IBA’s report with interest to see whether the changes they propose hold out any prospect of either collective ignorance or bias being corrected. I have also asked CRA to comment on my criticisms of their tests for bias. Watch this space but don’t hold your breath.