Scrutineer: So far, so good – but there are pitfalls in new rules on IFAs

Published on Sunday 28 June 2009 21:28

NEW rules to outlaw commission payments to independent financial advisers, outlined by the Financial Services Authority (FSA) last week, have been warmly welcomed.

The commission-based selling of investment products has come under increasing fire. The system long exposed IFAs to the charge of recommending products on the basis of commission paid rather than what was in the best interests of the client.

When you are choosing to invest in an Isa, or start out on saving through a pension plan, you want to be sure you are getting the best and untainted advice, not simply being sold the investment plan that best rewards the financial adviser.

The proposed change to an upfront fee-based system, set out as part of the FSA's Retail Distribution Review, is intended to rebuild trust and confidence in the retail investment market. It seeks to achieve this by introducing more transparency and impartiality at the point of sale.

So far, so good. But the problem here is that the switch to upfront fee payments opens up new problems of its own.

Commission payments, for all their stealth and opacity, spread the payment of IFA fees over the period of the client's investment.

One unintended consequence of the proposed new system may be a fall in the sales of long-term saving and pension products.

A second may be that investors will seek to avoid upfront fees by opting out of the advisory route altogether and making pension and investment decisions on their own.

The new system runs the risk of investors making unsuitable long-term investment decisions that may prove far more costly than the advice fee saved.

A third problem is that it may have the effect of pricing investment advice beyond the reach of less wealthy savers, particularly those starting out on the investment road.

I am broadly in favour of these new proposals by the FSA. They should mean that many savings products that currently do not pay commission, such as National Savings, government gilt-edged stock, exchange traded funds and investment trusts, will now be on a level playing field and that advice IFAs give will be free – and be seen to be free – of commission bias.

But the road to commission-free retail investment is far from straight and untroubled.

The most pressing concern is the disincentive effect that upfront fees may have on the retail investor, at a time when the need to encourage long-term saving has never been stronger.

It is a truism in this business that savings products do not sell themselves. They have to be sold to a market where savings commitment is a residual, to be found near the bottom of the list of regular household outgoings and commitments.

In a world that is "free" of commissions – and they can range up to 9 per cent on some products such as investment bonds – how many clients will readily accept an upfront advice fee?

That may open the door to a more virulent strain of mis-selling, where the retail investor is targeted directly by product providers without the intermediation of an IFA.

Moreover, the commission payments also cover the cost of client servicing over the lifetime of the investment. A good IFA is for life, not just for the initial investment decision.

One of the central requirements of an IFA's work today is "know your client". This is an obligation to ensure that the IFA is aware of the totality of an individual's circumstances – income and outgoings, risk tolerance, other investments and financial commitments – so that any new contracts fit best with an individual's circumstances and can be entered into with confidence.

I would say that in a very large number of cases – most certainly a majority and including myself – this is as much a journey of discovery for the individual investor as it is for the IFA.

The removal of commission bias does thus not remove all the risk to an investor of making the wrong or inappropriate choice. Indeed, with some product providers, there is every possibility of the risk being intensified.

Another problem is how the new regime will treat proxy or "ghost" commission – the provision by product providers to IFAs of services or professional benefits in lieu of cash commission.

This is an area which could influence IFA recommendations but about which individual customers will know nothing, but still end up paying for.

What might constitute a hidden commission in the new world of upfront advisory fees? And how would such commissions be policed?

There is much to welcome in calling time on commission payments. But there is much still to be sorted out before we can be sure the new world will really be an improvement on the old.