By Nicky Burridge
One of the most divisive issues in the financial services industry is whether financial advisors should be paid through fees or commission on the products they sell.
Those in the fee camp argue the only way investors can guarantee they are being given impartial advice is if they pay the advisor themselves through an upfront fee. Meanwhile, advocates for commission point out that, given the choice, most people opt to pay for advice by commission rather than a fee because being forced to pay an upfront charge would price many consumers out of being able to afford financial advice altogether.
Unsurprisingly, it is an issue that has been the subject of growing regulatory attention in recent years. A number of countries, including the UK and Australia, have banned financial advisors from being paid by commission. Others, such as the Monetary Authority of Singapore, have stopped short of a full ban, but have introduced enhanced disclosure.
Tony Noto, founder of fee-based Noto Financial Planning, has no doubt that paying for financial advice through commission has a distorting affect on the market. He points out that commissions are dangerous in industries, such as medicine and financial planning, where the expert has a lot more information than the consumer and the repercussions for bad advice can be severe.
Noto argues that, in markets where advisors are only paid through commissions, the most popular products tend to be those that pay the highest commission. He warns that the market is further distorted, as instead of competing for investors through product features, such feeas low costs and flexibility, insurers compete for advisor recommendations which leads to higher commissions and, in turn, higher costs for investors. “Commissions have a strong influence on recommendations and anyone accepting them should not be allowed to claim they provide objective, unbiased or independent advice,” he says.
His assertion certainly appears to be the case in Hong Kong, where investment-linked assurance schemes (ILAS) have been one of the most popular retail investment products sold in recent years. While all product providers pay the same level of commission on an ILAS, to avoid distorting the market in favor of a particular insurer, the amount an advisor can earn for selling one of the products is significantly higher than for many lower cost, more flexible investment schemes.
An industry insider, who wants to remain anonymous, showed BENCHMARK the commission formula for an ILAS. For every product sold, the advisor receives the equivalent of 3% of the first year’s premium for each year of the policy’s term in up-front commission. As a result, on a 25-year-plan, into which a consumer paid HK$10,000 a month, the advisor would receive HK$90,000. On top of this, they would receive a so-called override commission, which is an average of 40% of the basic commission, giving a total of HK$126,000. This money is taken directly from the consumer’s investment, meaning that 13 months after starting a 25-year-plan, the investment would be worth just HK$4,000, despite handing over HK$130,000.
Not only does taking out this money in the early years have a huge impact on the performance of the investment – compound returns on the commission would total HK$684,000 after 25 years, assuming annual growth of 7% – but the fact the commission is paid upfront means the advisor has little incentive to offer ongoing advice to the investor.
Problems with fees
While there is significant evidence to suggest paying advisors through commission distorts the products they sell, banning commission can also have a negative impact on the financial services market.
The UK’s former regulator, the Financial Services Authority (FSA), introduced a ban on commission on December 31, 2012 under its Retail Distribution Review, dubbed “death of the salesman” by the media. The FSA itself predicted that a quarter of all financial advisors would leave the industry due to the new regime.
Detailed research carried out by Cass Business School found that the average IFA in the UK would have to have 150 clients from whom they earned £1,472 (HK$18,400) a year in fees in order for their business models to be economically viable under the new regime. It went on to claim that to generate fees of this level, clients would need to have investible assets of £150,000 (HK$1.9 million), something just 2% of the population had. In other words, unless financial advisors significantly changed their business models, the vast majority of the population would no longer be able to afford financial advice. A similar study carried out by Deloitte estimated that 5.5 million people in the UK would either stop using IFAs or no longer have access to them.
Worst still, under the new regime, many banks also stopped offering advice to customers. The FSA found there had been a 44% reduction in bank advisors following the ban on commission, while there was also a 20% drop in so-called tied and multi-tied agents, who sell products on behalf of one or a number of banks or insurers. Two major insurers, Aviva and AXA, withdrew from offering advice altogether, while major High Street player, Lloyds Bank, stopped offering face-to-face advice to anyone with less than £100,000 (HK$1.3 million) in assets.
The message from the UK is clear: while paying advisors through commission may distort the market, banning commission puts financial advice beyond the reach of most ordinary consumers. Rick Adkinson, managing director of fee-based IFA Private Capital, undeniably thinks that something similar would happen in Hong Kong if accepting commission was banned. He says, “While I think fee- based advice is the way forward and is the only way you can deal with people, there are a lot of people out there who can’t afford fees and that means they will not get access to life cover and basic products.”
His colleague, Mathew Bate, adds, “It takes 30 signatures to take out certain products. It would take two hours to go through the application form with the client. For someone who is going to save HK$3,000 a month, it is not worth an advisor going through it with them.” He estimates that it would not be worthwhile for most advisors to work with people earning less than HK$50,000 a month.
Another issue is whether consumers themselves are actually prepared to pay for financial advice. Research carried out for the Monetary Authority of Singapore found that 80% of respondents said they would not be prepared to pay an up-front fee. A similar study carried out in the UK found that nine out of 10 consumers would only pay up to £25 (HK$310) an hour.
The rules in Hong Kong
When Hong Kong’s regulators recently reviewed the issue, they decided to introduce commission disclosure. Unfortunately, Hong Kong’s complex regulatory framework means that different sections of the industry have different regulatory requirements.
The Securities and Futures Commission and Hong Kong Monetary Authority, who between them regulate the sale of investment products by banks and IFAs, introduced a rule under which commission must be disclosed as a percentage or in dollar terms in writing prior to or at the point of sale, regardless of whether it is the firm or the individual that receives the benefit.
This rule also applies to ILAS, even though they are not classed as investment products. By contrast, insurance intermediaries selling ILAS only have to provide an Imp
ortant Facts Statement to their clients, highlighting, among other facts, that they have a right to ask if the intermediary will receive commission from the sale. The intermediary is currently only required to disclose the commission rate if the customer asks them to, although compulsory written commission disclosure is due to be introduced later this year. In other words, there is considerable variation in the commission disclosure requirements depending on who is doing the selling.
So what is the solution? Despite the distorting effects commission appears to have on the financial services market, banning it completely is likely to exclude a significant proportion of the population from getting financial advice.
Adkinson thinks greater transparency and full disclosure is the key. He suggests consumers should be given a sheet of paper showing exactly how much commission the advisor will earn in dollar terms which they would have to sign before taking out a product.
He thinks if people realized exactly how much they were paying upfront on certain products, they would be more likely to start asking what alternatives were available.
Noto agrees, “As long as some companies are allowed to hide their costs, the public is going to have a harder time accepting that financial planning costs anything. Once people realize it’s not free, they are in a much better position to make a judgment on value.” Adkinson also calls for initial product terms to be limited to five years, with the option to extend after this time. This move would increase the flexibility of products, and avoid the distorting impact under which an advisor recommending a 25-year ILAS receives five times as much commission as one recommending a five-year term. He would also like to see regulations simplified, as currently the red tape burden significantly adds to the cost of providing financial advice.
Meanwhile, Noto would like consumers to have a better understanding of what they are actually receiving. He points out that people working for fees are selling advice, while those working for commission are selling products. He says, “I would argue that investors that can’t afford fees should not be misled to believe they are receiving advice.”BM