Lack of clarity, understanding about new financial services act

It’s not enough to ‘manage’ conflicts of interest, they need to be eliminated.

By Donna Nicolof

Many investors are surprised, to say the least, when they learn how things actually ‘work’ in the financial services industry or the detrimental impact this may have on them as investors. We believe a lack of transparency and understanding still exists about what actually occurs around the provision of financial advice. 

The Financial Services Legislation Amendment Act 2019 and the Code of Professional Conduct for Financial Advice Services are now in force. While this will go some way to addressing well-reported issues in the industry, it is unlikely to eliminate the structural issues creating conflicts of interest, which are not serving investors well. 

A vertically integrated model creates inherent conflict of interest

In a market dominated by banks and fund management firms that manufacture and sell their own products, conflicts of interest can pose quite a thorny issue for investors seeking ‘independent’ financial advice. 

Investors may be attracted to the perceived safety of large institutions and economies of scale they believe will flow from engaging such institutions. However, the quality of financial advice they receive may be limited to the quality and scope of that firm’s financial products. 

Conflicted remuneration

One the most highly publicised and sensitive conduct issues in the financial services industry relates to conflicted remuneration. Let’s look at remuneration paid to financial advisers working at large wealth management firms as an example. Typically, their remuneration consists of a fixed component (a salary, paid by their employer) and a variable component, which is a percentage of the fees collected from clients by their employer, which in some cases can be up to 47% of the total fee. 

Disclosures provided by these financial advisers can be two to three pages of a head-spinning list of fees, commissions, and margins. Included in these fees are product referral commissions from third-party product manufacturers, brokerage earned on trades, and/or margins on cash or foreign exchange. 

Advisers earn product commissions when, for example, they recommend an investor invests money into a fund. The fund manager pays either an upfront commission or a trail (ongoing) commission to the firm, of which the adviser earns a portion. 

The conflict of interest arises because the adviser may be incentivised to recommend one fund over another based solely on their earning potential or related-party issues (where the entity offering the fund is a related party) rather than what is in the investor’s best interest. In relation to brokerage, the financial adviser may be incentivised to recommend the buying or selling of securities to generate revenue (also called ‘churning’). This includes selling investors into higher-risk products where the adviser incentive is greater. 

When you have a conflicted remuneration structure with the associated systems and processes, it is, at best, challenging for the adviser to prioritise their client’s interests ahead of their own.

Investors may be attracted to the perceived safety of large institutions and potential for economies of scale.

Getting the right financial advice

Key things to consider when seeking financial advice: 

  • Have a healthy level of scepticism – look below the surface, especially when things are always good and returns consistently positive. 
  • There are new disclosure requirements around conflicts of interest and commissions – although this will be provided to you in writing, ask your adviser to explain it to you.  
  • Understand the culture of the firm – what is the tone from the top when it comes to sales practices and putting clients’ interest first? How do their systems and processes support this?  
  • Look for excessive turnover in your portfolio, ad hoc security selection, and trades you did not approve.
  • Do you understand the fee structure used by your financial adviser? How is your adviser remunerated and how does the firm make money? Do they receive product incentives? Do they charge a margin on brokerage, FX or cash management accounts?
  • Are there related parties involved in how your money is managed, ie, advisers recommending investment in a fund manager owned by the firm? This could indicate a real conflict of interest as how would poor performance or undue financial incentive (due to favourable commission structure) be dealt with? 
  • Keep good records – and review what is being provided to you by your adviser. Educate and inform yourself, seek independent confirmation. 
  • Beware of inconsistent or ‘selective’ reporting over different time periods to present favourable performance outcomes (eg, platform-generated reports vs Excel/email formats). 
  • Consider if your portfolio (and related account activity) aligns to your financial objectives, risk appetite, and time horizon. 
  • Acting in your best interest also means advising you to not invest, even when this means the adviser would potentially miss out on revenue. Can you think of a time this has been the case? Does your adviser challenge your thinking? 

It’s not enough to ‘manage’ conflicts of interest, they need to be eliminated

Regardless of the extent of regulation, if financial advice is provided within the confines of a conflicted structure (driven by remuneration or otherwise), client outcomes will be sub-optimal. 

Contrast this with a financial adviser where clients are charged a transparent fee for advice, ongoing monitoring and review. Quite a different picture emerges, including a higher likelihood of better client outcomes.  

This article was published in the NBR on Sunday, 4 April 2021. The content was supplied and not commissioned or paid for by NBR.