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Ban on commissions flawed

Wednesday, April 28th 2010, 10:18AM 25 Comments

by Philip Macalister

The ISI’s surprising announcement that it was introducing a voluntary standard to ban commissions on investment products, including on KiwiSaver, will do more damage than good. My position, as I have said previously, is that commissions are fine. The caveat being that clients’ interests must be put first and that there is transparency, around remuneration. Removing commissions will in all likelihood have a number of detrimental impacts on the industry. One is that it is another force against the small advisory firms. There is already talk that such a move will be beneficial for the large vertically integrated firms, like banks, who will be able to cross subsidise advice for some customers. Don’t be surprised to see “free advice” from these firms as they will make their money from other parts of the process like asset management. Banning commissions will kill many of the KiwiSaver businesses. They are modelled on paying advisers commissions to give advice around KiwiSaver. There are bound to be many other detrimental impacts. Some of the other bits I have trouble with are: The ISI is trying to force a remuneration model onto advisers. Whatever happened to the free market and choice? I could understand it if fund managers all voted for Labour, the Greens or some other left wing party, but I suspect they don’t. Secondly the ISI makes this argument that consumers should be able to negotiate remuneration levels with advisers. This is a nice idea, but bizarre. Who negotiates fees with their lawyer, accountant or doctor? Surely a consumer could negotiate fees with an adviser on commission? Thirdly, they say because the international trend is towards banning commissions New Zealand should blindly follow these other countries. (No wonder there are so many sheep jokes about New Zealanders). I have no doubt that there are instances where commissions have influenced an adviser’s recommendation process. There are lots of comments along these lines and it seems to be accepted wisdom in some circles that is the case. However there is little empirical research to support this proposition. On the other hand one can argue that investors make bad decisions all by themselves. Just look at what happened with finance companies. By far the majority of money that went into failed finance companies was placed there directly by investors, not by advisers. Commission had little to do with it. My guess is that this voluntary standard won’t be widely used and that ISI members will have options for fee based advisers and those on commissions.
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Comments from our readers

On 28 April 2010 at 10:50 am Denim said:
"There are lots of comments along these lines and it seems to be accepted wisdom in some circles that is the case."

This is how all decisions seem to be being made these days - a few key people say certain things in certain circles and it becomes fact without any genuine evidence or investigation. And certainly very little thought given to any consequences of changes these 'facts' bring about.

It surprises me that KiwiSaver gets special mention in these discussions. I can understand that people might be wary of commissioned agents giving advice on a range of investment products, but KiwiSaver?? How does someone being paid a commission by a company to sell that particular companys product translate as the potential to decieve investors. And if they are, how would getting paid a salary with targets to meet be any different?

Further, how can someone being paid to educate someone about KiwiSaver under any pay structure be worse than an automatic enrolement where an 'investor' is given a dull IRD booklet to read, or worse just told to read a providers website and submit an application?

Commissions normally come out of a managers income not an investors but if fund managers have to bear the cost of underperforming salaried employees you can be sure that it's the investor that will end up wearing it!
On 28 April 2010 at 12:23 pm Kimble said:
"Commissions normally come out of a managers income not an investors"

Nope. Investors pay. In some way, investors always pay.

Consider the example of a real estate agent selling a house for $400k and taking $20k as commission. The house seller was willing to sell for $380k, because that is what they will recieve after commission is deducted. If the buyer came to them and offered $380k without going through the agent, then the buyer, logically, would have accepted it. The involvement of the agent means the buyer has to pay $20k more. The seller transfers the money from the buyer to the agent, but they dont actually pay the cost of it themselves.
On 28 April 2010 at 12:24 pm Kimble said:
Oops, the seller would have logically accepted it. My bad.
On 28 April 2010 at 2:04 pm Independent Observer said:
Thanks for your viewpoint Phil - it's pleasing to see the voice of reason breaking through the epidemic of ignorance.

1. Commissions are not responsible for the calamities of the past decade, and any suggestion to ban them will not stop the villains in future years.

2. Industry bodies should recognise and represent the voice of the populace, rather than making public declarations on issues that appear to have been loosely considered

3. The industry still has a chance to affirm their stance on the issue of fees v commissions (…and should never rely on ‘promises’ from Politicians suggesting that the problem has gone away…). To be effective the industry should discuss this issue internally and aim to lobby with one voice to minimize confusion and maximize efficiency

4. Finally – the Australian industry is extremely regretful about yesterday’s Regulatory announcement, with many industry pundits wondering how/why their leaders failed to avoid this outcome by speaking on their behalf (albeit that it was well sign-posted over the past 12 months). Language such as “conspiracy”, “political agendas”, "industry ineptitude" and “institutional timetables” are being freely referred to
On 28 April 2010 at 4:52 pm Kimble said:
Just on your first point, IO, who is saying that commissions caused the GFC, or the tech boom, or the finance company strife? I dont think the argument against commissions hinges on those things.

Besides, your first point doesnt really constitute a case in favour of commissions. What exactly are the arguments FOR commission-based remuneration for fiduciaries?
On 28 April 2010 at 5:24 pm ArthurDent said:
Hi Kimble. In some cases spreading the cost of advice over several years via trail commission makes advice more affordable. In addition the transaction cost of invoicing, bad debts, credit control etc for smaller transactions is far more efficient. Is it really in the clients interest to spend 20 minutes billing them for a small transaction? I always give the option of fee or commission, in most cases the clients choose the cheaper option of commission.Of course, if we are required to issue a 50 pages document every time the client phones us or asks for a one-off transaction it will soon be irrelevant as all small investors will be driven to DIY or tied workforces who can hide the cost to the client.
On 28 April 2010 at 5:25 pm Interested said:

Your house example cracks me up.

To explain why - throw in a competing agent with a fee of $10,000.

What would your seller do now?

Try a new example - this one is flawed.
On 28 April 2010 at 9:09 pm LPL said:
[quote]"I have no doubt that there are instances where commissions have influenced an adviser’s recommendation process. There are lots of comments along these lines and it seems to be accepted wisdom in some circles that is the case. However there is little empirical research to support this proposition."

Phil, reading your article I wonder if we are thinking about the same industry. I suggest if you are unaware of any evidence then you rock up to your local BDM of any insurance company and ask what happens to business when one company runs an attractive promotion.

Commissions of the past in most cases do not reflect the value that a consumer received. Ongoing trail/commission may provide a mechanism to 'pay the bill' but lets not kid ourselves that as an investment rises in value your work increases; as suggested by the increase in fee you take.

KiwiSaver poses a problem. The trail if you get it (in many cases the fund manager is retaining this as no adviser has been "attached" to the client)is paltry compared to the time and work that is involved, however it is done because advisers are well aware of the likely tsunami of income that will be theirs if they sign up enough of them. So, yes isn't it a worry if that tap gets turned off.

Banning commissions perhaps isn't the way. But like any consumer purchasing any product or service you should be able to expect a recompensable cost for the product or service you get.

Lawyers now provide a statement of charges prior to proceeding and now adviser income is under scrutiny. We can only hope the Govt take their regulation hammer to Accountants - oh and don't get me started on trades people!
On 29 April 2010 at 11:17 am Denim said:
Kimble, sure they consumer always pays at the end of the day, however, the fees a fund manager gets are an accepted cost for service. It's from these fees though that commissions get paid - it's a variable cost that rewards productivity and is certainly a pay model choice that should be available in any democratic, capitalist society. When costs are significantly increased by a pay rate maintained for an unproductive employee that you can never get rid of in our PC society then the costs can only be passed on to the consumer (on top of the already accepted fees).

What would be far more productive than restricting this pay model to try and stop a few renegades would be education. Financial literacy would allow people to understand any advice they receive and make informed decisions.

And once again, why is KiwiSaver involved? Is this a deliberate attempt to slow down KiwiSaver uptake and the huge amounts of tax money that isn't making it to the Government coffers? Clearly it wasn't budgeted for as predictions were well below the 1.4million that have joined.
On 29 April 2010 at 11:22 am Interested Observer said:
One question to resolve the commission debate - when did a commission-based advisor ever, ever recommend a product that wasn't paying any commission? 3rd party commissions are totally unacceptable for a fiduciary. Those that think otherwise are in dire need of the upcoming advisor training.
On 29 April 2010 at 2:06 pm Tony Vidler said:
Dear Interested Observer

Advisers frequently recommend solutions and/or products that do not involve commissions. Frequently. Many advisers I know, including myself regularly do precisely that.

Anyone that thinks otherwise has a very narrow and probably prejudicial view of an entire industry.

Many well qualified and/or competent advisers offer a vast range of financial advice (estate planning, cash management, debt management, taxation advice to name a few or product solutions such as bank term deposits), where there is either NO product, or NO commission of any sort. And they often do it without charging fees because the commission received on other lines of business does suitably compensate them for their time and expertise in providing this holistic advice.

It remains a ludicrous and banal argument to adopt the simple "commission is bad" argument, or to contend that "all advisers" are motivated to provide "advice" only because of a commission component. It is sometimes true of some advisers, it is often not true of many advisers. It is sometimes never true of some advisers. But it is certainly not true as a sweeping indictment of an entire industry that all advisers are motivated to act in exactly the same way simply because of some form of remuneration called commission.

The issue regarding commission remains as it has always been - and there is the point where regulation can (and intends to) make a positive difference.

Commission is fine as a remuneration method provided there is transparency in advance, conflicts of interest are disclosed and understood by the consumer in advance, and the two parties to the transaction are both happy with that form of remuneration. End of story. Free market at work on an informed and consenual basis. Who actually has a problem with that? Socialists do perhaps.

Moving beyond this point and dictating that consumers do not have the choice any longer to employ a commissioned adviser is dictatorial, and political correctness of the nanny-state variety. Effectively market movers and/or regulators who might wish to legislate it out of existence in only one commercial sector are telling consumers "we know what is good for you better than you do".

I for one find that an abhorrent position. But that is just me speaking as a consumer. Which of course I am, as well as being an adviser. I employ an adviser for myself, and am perfectly happy with commission as a form of remuneration for that adviser.

So why, as a consumer, can't I continue doing that?

And frankly, I personally would rather work with someone who calls a commission a commission - and I understand precisely what that word means - rather than someone who calls a percentage of my funds for successful product placement a "fee". That is still a commission to anyone of any inteligence, regardless of the semantics or window dressing.

So give me the choice: work with an adviser who calls a commission a fee and pretends it is something else entirely, or someone that takes business risk on my account whilst providing holistic service and tells me precisely how they get paid in a way I understand.

Easy choice mate.
On 29 April 2010 at 4:24 pm Geoff Peterson said:
Tony, you have given us a very objective, and honest answer here to this situation, clarifying the issues and breaking them down into sensible points easily understood by the majority; and I encourage you to write more often.
On 30 April 2010 at 9:31 am Tony Ryburn said:
There should be commissions alright - paid by the client as an agreed percentage of what they earn on the investments recommended to them by the advisor.
On 30 April 2010 at 10:00 am Andrew Parkinson said:
I endorse Geoff's statement in thanking Tony for his views. As an adviser I also regularly recommended products on which I get no commission. I am in business for the long haul. I want my clients to come back time after time, year after year and whilst I prefer the fee for service model where I rebate any commissions, I happily deal with those clients who don't want to pay a fee as I will be compensated by way of commission on some of the products I recommend, not necessaarily this one but perhaps the next or the next.

I have no problem recommending no commission products where they are the best solution for the client. I believe that in the long run if I act in an ethical fashion ALWAYS putting the client's interest first the client will keep dealing with me and I will have a successful business.

And refering to LPLs comment re insurance, IF two products offer the same client benefits and one pays a higher commission than the other what is wrong with advisers recommending that product with the higher commission? As a consumer I would think my adviser a fool if he did otherwise.

More and better education, disclosure and sanctions against those who do not act in the clients interests, yes, yes and yes but regulation just isn't going to work.

I believe one of our problems in the industry is that unfortunately there are many in the industry who do not act in a professional manner and bring the rest of us into disrepute. We all get tarred with same brush, particularly by the media and so comments like those of Interested Observer's become "accepted wisdom". Yes, the industry needs to tidy its act up and discussions and forums like this help us all, so please all keep contributing to the discussion, we need all points of view to help the rest of us to think and where necessary modify our own views.
On 30 April 2010 at 11:52 am Kimble said:
Think of this from the perspective of ommission rather than commission.

What happens to the fund manager that doesnt pay a commission? Would this manager still be likely to recieve money from commission structured advisers? The commission structure has affected the investment decision.

Tony V said,
"And frankly, I personally would rather work with someone who calls a commission a commission ... rather than someone who calls a percentage of my funds for successful product placement a “fee”."

Except a commission is paid for the sale of a specific product. The "fee" you describe would be charged irrespective of product. So the "fee" remuneration structure cannot possibly determine the product decision. The same cannot be said of commission.

It doesnt matter whether this actually occurs. If building public confidence in the advisor industry is a desireable goal, then it is the potential perceptions of the public that must be addressed.

ArthurDent raises a good point about commission being more efficient for one-off transactions. Does anyone have a solution for the problem he posed?
On 30 April 2010 at 12:28 pm virginflat said:
well how about accountants get trail commision from Tax dept?
that would reduce their bills and more people caould afford to go to one.
Oh, and perhaps IRD collect more tax?
On 30 April 2010 at 12:29 pm Denim said:
Kimble, If a fund manager thinks he can set up shop and start getting free money from clients through advisors who have a multitude of investment options to choose from they're dreaming, nothing is free, you need to pay for your clients. You either pay for expensive advertising and express a personal view to a consumer on why they should use your product, hire an employee who may or may not be productive and will be very difficult to get rid of if they're not, or you can tap into an advisor network and pay them a commission for their time. They may or may not use you, depending on what their client wants. A few rogues will use you if you pay more, not an industry.

Rather than ban a commission, how about standard commission rates across like products?
On 30 April 2010 at 1:00 pm Kimble said:
"If a fund manager thinks he can set up shop and start getting free money from clients through advisors who have a multitude of investment options to choose from they’re dreaming, nothing is free, you need to pay for your clients."

Thanks Denim.

The investment merit of a product ought to have nothing to do with whether it pays commissions to advisers. A manager that does not pay commissions should still recieve money from investors and advisers based on the investment merit of their product.

"Rather than ban a commission, how about standard commission rates across like products?"

So instead of banning commissions, you want the government to institute price controls? A little inconsistent with a democratic, capitalist society, dont you think?
On 30 April 2010 at 1:07 pm Interested Observer said:
But Andrew, with your insurance example you are placing yourself in a position where someone can accuse you of acting wrongly as you will, understandably, have a preference towards the higher commission. You don't actually have to act wrongly in order to breach your fiduciary duties, it is enough that you place yourself in a position where you could act wrongly.
Secondly, if you're truly acting in your client's best interests, you'll realise there's some fat in the product with a higher commission and be obliged to negotiate a lower management fee on behalf of your client.
Thirdly, while I understand advisors don't receive commission from every investment - an advisor is not going to stay in business for long if they don't have any revenue coming in. To illustrate - if you believe, say because of GFC, that the only safe thing to do is to stay out of the markets (which as a commission-paid advisor means you won't get any commission) - how long will you be able to keep advising your clients of that before you start to factor in your own lack of revenue? One month, two months, a year?
Fourthly, your insurance example actually confirms my earlier point - except you're assuming both products pay commission. My earlier point assumed that one didn't pay any commission at all. Clearly, judging from your comments, you would go for the one that paid commission - which was my point.
Finally, and in deference to Tony's very well made and valid response, - don't mistake my shrillness as a general hostility towards advisors. I know generally speaking, advisors are well intentioned and ethical etc. But being a fiduciary is an onerous undertaking and not one to be assumed lightly. Being professional isn't enough. Exercising reasonable care isn't enough. Disclosing fees is not necessarily enough (technically - although it does help). Complying with the Code isn't even going to be enough (although there is some debate about that). Much of what Tony says is quite logical and correct for most purposes. But the reality is that no two issuers are the same, and no two products are the same. How is an advisor going to prove that in recommending one over the other they weren't influenced by the higher rate of commission - because that is what they're going to have to do if a client alleges breach of fiduciary duty.
On 30 April 2010 at 5:24 pm Denim said:
Kimble, your comments are based in theory not reality. If there's even only 5 similar investment products that match a clients needs, a 6th product better have a serious point of difference if they want to get that in front of a consumer without some enticement - whether it be advertising, employees or independent advisors. Employees are a fixed cost, with a lot of administration whether they're good or not. Advertising to your market is hugely expensive. Commissions for productivity is the most viable option - make it transparent, provide summaries and disclosures and ideally have a finacially literate client (by introducing the curriculum to schools) who can take some resposibility themselves for ultimately making the investment decision.

" want the government to institute price controls?" - Who said anything about the Government, the industry's more than capable. But I'm certainly not interested in the Government making me a criminal to be involved in offering or accepting a commission pay model.
On 30 April 2010 at 5:39 pm Kimble said:
Sorry Denim, I want to make sure I follow what you are saying. Bear with me.

Are you saying that the products are best differentiated by the commissions they pay?

You also say employees are paid to sell the product, but they can be bad at their job and they cost a lot. Advisers on the other hand only get paid when they sell the product. So advisers are like casual employees who are working on a commission-only basis.
On 30 April 2010 at 6:02 pm Murray Weatherston said:
What does a voluntary ISI standard mean?
Is it a Standard that ISI members can choose to follow or not?
Or is it a Standard that ISI is introducing voluntarily (i.e. not imposed by regulator) but which is mandatory for each ISI Member?
There is a world of difference between these two meanings.
On 1 May 2010 at 9:33 am Independent Observer said:
I want to reinforce the stance of Independent Observer as opposed to those of Interested Observer:

Commissions v fees is a billing argument and is not the villain.

Adopting a fees-only-approach is not the answer, and is confusion the real issues.

The solution in restoring consumer confidence is a principles-based regime, and full transparency.
On 3 May 2010 at 10:53 am Tony Vidler said:
thanks folks for the nice words, and the interesting and provocative debate. I'd happily write more often too - if one had the time to keep on top of all the stuff happening in the "day job" at the moment then there might be a chance of that, but alas....

I'll say that the last comment by Independent Observer is spot on. I'll add to his comment by saying I believe that restoring consumer confidence in the advisory sector is going to be a matter of winning it back one client at a will take some years and a heck of a lot of work by every adviser committed to professionalism.
On 25 May 2010 at 10:51 am Interested Observer said:
For those that still think the commission debate is just a billing argument, there's a very good commentary by Brent Sheather that you should read.

In case the link doesn't come through - it was in the Personal Finance section of the NZ Herald on May 22 headed "Brent Sheather: Ban on commissions is a must".
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