The hidden cost of banning commissions

The move to outlaw commission payments to financial planners is gathering pace. Its advocates firmly believe it will usher in a healthier financial planning industry in which advice will totally focus on what’s in the client’s best interests — and not simply generating fee income for the planner.

The debate has been raging for years; newspaper articles have been written about fund managers ‘rewarding’ planners who push their product with handsome commissions, as well as the more overt rewards such as trips to exotic destinations.

Today there are few willing to defend commission payments. Even the industry’s advocate, the Financial Planning Association, seems to be accepting their demise as a fait accompli.

But are commissions the root cause of all that is wrong with the financial planning industry, as the advocates of change would have us believe? Will their demise usher in a brave new world for the industry and its clients? Are commissions what the clients really want or are policymakers at risk of throwing the baby out with the bathwater in their haste to ban commission payments and hopefully stop ‘product flogging’?

Let me explain. Financial planners can either offer clients a fee for service or take an ongoing fee (trail) that is built into the cost of running the fund — the management expense ratio. Both options are on offer from financial advisers, giving clients the choice. Considering the massive publicity that has been surrounding this issue for years, it’s hard to believe most investors are not aware of the difference and capable of making an informed choice.

Financial advisers’ income has to reward them to a degree that recognises their professional skills. For example, the cost of a Statement of Advice, which includes a client’s financial strategy, could be $2,000 or more. Ongoing advice, administration and investment monitoring will add to the cost that’s needed to adequately compensate the adviser.

Quite clearly, fees for providing the Statement of Advice, strategy and ongoing services will exclude many investors who now pay a minimal fee (if any) and allow the trail to remunerate their financial planner. Indeed, under commission arrangements it is, in my opinion, high-net-worth individuals who ‘subsidise’ the advice being given to less well-heeled investors.

So where will investors with portfolios of, say, less than $250,000 a year go? They may not have used their financial adviser regularly, but when they needed the service it was there at minimal or no cost because the advised products paid an ongoing commission.

No doubt some will simply stop getting advice — with all the potential for disastrous outcomes that heralds.

Indeed, in the fallout from the global financial crisis (GFC), we can observe that there have been a number of examples of small investors who have made poor investment decisions because they got caught up in market hype and decided against getting professional advice. Today, the markets are still recovering; caution now governs every investment decision. But one thing we do know is that markets are cyclical. There will be another bull market, with the surrounding hype, and investors will inevitably make bad decisions again.

However, many investors will still want the comfort of a second opinion. So where will they look? It’s my suspicion that many who stop seeing their planner will head to large financial institutions, notably the banks. The fees at these institutions could be much lower as they can be cross-subsidised by the fees on the banks’ products.

However, what products will the large institutions recommend? I suspect they will point these investors towards their own products. After all, the entire thrust of any large institution in financial services has been to capture all the financial activity of their clients. In my opinion, there will be three potential consequences if this state of affairs comes to pass.

First, many small, independent financial planning firms will go out of business; this will reduce investor choice, surely the antithesis of what the policymakers want. These firms will struggle to compete against the larger players that may get the financial benefits of products being cross-subsidised, allowing them to be more competitive on a fee-for-service basis.

Second, we may see an increase in salary advisers linked to large institutions, especially banks. No doubt part of the salary package of these advisers will include a bonus based on the amount of the institution’s product that is sold, which is what I thought we were trying to avoid with the fee-for-service argument.

Third, as trails become less important in the industry, we may see the value of financial planning firms fall closer to the multiples received by accountants, and this will inevitably reduce the incentive for well-salaried financial advisers to leave and start their own practices. Again, the end result will be to reduce competition.

One final point. Amid all the debate about the rights and wrongs of commissions, it’s not obvious to me that the investing public is clamouring for them to be abolished. I suspect they are more comfortable that some of their profit goes in a trail than paying upfront and ongoing fees.

Think of the banks and ask yourself what upsets their customers most — in a word, fees.

It is not even clear that commissions cost small investors more money over time.

What is clear is that paying a fee for financial advice, just like bank fees, will be more painful for investors with smaller balances, and reduce their investment advice options. Is that the outcome policymakers want?

George Lucas is managing director of boutique asset manager Instreet Investment.