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Client best interests: Part Two

Last month’s commentary on the Code of Conduct obligation to put “client interests first” generated a great deal of discussion.  In this follow up John Berry takes the debate a step further and asks some fundamental questions about what consumers expect, if better disclosure can help and whether a “best interests” standard is impossible to meet.  This is the second instalment of a 3-part commentary.

Monday, October 3rd 2016, 6:01AM 8 Comments

by Pathfinder Asset Management

This discussion covers two different models for financial adviser businesses in New Zealand.  The first is where advisers are “tied” and only sell in-house product.  Let’s call this model “restricted advice”. The second is where the adviser is free to select any product in the market.  Let’s call this “independent advice”.

The distinction is an important one because as the FMA notes in a document on its website “vertically integrated distribution models, where a market participant is the provider, manager and distributor of a product, can exacerbate conflicts of interest and result in poor investor outcomes.”  Elsewhere the FMA says “advisers in vertically integrated structures play a key role” to “test the investment information” for in-house product and question whether the products “are suitable for the customer”. 

Advisers play a key role promoting customer (consumer) interests.

What are consumers’ expectations?

What do consumers expect when they go to a vertically integrated bank 1 for financial advice?  If they are looking for a mortgage then they don’t expect their bank to show them mortgage products from other banks.  If they want to make a term deposit they don’t expect their bank to show them the term deposit rates of other banks. 

Should we consider complex investment products to be the same as mortgages and bank deposits?  The FMA says yes.  They argue a consumer does not go to a bank and expect them to show complex investment products from another provider.  But is there any independent evidence supporting this? 

It seems unlikely that investors associate the manufacture of complex investment products with banks like they do with mortgages. If you ask 100 consumers to name a fund manager, those who could would name “Carmel Fisher” or “Brian Gaynor”.  Neither of them works for a bank. 

When consumers talk to their bank about complex investment products, the consumer viewpoint is very different to a mortgage or term deposit conversation.

A lot of the difference is because with mortgages and term deposits consumers generally have some product knowledge. They know the questions to ask and they can easily access tables comparing providers. 

Contrast this with complex investment products where there is almost total information asymmetry. The adviser has the information and knowledge, while the client is often totally reliant on them.  From a customer perspective the sale of complex investment products is quite different.

This should not be controversial – indeed the FMA website says “information asymmetries are common to all financial markets, with investors usually having inferior information to the financial service providers who offer the product or service.”  The FMA go a step further to say the information asymmetry combined with a conflict of interest can result in something of a disaster for the consumer – “when conflicts of interest are combined with information asymmetries, it can be difficult for investors to know whether a market participant is acting in their best interests”  (note the FMA’s unexpected use of “best interests” – shouldn’t they refer to “interests first”?!)

For these reasons a consumer going to a bank (or any financial adviser) probably expects they will be shown the best investment product, and not simply given “restricted advice” relating to in-house product.  In essence, complex investments are not mortgages.

Can disclosure fix this?

What if the bank adviser hands a piece of paper to the consumer explaining that they will only be sold bank product?  Can disclosure fix the problem?  Probably not.

In New Zealand we don’t have a great track record of disclosing information in a way consumers can easily grasp.  Simply including this information in the adviser’s primary disclosure statement doesn’t help – it may or may not be read.  If it is read it doesn’t explain what it actually means – that the adviser will not look at other product in the market that may be less volatile, cheaper and better performing than the in-house product. 

It is not just the fact that only in-house product is sold that is problematic, it is the implications of this.  The downside of being sold an inferior in-house product is that it may underperform.  Higher fund manager fees of 1% p.a. over 20 years on $100,000 can build up to an astonishing $55,383 difference².  Simple disclosure will not help an investor grasp this.

Here’s a real life example of how disclosure alone cannot fix things.  

Have you ever driven a car to a service station and wondered which side of the car the gas tank is on?  Sometimes you may have had to guess.  But look closely at the dashboard of your car – next to the fuel tank indicator is a small arrow or triangle.  Virtually every brand of car has one, and it tells you if the gas tank is on the left or the right.  This “full disclosure” has been in front of you in possibly every car you’ve driven in the last decade – your eyes will have seen it but you probably didn’t know its significance so it meant nothing to you. 

Too often investment product disclosure is like the gas tank arrow on the car dashboard – there is full disclosure but no one knows the implications.  Simple disclosure of “restricted advice” is not a good fix.

What does the alternative (“best interests”) actually mean?

Critics of the “client best interests” standard say that the duty is so high it is impossible to meet.  An adviser has to research every product in the world and choose the best for the client - a duty that simply cannot be satisfied.

This absolutist approach seems unnecessarily extreme.  Whether the words chosen are “putting client interests first” or “acting in the best interests of the client” or something else, it does not matter.  What matters is what the duty means.  It should be fair to consumers and have substance – it should mean something like:

“As an adviser I am a professional.  I believe my process is objective and independent, and is of the best quality that can reasonably be expected.  I genuinely believe I am promoting my customer’s key interests.  For example from the universe of product available in the market I have selected an approved product list that hand on heart I believe is going to fit best.  If any product happens to be my firm’s own in-house product, I have chosen that product because I believe objectively it to be the best product in the market for my customer”. 

Note how the hurdle for adopting an in-house product should be a very high hurdle. This standard is fair to consumers and advisers.  It is not an impossibly high standard.

Of course hindsight may later prove the investment selection was sub-optimal.  The manager of a bond PIE fund chosen may underperform.  An AUT chosen may have had no currency hedging as the NZD rallied. A global equity ETF may have given large cap exposure while mid-caps outperformed. But as long as the adviser’s selection process was genuine, independent and robust, the standard should be met.  It is not impossible.

Other professionals in almost identical circumstances can comply with a “best interests” duty.  A fund manager building a multi-manager global equity fund owes a statutory duty to act in the “best interests” of unitholders.  This means researching and selecting what the manager sees as the best global equity managers for the multi-manager fund.  If a fund manager can satisfy that “best interests” duty (by selecting what they see as the best global equity managers) why can a financial adviser not do likewise (by selecting the best global equity product in the market)?  The obligations are not impossible.³

Final thoughts

Here are some final thoughts to ponder:

Look from the consumers' viewpoint:  Do consumers understand that the “restricted advice” model is different to the “independent advice” model?  More importantly, do they fully understand the implications of the difference?

More disclosure doesn’t always help:  With complex investment products is there a way that better disclosure can bridge the information gap between adviser businesses and their clients?  (Probably not as we face the “fuel tank disclosure” problem).

The adviser’s standard must be fair to consumers:  Putting “client interests first” or acting in the “clients best interests” does not need to be an impossible absolutist standard.  But it needs to be fairer, more independent and a higher standard than what “restricted advice” currently provides.

What we need in New Zealand financial markets is a sensible and consistent consumer-centric approach to both regulation and our overall industry framework.  Some might describe it as creating “fair efficient and transparent” financial markets.  But does this apply with restricted advice? 

When it comes to “restricted advice” the FMA supports a narrow interpertation of “client interests first”.  Yet the FMA’s “Strategic Risk Outlook 2015” 4 clearly states that one of seven strategic priorities for FMA operations for 2015 to 2018 is:  “Aim:  sales processes and advisory services reflect the best interests of investors and consumers.”  Did the regulator just say sales and advice should reflect the “best interests of investors”?  Boom. 

If the FMA’s Strategic Risk Outlook policy is adopted into the Code of Conduct a “best interests” duty would be imposed on investment advice.  Job done!!

John Berry, Director
Pathfinder Asset Management Limited

Disclosure of interest:  John is a founder of Pathfinder and invests in all Pathfinder’s funds. 


1 This commentary is not intended to pick on banks – but they are the most convenient example to use for financial advisers that are vertically integrated with a fund management business.  Most banks focus advice around their own investment products  – the key exception is BNZ which to their credit provide “independent advice”. 

2 The $55,383 difference assumes one manager returns 6% pa net of fees and the other manager returns 5% p.a. net of fees on $100,000 over 20 years.   No allowance is made for inflation or tax.

3 Note that a fund manager owes a duty to act in the best interests of unitholders as a class while financial advisers owe the duty to investors as individuals. 


Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors.

Tags: Pathfinder Asset Management

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Comments from our readers

On 3 October 2016 at 8:44 am Barry Read said:
Hi John

Good words and I agree.

MBIE had Colmar Brunton complete consumer focus groups for users and non-users of Financial Advice Services, prior to the FAA review. The report can be found on the review page on the MBIE website.

I thought the research (While only small numbers) showed that consumers may understand these choices better than we often give them credit for. My own informal discussions with non-industry people support this thinking as well.

The two key points from the groups that I think are applicable to your article are;

1. Consumers seeking advice from the product or service provider themselves (The Bank) can understand the restrictions of the advice service

This is an exert from the report;

((A number of people in the non-users group raised the issue of fees/commissions and affiliations. They feel these ties can make a financial adviser feel like a ‘sales agent’ for an organisation. They are not sure how
this would affect their perceptions of a financial adviser, but some comment that these affiliations might
be a trade-off. That is, they would have access to professional advice, which is positive, but this is
tempered with the awareness that this advice may have some biases.

Users in theory prefer that financial advisers are independent and not affiliated with any particular
organisation. But in practice, they are comfortable ‘trading off’ independence with not having to directly
pay financial advisers themselves.

I think for me both, it [disclosure] makes me both aware and wary of their recommendation,
but also confident that I know that that's on the table, and I can factor that into my
Investment advice client))

The second point is disclosure can work:

Another exert;

((Consumers discussed five elements of the Acts that have been designed to provide consumers with the
confidence to make informed financial decisions. The two elements of the Acts that consumers feel have
the most impact on their trust and confidence in the financial services sector and provide them with the
tools to make informed decisions are:
 The need for financial advisers to disclose fees/commissions and affiliations
 The four disputes resolution schemes.

they are aware that their financial advisers may financially
benefit by offering them investment products from companies with which they are affiliated. Disclosure of
this has the same impact on these investment advice clients as insurance advice clients – it provides them
with a sense that their financial adviser is open and transparent.
One of the investment advice clients feels that his financial adviser’s affiliations will affect the source of
investments offered to him. He tempers this with the sense that he has access to investments and
information he might not have otherwise.
“I always think if someone else is paying them, I will always think ‘OK where's their
motivation, come performance appraisal time, what are they being appraised on?’ And
consequently I have to take their advice with a grain of salt. But having said that they have a
take on things that I don't have ready access to otherwise, so it's very useful to hear it and
then evaluate that.”
Investment advice client))

Which is why I still believe a clients (Best/First) interests standard (Not a full on fiduciary role) can work for Financial Advice provided by product and service providers.

On 3 October 2016 at 8:49 am Brent Sheather said:
This story is both uplifting and sad. It is uplifting because John neatly summarises the issues. It is sad because despite Mr Berry’s clever analysis there will be no change in behaviour from Government or the Ministry of Investment Banking. It is sad because the FMA acknowledges the fact that vertically integrated businesses are designed to exploit consumers yet continues to argue as per the polo shirt comment that such activity is not only okay it can be construed, somehow, as putting client’s interests first. Furthermore despite the acknowledgement that the vertically integrated structure is flawed the FMA board is dominated by past, present and future executives from vertically integrated organisations. It is sad because although the FMA acknowledges that disclosure doesn’t work the Ministry of Investment Banking and Government limit the FMA’s arsenal in defending retail investors from bankers to just disclosure. A reasonable person looking at all these issues would conclude that regulation has been absolutely captured by vertically integrated businesses.

Mr Berry also highlights the sad fact that the Chairman of the Code Committee doesn’t have a good grasp of the issues when he said words to the effect that “best interests” are impossible. His perspective is obviously the perspective of banks and whilst putting client’s interests first are next to impossible in the context of a vertically integrated business and completely impossible if one is looking to maximise profits in a vertically integrated business that’s not the only option to deliver financial services. Absent those constraints and “putting client’s interests first” is quite possible when you separate retail from investment banking. By the way I ignore semantics and don’t differentiate between putting client’s interest first, best interests or whatever. Retail investors won’t differentiate ….as we know many are illiterate so we need to keep things simple.

Best practice is clearly achievable by following the strategies of the average pension fund.

On 3 October 2016 at 10:45 am Observer said:
Brent, Are you saying that advice from a tied adviser is never "good advice"?

If the product(s) recommended actually meet the client's expectations, does it matter whether they were recommended by an adviser with access to a wide universe of products or an adviser only able to sell a few products?
On 3 October 2016 at 12:06 pm Brent Sheather said:
Hi Observer

I think that is probably a pretty fair assumption. Even the term “tied” doesn’t have good connotations unless you are into unnatural stuff which I am sure you are not? Let’s be honest – most “tied” products have much higher fees than passive products for a start and a lot of active products as well. I am not talking insurance, just investments.

Too many people in this industry neglect to focus on the facts and the facts are that fees are critical, all other things being equal, and “tied” products, nine times out of ten, have much higher fees than passive and other products that don’t pay commission. Commission is another issue and products which pay commission generally pay higher fees than those that don’t.

By the way clients’ expectations aren’t really relevant because many clients don’t have a clue and that’s why they trust financial advisors. A key role of financial advisors is to choose between financial products so as to get the best deal for the client. Advisors which can only sell their organisations products obviously can’t do this so that is why they stress other services like dog-walking, marriage guidance and talking at funerals.
On 3 October 2016 at 12:38 pm doomben said:
One thought experiment is to extend what John is saying to fund managers.

Lets say that no NZ fund manager can run a fund unless, hand on heart, they believe their fund is the best of the universe of funds of that type available to investors.

It would be interesting to see how many funds would close in this case?

My guess is none would close.

People running funds actually do believe that they are "above average". They would dismiss trifling things like bad returns as merely bad luck.

I think the same would happen with in-house advisers. If you work for Bank A, you are predisposed to believe that Bank A product is superior. Otherwise you probably would not work at Bank A.

(Or if you are more realistic, that all funds are equally useless so it makes no difference whether you use the in house fund or not).
On 3 October 2016 at 1:45 pm Carey Church said:
Firstly, I would like to thank John for two things:
1. Letting us all know about the fuel gauge thing and
2. For stimulating debate and thought with his continual series of thought provoking considered articles.

My understanding is that while the USA, UK and Australia all have a ‘best interest’ standard this is for defined and discrete groups of financial advisers. My understanding is that the issue in New Zealand about ‘best interests being unworkable’ is because we have one Act (FAA) that applies to all financial advisers, not just investment advisers and that this is what causes the complications.

I believe that there is an awful lot more discussion and research that can and should be carried out into the implications of whether we should apply clients interest first or best interest standards. Hopefully this will happen over the next few years.

However, surely it is a great step that we are making ALL people that talk/give advice/don’t just take transaction instructions to the consumer about money to be held to a standard of something? With specific instructions to the QFE’s that they can’t incentivise their employees to act in a way that is not in the clients best interests?

I certainly agree about disclosure. This is why the disclosure needs to be in simple clear terms, ideally on one page and the same format for everyone. But, as the old adage goes – you don’t know what you don’t know. Therefore, the concept of starting at the top and looking at culture and governance appears to me to be good first step.

We are dealing with a hundred years of culture, which has been exacerbated in the last thirty years where participants in the financial industry believe they have a right to have very high remuneration and rewards. These expectations are going to take a long time to change (refer Wells Fargo debacle and the CBA CEO bonus payments). But we have to start somewhere.

Maybe I have been around for too long, but I think it is great that we are:
1. Putting in place industry wide standards.
2. Providing the ability for the consumer to get access to assistance in making financial decisions and enabling them to access insurance, KiwiSaver and non property investments.
3. Having informed professional discussions about these issues as an industry.

Sometimes it just takes little steps to get to a ‘perfect’ solution.
On 3 October 2016 at 2:46 pm blogger billy said:
What the FMA staff might say at the water cooler

Putting clients interest first does not help our banker mates
And clients best interests just creates awkward debates
But we’ve got clever lawyers who can within a day or two
Write pages and pages of arguments that will confuse you
They even confuse themselves and the Goldenboy too
But everyone believes us coz we’re the FMA
We are the light, the power and the way,
And we’ll make sure we get the champers and caviar
But for the NAFA’s its only vinegar

NAFA - non aligned financial adviser
On 4 October 2016 at 8:18 am Charity said:
Here’s the larger problem. It is odd indeed that advisers, clients and industry professionals like John Berry are screaming for more regulation and higher standards and the regulator is advocating for less.

In other words, Rob Everett is advocating strongly that an independent adviser has one set of rules in putting the client first and a bank employee (with an ASB polo) has a different standard in putting the client first.

Why is it that FMA think a lower standard in the industry is advantageous? You no longer work for Merrill Stench Rob.

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