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Client interests first (or business interests first?)

This commentary wraps up the three-part series on a financial adviser’s duty to put their client’s interests first.

Monday, October 17th 2016, 5:00AM 7 Comments

 The purpose of this series has been to question whether this duty works from a consumer viewpoint.  John Berry rounds out the discussion by asking (a) what are the benefits of the current “client interests first” interpretation? and (b) is this the duty we’d introduce if we were constructing a financial system from scratch?

As with the previous commentaries two different models for financial adviser businesses are covered.  The first is where advisers are tied and only sell in-house product (“restricted advice”). The second is where the adviser is free to select any product in the market (“independent advice”).

What are the benefits of the current system?

The current system regards “restricted advice” as putting “client interests first”.  Surprisingly none of the roughly 50 reader comments on parts one and two of this commentary set out a case for why this interpretation is appropriate.  Maybe the benefits are obvious and no one thought they need to be stated. 

Conversely, maybe it’s a touch awkward for the industry to publicly explain the current system’s rationale.  Or just may be no one is sure why we have the system we have.

Taking a pragmatic view, there are arguments in favour of “restricted advice” being treated the same as “independent advice”.  These benefits are:

  • Accessibility of advice:  Firstly the current system may make financial advice more accessible and available for consumers.  If we had to call advisers from vertically integrated businesses “salespeople” then consumers may have less confidence in seeking their guidance and may instead opt for a “do it yourself” approach.  

    Asset class allocation help from a “restricted adviser” is better for consumers than not having any help. If we are going to accept this pragmatic reason for compromising on what advice means, let’s just be clear and explicit that we are compromising for the greater good of investors (i.e. trying to deliver the best “accessibility outcome” for the New Zealand investing public as a whole, not the best “investment outcome” for each individual investor). ¹
  • The duty fits a range of business models:  Secondly the current system works because it fits the reality of nearly all financial adviser business models (both restricted and independent advice).  The current interpretation of “client interests first” provides a broad umbrella for the industry that everyone can shelter under.  Again, if we rely on this argument let’s be honest and explicit about it – the duty to customers suits business models of product providers. 

    But there is something deeply ironic about putting “business interests first” when designing a standard called “client interest first”. 

What if we had to build a financial system from scratch?

The best way to think about how “client interests first” should be applied in practice is to start with a clean sheet of paper.  Imagine we are designing a new country’s financial system from scratch.  Would we say:

“Ok advisers, you can divide into two groups.  “Group One” will sell only their own in-house product to investors.  You guys don’t have to think about any other product in the market, even if it’s a better product than yours.  Just fill your client’s boots with your own home grown product.  “Group Two”, you guys will be selecting from all products in the market.  Don’t build your own fund product, instead choose what you think is best for clients.  And we’re going to call everyone in Group One and everyone in Group Two “financial advisers” because you all do exactly the same thing.”

Would we really think that Group One and Group Two advisers provided an identical “client interests first” service to clients? Would we really set it up this way if we were designing NZ’s investment market from scratch? No, that would be bonkers. 

Under the current system consumers operate in a “caveat emptor” environment (“let the buyer beware”).  Whether they know it or now, a restricted adviser is effectively saying to clients “you have chosen my firm therefore you have already narrowed your product universe – you are on your own with that decision.”  If we were setting a financial system up from scratch I doubt we’d ever choose that.

Any other angles to consider?

In simple terms a vertically integrated financial business is likely to work as follows:

  1. the fund management arm builds in-house fund product
  2. on the private client side an investment committee chooses the building blocks (funds) for client portfolios.  This is likely to include or even be dominated by in-house product.  The funds selected are the firm’s Approved Product List.
  3. the financial adviser implements the Approved Product List.  S/he puts their client’s interests first and provides “restricted advice”.

In this model, what is the duty that the investment committee owes?  Their role is absolutely critical to the investment process and the outcomes for clients, but do they owe any client duty?  The fund manager (step one) and the financial adviser (step three) owe an explicit duty to clients – so why not the Investment Committee (step two)?

One possibility worth exploring is requiring all vertically integrated financial adviser businesses to have an investment committee selecting building blocks for portfolios – and they must act in the best interests of clients when doing this.  They may select their own in-house product, if it can be objectively justified.  The adviser then provides “restricted advice” – putting the client’s interest first in selecting products from the investment committee’s Approved Product List.  That works.

Final thoughts

If we were creating NZ’s investment industry from scratch would we choose to treat “restricted advice” and “independent advice” as exactly the same thing and as equally beneficial for consumers?   If we say “no we wouldn’t set it up that way” then the system we have now is compromising consumer interests. Maybe we are compromising to improve accessibility of advice.  Or maybe the compromise is to suit adviser business models.  But if there is a compromise, lets acknowledge it.

Settling the right standard for financial advisers and adviser businesses is going to mean finding the right balance between client duty and business operations.  At the moment vertically integrated businesses have the best of both worlds: a “client interests first” duty that sounds impressive (but means nothing) and the ability to conduct business operations in a way that maximises profit from consumers.

We do not need to ban vertically integrated operations.   We should continue to allow providers freedom structuring their businesses so they can both build and distribute product.  However, this freedom must live within a meaningful duty to advance the interests of clients.  What this may mean is:

  • For Fund Managers: a duty on the in-house fund managers to act in the best interests of unitholders (this is already a statutory duty under the FMCA)
  • For the private client Investment Committee: a “best interests” duty to clients of the firm to thoroughly and objectively look beyond in-house fund product when setting the Approved Product List; and
  • For Financial Advisers: if the Investment Committee has a “best interests” duty then a “clients’ interests first” duty now makes more sense for “restricted advice”

Let’s finish with a real life example of the “client interests first” duty in action. The 2014 business plan for a vertically integrated fund management business provides that “within a client best interests framework we are working” to “lift [our in-house funds] representation to 50%” of client assets under management (AUM). 

At that time its in-house funds were 32% of AUM.  Its funds were among the most expensive in the market, performed abysmally, lacked any transparency and had sub-standard governance.  It was never in the interests of clients that they were loaded with more of this in-house product.  The Code of Conduct allows this to happen – it shouldn’t.

John Berry, Director
Pathfinder Asset Management Limited

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


¹  It would be a big positive to be able to argue that vertically integrated financial businesses make financial advice more accessible by lowering the cost of advice.  This should be possible because of the synergies of controlling each level of the process (i.e. from fund product manufacture to sales) and having margins at each level.  Unfortunately, there is only one case I am aware of where the business rebates their fund manager fee to clients who also pay advisory fees to their in-house AFAs.  The argument that vertically integrated businesses lower the overall cost of advice for consumers doesn’t seem to stack up.

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Comments from our readers

On 17 October 2016 at 10:21 am Comprehensive Planner said:
“Client First” or “clients best interest first” sounds somewhat like an argument in semantics, however when you take a closer look at the regulation overseas and how each treat these two differently you start to understand a little about the importance of getting this right here.
The term “Fiduciary” has little weight here in NZ but in the States, Canada, Australia and others it has significant legal implications, so maybe there is something to learn there for New Zealand. Given that the use of Fiduciary in New Zealand legislation is currently pretty much restricted to Trust law and even then seemingly only in clarifying the Duty of Care requirements.
I feel that the financial services legislation here while focussed appropriately upon consumers’ needs like protection and redress, it does this in a somewhat convoluted way when it centres on both product and advice together. The FMCA seems to look predominantly at issues around the structure of financial products but it is the FAA that focuses upon the advice that is at the centre of the client relationship and adviser obligations flow from this. By effectively conjoining these two pieces of legislation in the current discussions we tend to lose sight of the differences.
I feel that if we were to build a new financial advice system from scratch, we should look at the involvement of each participant, Financial Product providers and distributors would be treated differently to those providing advice around client needs and the options available to meet those needs in a realistic way.
Unfortunately, in New Zealand a very large number of product providers also attempt to provide advice and this in my opinion is where significant conflict begins, as the primary driver for product developers is to distribute as much of their product into the marketplace as possible, while the primary driver for most providing advice, is to provide as much advice as possible to as many clients as they can continue to service. The difference is not at all subtle, product vs services, yes advisers want to provide services in a profitable manner that both pays them for their time and provides a profit to their business, but product providers are focussed upon their product sales and profits to their shareholders.
I also feel that we should not be encouraging any legislation that purports to require the “Best interest” as this is almost impossible to define over time and circumstance, what is best for one may not be for another and what is best today is unlikely to be the best later on when a client suffers either a downturn or a change.
So, in conclusion, a clear separation between product and advice would be the best option but this would require the tentacles of the QFE’s and other product providers to be released from around their distribution networks. Win the advisers favour by providing appropriate products and service that supports the adviser to service their clients and recognise that it is the advisers that should be the clients of the product providers and the consumers that are the clients of the advisers.
On 17 October 2016 at 12:34 pm doomben said:
I am not sure why you would think a “best interests” duty for Investment Committees would make any difference.

As you point out, fund managers already have a similar duty to their clients.

But I have never once heard of a fund manager closing their fund on the basis they are not meeting their duty because there are better funds their clients could invest in.

Yet as Brent never tires to point out, many managers are rubbish and what they are doing is not in the client's best interest.

The same would happen with Investment Committees.

Without some "smoking gun" email trail, how would you ever prove an Investment Committee using in-house funds was not doing so believing it was in the client's best interest?

And if you separated funds from advice, I suspect all that happens is the biggest brand/advertising budget (=banks) wins anyway.
On 17 October 2016 at 1:24 pm John Berry said:
Comprehensive Planner - thanks for commenting. I agree completely that separating the manufacture of fund product from sales/distribution would be the optimal solution. If we were setting up a new financial system, from a consumer perspective there would be no vertically integrated providers.

However the vertical model is now deeply embedded in NZ. I think a more realistic outcome for consumers is to lift provider duties so they can't simply default to distributing in-house product. The exception being where a provider is happy changing "adviser" titles to "salesperson"....
On 17 October 2016 at 1:36 pm Simon Hassan said:
As (I think) the last OECD jurisdiction to regulate financial products and services New Zealand has a great opportunity to get it right.

The laws that govern the conduct of financial markets and advisers have entirely appropriate and commendable purposes:

1. promoting ‘the confident and informed participation of businesses, investors, and consumers in the financial markets’ and of promoting and facilitating ‘the development of fair, efficient, and transparent financial markets’ (Financial Markets Conduct Act 2013, section 3), and also of

2. promoting ‘the sound and efficient delivery of financial adviser and broking services,’ and of encouraging ‘public confidence in the professionalism and integrity of financial advisers and brokers’ (added in Financial Advisers Act 2008, section 3).

All the right words: ‘confidence’, ‘participation’, ‘fairness’, ‘efficiency’, ‘transparency’, ‘soundness’, ‘professionalism’, and ‘integrity’.

So what are we doing now?

First, let’s remember that – at the 11th hour: just before the enactment of the 2008 law; and under significant lobbying pressure from banks and other institutional providers of financial product who employ people to ‘distribute’ (sell) these products – the definition of affected financial advisers (currently called 'authorised') was drastically narrowed – from several times this to fewer than 2,000 – and then with significant relief for those who worked for a big institution (cos everyone knows they only do right: year right!).

So what are we up to? We are reviewing our new laws – after an initial shakedown period. Sound like a good idea.

So how will proposed changes foster ‘confidence’, ‘participation’, ‘fairness’, ‘efficiency’, ‘transparency’, ‘soundness’, ‘professionalism’, and ‘integrity’?

Let’s see.

But if I was running the review I'd say - with a fair transitional window (2 years?), I’d want the law to require:

those who refer to themselves as ‘financial advisers’ to provide advice in the best interests of clients (as fiduciaries) – and if they are employees, for their employees to empower and require their advisers to place clients’ interests ahead of the interests of their employers; and

all others who assist consumers with financial decisions to describe themselves clearly and accurately as ‘agents’, or ‘salespeople’ for their employers, and to tag any advice or guidance with an appropriate health warning.

That way, who knows, we may get what we say we want! Confident and informed participation, the development of fair, efficient, and transparent financial markets, sound and efficient financial services, professionalism and integrity.

Wouldn’t that be nice!
On 17 October 2016 at 4:19 pm Brent Sheather said:
Hi Simon

With due respect I don’t think your suggestion will work at all….at least if we define “work” as getting a better deal for Mum and Dad. Disclosure doesn’t work so agents just need to smile and say nice things and Mum and Dad will disregard any health warning …..and remember only 5% will read that anyway. The only way to get a proper advisory industry is to reform finance from the bottom up and that means splitting investment banking from retail banking i.e. throw vertically integrated businesses out the window along with commissions, CDOs, ethical investment, finance company debentures etc etc. Both the US presidential candidates have made noises that they will look at some version of Glass Steagall which is all about eliminating the conflict implicit in having investment banking and retail banking under the same roof. Note that they are looking at eliminating conflict not “managing” conflict. Everybody knows that anyone who talks about “managing” conflict can’t be trusted. That’s Stage 1 finance.

By the way if someone said that I wasn’t doing a good job, that my business model was broken I would be defending myself on Good Returns. The silence from the FMA is deafening which is not surprising because it is very hard to defend the indefensible.

I do feel sorry for the FMA executives because it must be difficult to do the right thing i.e. regulating bankers properly when Government and your board is full of bankers. At least the rest of the world is moving in the right direction….even Theresa May is saying the right thing now and the FCA has a new swagger. With Elizabeth Warren a close confidante of Hilary maybe we are seeing the beginning of the end of bad regulation.

Brent Sheather
On 18 October 2016 at 3:20 pm Simon Hassan said:
I agree in principle, Brent. And certainly a 'clean sheet' total separation of products from advice would be the shortest cut route to clarity for consumers and a trusted advisory profession. And it would certainly work for our business.

But I'm not sure it wouldn’t do more damage than good to investors - in aggregate - along the way.

The issue is a global one. Michael Kitces provides an excellent analysis of the issues around investment advice/sales remuneration in the US in a post ‘The Transformation of the 1% AUM Fee – From Levelized Commission to Fee for Advice’ on his ‘Nerds Eye View’ blog today.

So advisers, product providers, regulators and consumers are dogged by the same issues around the world.

In the US two types of investment advisers are gravitating from different directions towards an annual fee model, typically of 1.0% pa. But the fees are for different things:

1. One group is independent and charges its fees for ongoing advice and related services. They don’t have ties with product providers and the products they provide are essentially ‘fee.’

2. The other group (formerly brokers and salespeople) are employed by, tied to, or otherwise in a relationship with product providers. Their ongoing fees essentially replace what they used to get in brokerage/commissions for selling products, bundled together with related services and ‘advice.’ Their 1% is made up of 0.75% as a 'levelised’ replacement of what used to be an initial sales brokerage or commission, plus 0.25% to replace the old 0.25% trail commission.

In New Zealand much of the second group is still remunerated by commissions, which have still not been outlawed here.

One might think the market could sort things out, but consumers have trouble distinguishing one kind of 'adviser' from the other - a task made more difficult by the way the regulatory maze complicates things.

In time I think the market COULD sort things out. But I strongly doubt that it could do this without significant help from the regulator (setting minimum standards) supported by a genuinely professional body (developing and promoting professional standards, working with educators and providers of credentials, supporting financial literacy initiatives, advising the regulator, and promoting aspirational goals).

Structural change is required – and sooner rather than later. The damage being done by persistent confusion in the market, and conflicted advice models, continues to undermine trust.
On 19 October 2016 at 9:34 am blogger billy said:
Brent is right in that the FMA executives are lorded over by a government appointed board full of bankers. But I don’t feel sorry for them - their job is to put the consumers of NZ interests first and they are not.

It would be good if just one of them stood and showed some intestinal fortitude.

BUT we can do something as it’s election year and the govt majority is around zero.

I think they would wilt/even panic if they thought 4,000 to 5,000 NAFA’s might decide to vote for Winston (I gather he does not love the Ozzie banks)

I remember a while back when our local MP was not helpful when we were battling NZTA for a roundabout. He quickly jumped to our aid when he saw that our campaign had a high level of local support aka his voters.

So we ALL need to tell
that National wont be getting our votes unless the revolving doors are closed.

I have already done so

What a great time to bring Elizabeth Warren in election year – ideally May next year.

National won’t be happy if she gets some traction and even worse, some good press coverage

We can do it, chaps, just pledge some money and also ask your professional body to stand up

Be it SIFA, PAA, IFA or whoever. Lobby them. A lot.

Remember this is not for us, but it is in the best interests of the NZ mums and dads.

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