The use of commissions to remunerate financial advisers in Australia has been extensively debated. This debate came to a head when commission payments on superannuation and investment products were banned by 2012’s Future of Financial Advice Bill.
The Final Report of the Banking Royal Commission has further fanned the flames by explicitly calling for the banning of grandfathered arrangements, while recommending the government consider banning life insurance commissions altogether at the next scheduled ASIC review in 2021.
At the heart of these reforms and recommendations is the belief that commission-based remuneration models represent a conflict of interest whereby advisers are incentivised to prioritise their own remuneration above their client’s needs. The defence of commissions often centres upon the argument that they ensure an important service is pro-actively promoted to consumers – particularly in the case of life insurance. While these arguments are often presented, they are usually framed as unimpeachable truths, though they are rarely accompanied by verifiable evidence.
In March, wealthdigital released a white paper which projected a future for the advice industry in which commissions are completely banned. But should that be case? What has independent research into the influence of commissions found? This month’s wealthdigital Industry Insights looks to peer-reviewed studies in an attempt to determine whether commissions are a positive or negative influence on financial advice.
The theoretical models
The common starting point for academics when looking to answer a complex behavioural question is to create a theoretical model. This allows the outcomes of surveys and studies to be analysed using a commonly understood range of causes and effects.
The pioneering work in the field of advice remuneration was performed by European economists Roman Inderst and Marco Ottaviani. Those with a background in mathematics can read their initial paper here. A heavily simplified analysis of their model is that differences in commissions between products, the strength of adviser research, potential punitive ramifications for poor advice and the naivety of clients all inherently influence the likelihood of an adviser providing good advice to a client.
Inderst and Ottaviani found that, where a client is naïve and is unaware of commissions paid to the adviser, there is no incentive for the adviser to take direct fees over commission, and hence be required to exert maximum effort in providing advice. By contrast, they found that informed clients who know about commission structures factor in potential biases in the advice and use this to ensure their adviser provides well researched and argued recommendations. If the adviser wants a higher commission, an informed client ensures they justify it. Inderst and Ottaviani concluded that banning commissions may, in fact, reduce the quality of advice to informed clients.
Inderst and Ottaviani’s research was built upon by Janko Gorter as he conducted research for the central bank of Holland. Gorter found that, where advice may be provided by both product providers and independent advisers, informed clients would exclusively seek advice from an independent source and naïve clients from the product provider. In this case, the naïve clients would be better off seeking advice from the independent source, however they overestimate the quality of the advice provided by the product provider.
German economists Jörg Schiller and Markus Weinert used Inderst and Ottaviani’s model to look at an advice environment where fee-for-service advice is the only option. They concluded that, even in a strictly fee-for-service environment, advisers are still incentivised to provide biased advice by the time cost of persuading clients to make a decision, particularly when clients have a pre-conceived notion of the best product for them. Schiller and Weinert also found that advisers paid on a fee-for-service basis still have an incentive to give poor advice to naïve clients, however increased competition in a marketplace reduces this incentive.
Ultimately, theoretical models developed to date have found that uneven commissions between products do create incentives for advisers to give poor advice to clients. That said, fee-for-service is not free of conflicts of interest either.
These conclusions were, however, all derived from theoretical situations. Real-world studies provide an important testing ground for the conclusions drawn from hypothetical marketplaces.
All around the real world
There have been a number of population and survey studies done around the world on the impact of commissions on advice quality. Unfortunately, other than ASIC reports (which contain their own inherent biases), we found little, if any, meaningful research conducted in Australia.
Are advisers swayed by commissions?
US-based academics Santosh Anagol, Shawn Cole and Shayak Sarkar, conducted a study in India where life insurance agents were “shadow-shopped’ by auditors using fictional life situations. Their study judged agents’ recommendations on how much term life cover, versus how much whole-of-life cover, the agent recommended. In the Indian context, whole-of-life policies were more appealing to agents as the commission rates were higher, while a combination of interest-bearing accounts and term life cover better suited most clients.
They found that the insurance agents routinely recommended too much of the higher commission, lower value option. They also found that agents tended to favour recommendations the clients already believed were correct, even if this belief was false. The study did note that the quality of agents’ advice improved if the client claimed to have received poor advice from another agent previously.
Jirí Šindelář and Petr Budinský examined the impact different commission structures had on advice in the Czech Republic. Šindelář and Budinský used data provided by eight independent advisory companies on over 10,000 transactions. The transactions were assessed for the quality of client outcomes. They found that higher commission rates resulted in poor client outcomes in only a small minority of situations. Šindelář and Budinský’s findings provide an interesting counterpoint to those of Anagol, Cole and Sarkar.
Are commissions the only cause of poor advice?
Juhani Linnainmaa, Brian Melzer and Alesandro Previtero, a trio of academics in the US, analysed the trading habits of Canadian investment advisers. They used extensive data (covering over 5000 advisers and 500,000 clients) from Canadian investment managers to identify poor advice. The study tracked indicators of poor advice such as frequent trading, using expensive, actively-managed products, return chasing, home bias and preference for growth over value. They used these markers to determine whether the apparent motivator for switching trades was client benefit or higher, commission-based remuneration. Their study also compared the transactions on the adviser’s own portfolio to those of their clients.
Limmainmaa, Melzer and Previtero concluded that only in a small fraction of trades (less than 2.5 per cent) did the adviser benefit and the client not benefit. The fraction is even smaller (less than 1 per cent) where the adviser benefited and it cost the client for no benefit. Furthermore, it found that while poor advice was relatively common, there was a strong correlation between the adviser pursuing the poor behaviours on their own investment portfolio and recommending those same behaviours to their clients. In essence, they found that poor advice was more commonly motivated by the adviser’s flawed investment strategies than by conflicted remuneration models.
If you take commissions away, do clients stop seeking advice?
In 2017, Dutch authorities banned commission-based payments on mortgage advice. Academic Marc Kramer used a survey to examine the impact on consumer behaviour of the this ban.
Kramer surveyed over a thousand people to determine whether they would seek advice, or an execution-only service when purchasing a mortgage. He randomly assigned the surveys, with roughly half outlining a scenario where the client pays a higher interest rate when advised (with a commission going to their adviser), and the other half paying upfront fees which are higher when receiving advice than when using an execution-only service.
Kramer found that the proportion of clients seeking advice dropped from 67 per cent under the commissions-based scheme to 55 per cent when an upfront fee is payable. Kramer applied subgroups that used variable sizes of commissions and upfront fees and found that the higher upfront fee, the lower the percentage of clients seeking advice. Furthermore ,he aimed to ascertain the financial literacy of the respondents using a survey and found that, generally, the more literate the client, the bigger the drop off in advice-seeking under the upfront fee arrangement.
Is conflicted advice better than no advice?
John Chalmers and Jonathan Reuter examined the value of receiving potentially conflicted advice over no advice at all. Chalmers and Reuter looked at investment results for members of the US-based Oregan University System’s Optional Retirement Plan. The plan provided data on the outcomes for members who used commission-funded, broker-recommended portfolios versus those who chose self-directed options.
Chalmers and Reuter found that clients with brokered portfolios paid higher fees and earned lower risk-adjusted returns than clients with default, lifecycle portfolios. Their study also found that brokers tended to recommend funds that pay higher broker fees.
Most research finds that commission-based adviser remuneration has some detrimental effect on the quality of advice provided to clients – albeit often only a small one. That said, the studies outlined in this article have found that advice quality can be significantly improved by increasing competition, educating clients, increasing punishments for poor advice and better training advisers. Interestingly, these four solutions have all been considered or implemented in various quantities in the Australian market.
Studies also find that replacing commissions with upfront fees will reduce the number of consumers who seek advice. Furthermore, fee-for-service models are no panacea, and carry their own incentives to provide less-than-ideal recommendations.
The conclusions drawn by the research conducted to date are still debatable, and further independent studies are essential to inform the direction of the industry, particularly in Australia. History shows that, just because something sounds true, doesn’t mean it is. It is important that the industry and its regulators are well informed before they start pursuing the financial equivalent of miasma theory.
Ultimately, studies only represent trends, averages and means. Individual adviser-client interactions occur every day and the quality of advice provided is in the hands of the planner themselves.