Restricting Investment Sales Inducements: Impact of Reform, Other Mis-selling Solutions

Categories: Fiduciary Duty, Standards, Ethics & Regulations (SER)
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In recent years, a number of markets have launched initiatives to improve access to financial advice by bringing greater transparency to the financial advice industry and addressing the problem of mis-selling. These initiatives have included improvements in the clarity required of financial advisers in reporting fees and conflicts of interest or, in some cases, limits or bans on inducements (payments, commissions, gifts, or kickbacks associated with the sale of investment products, often paid to advisers by distributors). Other markets are still in the evidence-gathering and decision-making stage, contemplating how best to increase the quality, availability, and independence of investment advice locally and reduce the risk of mis-selling.

In our recently released paper, Restricting Sales Inducements: Perspectives on the Availability and Quality of Financial Advice for Individual Investors, we explore the current state of play in markets that have decided to ban inducements, such as the UK and Australia, and others that have opted for increased transparency in lieu of an outright inducements ban.

Most of the reforms around inducements have taken place in the past few years. Investor behavior and response to new products and advice schemes are not entirely predictable, and reactions in markets where reforms have been introduced should be closely observed. Regulators and lawmakers in markets considering inducements reforms in their markets would do well to pay attention to the consequences — intended and unintended — of inducement reforms already implemented in other markets.

We find that in markets that have banned inducements, larger financial institutions are moving away from providing advisory services to smaller clients because of a lack of economic incentive to serve those clients. There is a concern among CFA Institute members that such middle-market retail investors will not have proper access to financial advice.

In markets that ban commissions (inducements), new platforms with direct-to-consumer or low-cost/low-service investment options are expected to proliferate. This shift may result in aggressive direct-to-consumer advertising of financial products, a practice that may lead to instances of inappropriate investments sold to retail clients without proper oversight.

A lack of proper enforcement of existing rules meant to combat mis-selling and inducement abuses is also a problem because a number of regulators lack either the resources or the ability to enforce investor protections already in existence.

Retail investors tend to prefer a commission model to a fee-for-service model, which complicates the move toward fee models in markets that have banned commissions and may result in a large underserved population. This preference for a commission model often arises from a misunderstanding of the fees charged through inducements or commissions. Often investors think financial advice paid through inducements is free. Investors also often fail to understand just how much they are paying advisers, whether they are operating under a commission or a flat-fee structure. Greater transparency requirements and more investor education will help investors make better informed decisions.

Transparency should be part of any solution aimed at addressing mis-selling because simplified disclosures that give investors the information they need to make informed decisions can only improve the investment experience. Transparency should start with fee transparency, including a more informative breakdown of the fees that investors pay. Investors need to be informed about all the fees that they are paying and about the origin of each of those fees (from the adviser, the distributor, or any other participant). It is also important to pursue uniformity in fee disclosures across jurisdictions to allow comparability of fees across markets, especially in the EU, where cross-border financial transactions are more common.

In a survey of CFA Institute members on inducements (which can be found in the appendix of the report), the two most popular solutions to mis-selling that did not involve inducement or commission bans were:

  1. revising commission structures to eliminate those that encourage volume sales (tiered commissions)
  2. setting equal commission levels (as a percentage of management fee) for all products in the same category

We encourage financial advisory firms to explore such reforms as self-regulatory mechanisms that can address some of the conflicts of interest in the adviser–client relationship without the need for outside regulatory forces. CFA Institute members also stressed the importance of improving transparency and disclosure and were wary of any policy reform that would diminish the incentives to open distribution networks or reduce the accessibility of investment advice for small retail investors.

Finally, we also encourage financial advisers to invest in consistent and quality adviser training focused on fulfilling the needs of the client so that advisers can better understand their clients’ goals and choose better products to help them reach those goals.


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Photo credit: iStockphoto/MHJ6

15 comments on “Restricting Investment Sales Inducements: Impact of Reform, Other Mis-selling Solutions

  1. I think it is a good start of the financial advisers fiduciary obligation towards their clients. With all greater transparency of the financial advice and also the mis-selling of the investment products will be minimal, if not totally eradicated. This gives the clients more opportunity to really have more idea on how much fees, commissions, payments, gifts, and kickbacks associated with the sale of investment products they are paying for to their advisers. These initiatives will definitely have impacts and improvements in the clarity required of financial advisers.

  2. Matt Orsagh, CFA, CIPM said:

    Thank you for your comment. It is still early days as far as regulators and policy makers addressing the inducements issue. The coming years will tell us whether inducement bans or enhanced transparency works best in protecting investors.

  3. Tom Scholz said:

    Excellent article, Matt. I hope we as an industry can shine a light on inducements because I am somewhat is disbelief that inducements are allowed and so commonly used. I am glad that you and the previous commenter used the word “kickback” because that is what most inducements are.

    • Matt Orsagh, CFA, CIPM said:

      Inducements is an issue that seems to be at top of mind in many markets. Most of this activity is in Europe for the time being (as you can see from the report), but markets such as Canada and Australia have also tackled this in the recent past. It remains to be seen whether the issue rises to the top of mind for investors and policymakers in the US as the issues surrounding the financial crisis fade into the background somewhat.

  4. Dan Carroll said:

    The US is so far from an ideal model for the client that it is hard to believe that we can get there. The sales cultures in our leading institutions reward people all the way to the senior management for doing what is best for the company and the the sales revenue. Fiduciary models exist, but their are fewer than 30 years ago, and where they exist, at least in traditional banks and trust organizations, managements have weakened the fiduciary cultures by introducing sales incentives for the most profitable products or services. Better transparency, performance reporting(before and after fees, comparisons), and investor education would help. Buyer beware continues to be the best advice for all of the clients.

    • Matt Orsagh, CFA, CIPM said:

      Yes, incentives at all points along the chain need to be addressed to better align the interests of investors and their advisers. Transparency helps, but investors need to know what to do with that information in order to ensure that their best interests are being served.

  5. Mark Jasayko, CFA said:

    In addition to educating investors on a fee-model (based on AUM), there should also be education on the inherent conflicts involved in binding advice to a commission model (misplaced incentives, lack of goal congruency between the investors and the advisor, and that “commissions” are more about the “price of access” to an investment, not primarily about access to objective advice).

    • Matt Orsagh, CFA, CIPM said:

      We agree. Investor education isn’t just about fees, but to find out to what extent the incentives of an adviser are aligned with the interests of their clients.

  6. Donald Steinmann said:

    This is a deep and complex problem. First you have an industry that is totally profit driven. 2 and 20 fees. Internet stock funds introduced in 1999. Stocks brokers fighting to the death against a fiduciary standard. It’s all about lining the pockets of our industry with limited evidence we are providing *any* value. With apologies to Gordon Gekko, greed is not good. The argument that smaller investors will be underserved by these regulations is nonsense. They are underserved already. Most investment advisors won’t talk to someone who has less than $500,000 in investible assets.

    But the client is also culpable. They don’t understand what their investments cost, and they do not want to know. It’s complicated and boring. It’s like oil changes. This car needs it’s oil changed every 3,000 miles and this one is 10,000. Why? We don’t know and we don’t care. We just want our car to run. Clients just want to make money. A client who makes 7% a year will probably be just as happy as one who makes 8% a year. That the other 1% goes into their ‘advocates’ pocket, they don’t understand and don’t care.

    Here is the fundamental problem with our industry as a ‘profession’. If I sit down with a CPA, he will do his best to save me money on my taxes for his fee. He may do a good job or a bad job, but he’ll do his job. But when I sit down with an investment professional, I have to ask the question “What’s in it for him?, Is he doing the best for me of the best for himself and his firm?”. Until we can remove that fear, our industry has a long way to go.

    I believe this means we ought to do a radical rethinking of how our industry operates and how everyone is compensated.

    • Matt Orsagh, CFA, CIPM said:

      Investor education and better aligned incentives both need to be part of a solution to combat mis-selling. There is no magic bullet. We have seen that in markets that ban inducements, firms are moving away from servicing smaller clients. So whatever level of service those clients are now getting is likely to fall if inducements are banned.

  7. There is an inherent agency problem when inducements of any type are used to compensate those who purport to give advice. Can any serious investment practitioner deny this with a straight face? The idea that misselling can be corrected with improved transparency or more uniform disclosures is enticing but ultimately not enough. Realigning sales incentives is necessary to curb abuses. As long as commission rates are variable across asset classes and products, and salespeople are permitted to masquerade as advisors, abuses will persist.

    • I have worked for a brokerage firm helping retail representatives select investments to sell to their clients (not necessarily wealthy clients) and now have my own firm working mostly with individual investors (mid-level incomes.) Certain products are sold with commission and certain products are sold with advisory fees. I disagree with several of the respondents who believe payout alone determines the products sold. We can sell either so what is right for the customer is what determines the sale. With commissions you earn more immediately and with fees you earn more over time.

      The largest abuses I have seen are due to lack of education and/or ethics of some sales representatives. Being able to sell doesn’t necessarily mean you are educated enough in our business to do so. Currently, people who are selling index annuities with just an insurance license are great examples of this. There are stories of them going door to door in retirement communities in Florida where I live. These individuals are often new to the business and give all of us a bad rep. People who only have insurance licenses believe that insurance is appropriate for anyone. People who only have advisory licenses believe that money management paid with advisory fees is the only way to go and their clients also miss out on investments with guarantees that could secure their retirements. It seems that people who work with the public should have a diversified product mix which could include a diversified payout structure as well. Our broker/dealer does look at our mix of products to make sure we are not abusing. Unfortunately I do not have any great ideas on how to regulate intelligence and experience.

    • Matt Orsagh, CFA, CIPM said:

      Thank you for your comment. In our survey of members, realigning incentives was given a high priority for addressing mis-selling issues. We are interested to see which jurisdictions that are currently addressing mis-selling and inducements adopt such measures.

  8. Raimondo Eggink, CFA said:

    I fully agree with Donald Steinmann: “the argument that smaller investors will be underserved by these regulations is nonsense”. Indeed, under the existing model of kickbacks, the portfolio of a small investor generates a small kickback. The cost of serving him remains the same though and that’s why the small investor is and will remain underserved. The problem is mainly about client preferences and their aversion to explicit payment for advice.

    I would like to highlight another issue, which seems to be absent from the discussion. There exist examples of fund managers who have good products, but will not make them available on a low-cost/low-service basis (e.g. fund supermarkets) in order not to alienate their intermediaries to whom they pay kick-backs and who generate the bulk of their volumes. In some markets this results in a suboptimal product offering for affluent investors, who do not need advice or get it elsewhere. Furthermore this may create another barier of entry for innovative fundmanagers who do not wish to engage in the misselling game.

    • Matt Orsagh, CFA, CIPM said:

      You bring up a good point. Transparency about these relationships could be helpful. Some of those products offered may or not be the best option for an investor, but they should be able to understand whether there are any kickbacks involved and how significant or nominal they are, in order to make the most informed decision.

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