‘Never trust an IFA, they are commission-grabbing ******s.’
This is a typical comment on Citywire’s forums – often underneath one of my articles – and seems fairly representative of the average Citywire reader’s opinion of Frankly, many of those in the industry have only themselves to blame for this shoddy reputation. Although I have come across many fantastically professional, diligent and honest individuals during my career, I have also met my fair share of salesmen only interested in earning the maximum commission.
Despite this, I believe financial advice is severely undervalued in this country. The value it can add, both in pound-note terms and in terms of comfort and confidence, is seriously underestimated.
I normally write about investment matters, but I thought it was time I set the record straight about our industry, the sharp practices to look out for, the changes that are afoot, and the value that good-quality financial advice can add.
It’s all about incentives
As anyone who’s ever read Freakonomics can tell you, people respond to incentives whether consciously or unconsciously.
Commission is an incentive that misaligns the interests of the client with that of the adviser (salesman). A commission-based adviser’s objective is to sell a financial product since he or she will not be paid otherwise. This product may well meet the client’s objectives, but it may not. The commission incentive ensures that client and adviser have a different objective.
If paying by fee, the adviser gets paid whether or not a product is sold. A fee-based adviser is much more likely to recommend a client keeps their money in cash, or uses it to pay off a mortgage, for example.
Commission has been a major component of almost every mis-selling scandal, whether it involves IFAs or not. For example, the Financial Services Authority (FSA) recently expressed concerns about how poorly constructed incentive schemes caused mis-selling of payment protection insurance (PPI) at banks.
Luckily, commission is about to be banned under the retail distribution review (RDR). This comes into play from the beginning of 2013, and will go a long way to cleaning up our industry.
However, an inappropriate fee structure can also wrongly incentivise advisers or discretionary managers. For example, a typical trick by many wealth managers is to charge a relatively small annual management charge, but also charge, say, £25 for each trade.
This gives firms an incentive to trade, which might not necessarily be in the clients’ best interests. At Equilibrium we worked out that a single switch (which remember is actually two transactions – a sale and a purchase) for all our clients could earn us £200,000 if we charged £25 per trade! That is an incentive we do not want to have.
Even after RDR you will need to think carefully about whether the fee structure being proposed offers an inappropriate incentive.
The value of advice
Although it is important to be aware of the potential for sharp (or just poor) practices, professional financial advice can be invaluable.
Financial advice covers a wide range of areas, but quality advice can, among many things:
- Reduce the amount of tax you pay, whether that be on income or gains from investments.
- Help protect your family against the unknown with appropriate insurance.
- Help you plan for the future, knowing how much you need to save for retirement and work out when you can afford to retire.
- Reduce inheritance tax on your estate.
- Build appropriate investment portfolios to match your risk tolerance and objectives.
Most Citywire readers have as much chance of selecting decent investment funds as the average IFA. Unfortunately, selecting a good fund manager is a fairly minuscule piece of the investment jigsaw, with asset allocation accounting for more than 90% of the variance of investment returns. Quality investment advisers therefore focus on asset selection rather than fund selection.
Do advisers avoid investment trusts?
One myth that I consistently see repeated on Citywire forums is that advisers only recommend investing in unit trusts or open-ended investment companies (Oeics) instead of investment trusts. They do so – so the story goes – because they get paid trail commission.
Quality advisers who use wrap platforms rebate trail commission back to their clients. They also get a discount on annual management charges, which makes unit trusts similar in cost to investment trusts, often cheaper. We find that the discounts we can obtain on funds often pay for a large part of our fees.
After RDR, trail commission will be banned, and to call themselves independent, advisers will have to consider investment trusts, exchange-traded funds (ETFs) and a much broader spectrum of products as well as unit trusts.
Some may decide they haven’t the time or resources to review all the relevant types of investment. These advisers will no longer be allowed to call themselves ‘independent’, but rather they will offer ‘restricted’ advice.
The RDR also means advisers must now achieve a much higher level of qualification before being allowed to give advice. The previous benchmark for financial advisers was the Certificate in Financial Planning. This was a level-three qualification. From next year, all advisers must be qualified to level four as a minimum. All advisers will also have to sign up to a code of ethics and be a member of a professional body.
To be sure of professionalism, look for chartered financial planners who have qualifications equivalent to degree level. Chartered financial planners must also have a certain amount of experience and carry out a set amount of learning each year to maintain their chartered status. The same can be said for certified financial planners, although their qualification is equivalent to the first year of an undergraduate degree course.
Frankly, most quality financial advisers can’t wait for these new rules to come into play since this will force the unscrupulous and the unprofessional to either clean up their acts or go out of business.