A structural problem at the heart of financial planning

Financial planning has long had two major problems, and the intersection of the two problems is where the action is. The Royal Commission into banks is merely uncovering what most people in the industry have known for a long time.

Problem 1: Do Financial Planners provide advice or sell product?

If I go to a used car salesperson, I expect them to try to sell me whatever they have in stock regardless of what I need. If I go to see a mechanic, I expect them to solve the problem with my current car - not to try to sell me a different car.  There is little confusion.

Financial planning customers think they are seeing a mechanic who will fix their finances, but banks and financial planning companies reward planners like used car salesmen – the more you sell the more you earn. And if the royal commission has confirmed anything, it is that incentives matter.

If you reward your planners like used car salespeople, then natural selection will lead to the planners who are the most like used car salespeople staying, and the best mechanics leaving. I have seen plenty of good planners languish at the bottom of the bonus tables while the planner who owns an expensive suit, hearty laugh, strong handshake, loud voice at the pub but little else sits at the top.

Problem 2: Not that many people need expensive advice

The average person who is paid a wage, has a standard superannuation account and no complicated legal structures needs very little in the way of advice. For most, an initial boilerplate plan and a courtesy call once a year is enough. Maybe a few hours every five or ten years when they inherit money, get divorced or retire. Let’s call these people “easy clients”.

There are people who do need more complex advice, with trusts, multiple businesses, lots of variation in taxable income and/or international assets. Let’s call these people “hard clients”.

Most planners charge a very similar fee for both types of clients. i.e. the easy clients subsidize the hard clients.

The intersection of the problems

Let’s say you are an executive at a bank or financial planning firm. Your “mechanic” planners don’t make you much money, as they don’t sell enough. But when the royal commission starts, you will be grateful you hired these planners.

Your “used car salesperson” planner who has been busy convincing “easy clients” to sign up to whatever product pays the highest commission is generally going to be OK as well. Sure there are ethical issues overcharging clients, but those ethical issues generally don’t see you in the hot seat at the royal commission. And they probably earned you a six or seven figure bonus most years.

Where it all goes wrong is when your “used car salesperson” planner has strayed into the “hard client” realm. Those are the ones that end up with you in the witness chair at a royal commission.

Solutions?

Hopefully it is clear by now that relying on financial service companies to "do the right thing" is not a solution. It is also clear that this is not a problem with the banks, it is a structural problem in the industry.

One thing that I hate is the current "enforceable undertaking" punishments that get handed out: company pays a big fine, makes either no admission of guilt or a very carefully constructed admission and everyone pretends things are OK.

For example, last year as part of the interest rate rigging scandal, both NAB and ANZ copped a $50m fine each but nothing further. It boggles the mind to work out what crime anyone could commit that would be so heinous as to be worth $100m in fines, but not so serious that anyone should go to jail. 

There are a few solutions that would help:

• Clearly define legally the difference between those who advise and those who sell investment product and don't let anyone try to do both.  
• Change the remuneration structure so that planners charge either a fixed fee or an hourly rate. This is going to require regulation - very few will do this voluntarily.
• Increase the punishment for individuals - jail time should be on the cards. At the moment the equation, if you are planning on doing the wrong thing, is: Upside = million dollar+ bonus, Downside = lose your job, company pays a fine on your behalf. For many, that payoff is attractive.   
• Increase the punishment for companies. If you want to fix behaviour at the company level then you are going to need a much bigger shock than a few hundred million in fines.  Should AMP lose its financial services licence? There are huge risks to financial stability, tens of thousands of shareholders, customers and employees would be gravely affected. But, you would get decades of improved corporate behaviour from the rest of the market.

The two most important questions

1. What would it take for a big financial services company to lose its licence? At the moment, I think the answer is that there are no circumstances which could arise where a big financial services company would lose its licence.
2. What would it take for a lot of people to go to jail? I suspect the number of people who go to jail for crimes to date will either be zero or insignificantly different to zero.

I am hoping that the main things to come out of the royal commision will be changes to the law that will mean that next time people will go to jail and that companies will lose financial services licenses for the types of behaviour exposed at the royal commission. 

If both of these don't happen then I'll see you in 10-15 years at the next royal commission so we can discuss the same topic.

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.