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Commissions: “Know me before you judge”

Friday, December 4th 2009, 9:32AM 7 Comments

by Philip Macalister

This whole public debate about commissions is so misguided it’s enough to drive one mad. For the record, I don’t mind if advisers earn commissions as long as it is disclosed and customers have choice. Also to get things clear, there are different remuneration structures for the various disciplines of advice, namely; investments, KiwiSaver, mortgages and life insurance. I think the debate is only about investment products, however it seems that some commentary has included all financial products and services. With life insurance I tend to agree that remunerating risk advisers on a commission basis is probably the default setting. If you take the argument insurance is sold, not bought, then a commission basis is fine; just disclose it. Mortgages are similar. There is a slow trend to an advice model here and that is encouraging to see. Investments are where things get interesting. This whole idea about banning commissions seems to have come about due to the collapse of various finance companies and perceptions that advisers poured clients into finance companies because of the commission they were paid. There is a slight element of truth to this. However the big over-riding fact which is being ignored in the debate is this: The large majority of the money which went into finance companies that collapsed, went in directly from investors. This money did not get there through advisers. By my reckoning, around a third of the money in collapsed finance companies came through advisers, yet they are getting 100% of the blame. Banning commissions isn’t the answer. It’s investor education, as I argued here. Also it’s up to the product manufacturers to change the way they reward advisers and the regulators to make sure dodgy operators are closed down. Yesterday I sat in on an AMP briefing about what it is doing with its advisory business. One of the interesting things was when CEO Jack Regan talked about the attributes needed to be a successful adviser. I won’t list them all, but what is worth noting is that the whole package was wrapped up by acknowledging advisers were sales people; the term used was “professional salesmen”. Many sales people are remunerated on a commission, or partial commission basis, so why can’t advisers? Another ignored point which bothers me is around share brokers. Hello, these people have been commission-driven salesmen since Adam was a cowboy. Do they get the same opprobrium as financial advisers? Nope. I bet if you looked at many of their portfolios over the past couple of years you will see some significant losses. Apparently that is OK. Very strange.
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Comments from our readers

On 4 December 2009 at 11:19 am Tony Vidler said:
Well said Phil. Very very well said.
On 4 December 2009 at 1:02 pm David Whyte said:
Likewise agree - well said - and as I've posted before, it is vital that the debate demarcates the line between investment and risk.

The tendency for other publications and journos - such as last Saturday's Herald (section C8) in which Diana Clement ran a risk compensation structure commentary as part of the investment commission debate is undesirable.

While I agree with her criticism of 'churning', the claim that commission skews advice on "mortgages and insurance as well" needs to be more critically examined.

As I understand it, the South African industry has an effective answer to churning, twisting, or whatever you call the inappropriate replacement of a life insurance product. I stress 'inappropriate' as there are perfectly legitimate reasons to replace a policy when benefits cannot be amended to reflect changed client circumstances - or should "new generation benefits" be unavailable on an "old generation" product - and a new policy has to be arranged. This is reasonable, always provided the clients qualify medically etc., of course.
In SA, no commission is payable on the issue of a new contract on the same life for a defined period of years - that's my recall but perhaps some kind soul could offer a more specific rendition.

However, the worrying tendency of running the two issues as one debate needs to be strenuously resisted as these are quite separate and distinct discussions.

On the subject of risk commissions, my question to Diana Clement is this; If commissions skew advice in the insurance space, why has the highest commission payer consisently failed to gather all the new business sales available?

To my mind making this an all-inclusive discussion is dangerous as NZ has a seriously underinsured population already and further barriers to disseminating financial protection benefits will ultimately rebound on the community. Pity the Australian consumer who faces three possible taxes in obtaining a combined benefits product via his employer - namely GST, Stamp Duty,and FBT. It says much for the utility of the product that there continues to be growth in sales, albeit at a level insufficient to address Australia's underinsurance issue. I can think of no other consumer product which has to bear this added expense, while seeking to relieve the State of the responsibility of tending for those citizens who are left in dire financial straits by death and/or disability.
In a similar vein, the Code Committee's proposal that the status of independence cannot be claimed if commission is made available is reasonable on the investment side of the industry, but has little relevance on the risk side. If we get caught in the tautological debate about the meaning of independence, we'll get nowhere fast - particularly with the consumer.
An autonomous entity can defined as being an enterprise undertaken or carried on without outside control and I propose that risk advisers be regarded as autonomous - at least those who operate without a contractual production obligation to any product provider(s). I agree that it is important that a consumer is able to identify the nature of the relationship between adviser and product provider, and that those who operate without autonomy should declare this, while those who are free to choose without quotas, targets, or similar obligations to be met should also define their status.
No doubt more ink will be spilled in the debate, but I urge the separation of the investment and risk debates to avoid confusion, misunderstanding, and overlap.
On 4 December 2009 at 2:13 pm Brent Weenink said:
Phil, you "ask' the question... "Many sales people are remunerated on a commission, or partial commission basis, so why can’t advisers?" I think this is a good question, and perhaps not enough people are asking or answering it.

The reason, respectfully, is that advisors are fiduciaries, and have fiduciary oblugations. Sales people aren't fiduciaries, and don't have the same obligations. It is these fiduciary obligations that require an advisor to act in the best interests of a client, to obtain client consent to all remuneration received as a result of the relationship, and to avoid any suggestion of being in a conflict of interest. Salepersons are not subject to any of those duties, but are free to "sell" the product. The "leveller" being that with a saleperson, the client knows they are being sold a product, and aren't relying on or trusting that saleperson for independant advice or analysis (which is the source of a fiduciary obligation).

You also refer to stockbrokers (I'm not one incidentally). Stockbrokers are clearly fiduciaries and are subject to those same obligations. However, in fairness, the industry is far more aware of it's fiduciary obligations than most of the financial advisory sector. That is mainly because there are prescribed rules and procedures around these fiduciary obligations enshrined in the NZX Rules and enforced by NZX.

Much of the debate seems to confuse commission which is charged to and paid by the client (e.g. stockbroking), with commission received or rebated to advisors from 3rd parties other than the client (such as finance companies). It is the source and, partly, the dislosure of remuneration, which is the main issue - not so much the formula by which it is calculated (although I agree there are some issues with transaction based calculations).

Don't mean to disagree - but it's an interesting topic.
On 5 December 2009 at 9:30 am Independent Observer said:
I've said this before: the commissions v fees debate is a discussion about the billing mechanism, and is a distraction to the real issue.

The issue that requires attention is disclosure. That is - if the adviser is required to fully disclose ALL earnings from their advice, then the mechanism for payment (commission or fees) is largely irrelevant, and will be determined by the consumer.

My advice to Regulators is to remain free-thinking on this issue, and not to follow the findings of our Australian colleagues. Further - I would encourage Regulators to implement a Principle-Based rules structure for the NZ industry, as opposed to regurgitating the Aussie Rules-Based approach. The former will take longer to implement, although will solve issues such as commissions v fees easily... whilst providing a level playing field for all financial services participants.
On 7 December 2009 at 2:40 pm alan said:
Brent Weenink suggests that a "salesman" has no fiduciary duty and thus can sell (or oversell)without restraint. With respect, I believe everyone selling a financial service or product has an ethical duty to do what is right for the client, regardless of the financial outcome for the salesman.
On 8 December 2009 at 12:25 pm Brent Weenink said:
We mustn't confuse ethics with fiduciary obligations. The two are quite different. Fiduciary obligations are far more onerous than mere ethics, and should not be lightly assumed or imposed on a person. There a very few professions/occupations that are actually fiduciary. Lawyers, trustees, & stockbrokers are the main ones. Arguably, all financial advisors are fiduciaries, although that is not entirely clear (the test is "trust and reliance on advice"). Banks, for example, are not generally regarded as fiduciaries, even though they have ethical standards, and often provide financial advice.
One of the biggest differences is in the accountability of fiduciaries. For instance, a breach of a fiduciary duty by an advisor (such as failure to declare 3rd party commission) could well lead to that advisor being liable for all loss on the investment, far in excess of the retained commission, even if they had otherwise provided perfect advice, and the loss had nothing to do with the breach.
Much of the current debate, I believe, is because the fiduciary obligations of financial advisors are not well understood or necessarily accepted.
While the Commission & Code Committee are doing a good job, the new Financial Advisers Act unfortunately just adds to the confusion. The Act actually prescribes a far lower standard of "reasonable care", which isn't fiduciary at all, but based on negligence. The Code Committee is proposing yet a different standard of "client interests first and acting with integrity" - similar to fiduciary - but different. The worst thing about the new legislation is that, in my view, not only is it prescribing a lower duty of care, it's probably neutering potential fiduciary claims against financial advisors for current failures.
On 14 December 2009 at 2:03 pm Pete said:
Chapter 1 of Professor Greg Mankiw's book Economics lists 10 principles of economics. Principle 4 says:

"People respond to incentives"

Economist Gareth Morgan explains how this works in the financial planning industry in NZ:

"Now I’m not against people making a living… but I do have a big problem with financial products being sold on commission. Commissions immediately and automatically compromise a salesperson because they must sell the product that pays their wages rather than consider the product that best suits the investor, or whether the person should in fact have any product. In the aftermath of the Blue Chip, Bridgecorp, Hanover, ING Frozen funds and similar investment disasters, the NZ public seemed, finally, to be understanding this—that salespeople sell what they’re paid to sell—the investor’s interests come a distant second."

Distribution operations in many fields in NZ are further incentivized by big suppliers using "soft dollars", "channel health programs" and the like and by giving bigger allocations of scarce, in demand, product to sales outlets that support them. When there is a choice between supporting your family and doing the right thing by your customer, salespeople quickly learn to make the correct choice.

He who pays the piper, calls the tune.
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