In an address to the Advocis symposium, Ontario Minister of Revenue John Wilkinson urged financial advisors to adopt a system of self-regulation. He argues that fraud is rare and self-regulation is better than government-imposed regulation. (Thanks to Preet at Where Does All My Money Go? for pointing me to this story.)
While eliminating fraud is a worthwhile goal, outright fraud is not the major problem we have today among financial advisors. The real problem is systemic. Conflict of interest rules this industry. Until the system is fixed, neither self-regulation nor government-imposed regulation is likely to help.
To defend these claims, let’s start with a small story about a couple in my extended family who changed their lives by uprooting themselves and moving to a warm country with nice scuba diving. I prefer not to name the country, but it has been declared the most corrupt nation on earth in the past.
Among the many amusing stories of life in a different country, this couple explained how all services seem to require bribes. Opening a bank account, arranging for telephone service, and just about anything else requires a bribe for the clerk. Bribes are so deeply ingrained in the culture that the bribe amounts are standardized and posted on the walls. At some point, they stop seeming like bribes and seem more like service fees.
In the same way, for those of us who understand how most financial advisors are paid, the system seems normal. But if we take this system to a new context, the problem becomes evident. When a politician awards a $25 million contract to a firm that then kicks back $250,000 to the politician, we are properly outraged. But when a financial advisor recommends mutual funds to a client who doesn’t understand that the advisor will collect a substantial commission and possibly yearly trailing commissions, it all seems normal. One big difference between the politician and the financial advisor is that the politician’s actions are illegal, but beyond that, they look very similar.
Some may argue that commission-based models for salespeople are a way of life. This is true, but financial advisors don’t look like salespeople to most of their clients. We expect the guy at the electronics store to push us to buy a big-screen television because he wants his commission. But, financial advisors look more like lawyers or accountants to their clients. These clients have a right to expect objective advice. Instead, our current system encourages financial advisors to recommend whatever investments pay the greatest commissions. What’s worse is that many of their clients have no idea this is going on.
One step in the right direction would be proper disclosure of fees to clients. Currently, fees are disclosed in percentage terms with confusing language. Better disclosure would be for the advisor to take the amount of money the client will be investing and show the client how much money (in dollars) he or she expects to pay in fees over the upcoming decade based on the investments the advisor is recommending.
Wilkinson says that the relationship between advisor and client should be based on trust. I agree wholeheartedly. Unfortunately, the current system does not encourage advisors to act in a way that is worthy of this trust.
These problems don’t mean that all financial advisors are dishonest. In fact, a great many advisors work very hard to do what they think is best for their clients. These honest advisors are no doubt discouraged by the actions of their less honourable colleagues. Good advisors do their job well despite the system not because of it.