# UK Regulator moves to ban commissions



## Marc (25 Jun 2009)

Reported in the Financial Times today, the Financial Services Authority in the UK has announced today that it will seek to ban Financial Advisers from receiving commissions from 2012.

The FSA said: “The proposals bring to an end the current, commission-based system of adviser remuneration: we propose to ban product providers from offering amounts of commission to secure sales from adviser firms and, in turn, to ban adviser firms from recommending products that automatically pay commission.”

See the article here

[broken link removed]


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## PMU (1 Jul 2009)

Marc said:


> Reported in the Financial Times today, the Financial Services Authority in the UK has announced today that it will seek to ban Financial Advisers from receiving commissions from 2012.


 
  Marc:  This is all well and good, but how much will it cost clients? I’ve never been to a finance adviser but, if we move to a fee-based system, how much is this likely to cost the investor and would the advice received be any good (by this, I mean what is the likelihood the adviser’s advice would generate excess return for the investor over what the investor could get by investing in say an ‘vanilla’ 70:30 stock/bond split)? 

  For example, how much would you estimate a financial advisor (not you personally) would charge an investor to: develop an investment strategy for someone with €100,000 initailly to invest, with additional investments of €10,000 pa; that would have an estimated return of say 7% after inflation, with a volatility no greater than a benchmark of say 70% euro large cap stocks / 30% euro government short term debt; and to recommend appropriate investment vehicles; and with no counterparty risk? (This to assume the investor could provide a full statement of their tax position, assets and income, i.e. no time needed to factfind).


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## Marc (1 Jul 2009)

PMU,

Thank you for your well considered reply.

I think that it is important to stress from the outset that any advice provided on the basis of commission is at a cost to a client since commissions are paid out of product charges. The point I would make is that the charges and the commissions are opaque and often concealed.

  I like to quote Sir Howard Davies former chairman of the Financial Services Authority in the UK:

  “The biggest disappointment of my time at the FSA has been the failure of firms, and particularly their senior management, to learn the lessons of past mis-selling. Sadly, the recent history of the British retail financial services industry is proof of the adage that those who fail to understand the mistakes of the past are condemned to repeat them. Though the pensions mis-selling debacle, which cost the industry over £11 billion in compensation, should have been a stark lesson of the dangers of uncontrolled and unsuitable selling, it is hard to see evidence that that lesson has been widely understood. Again and again we find examples of High Street firms disregarding the suitability requirements in our rulebook. Requirements which merely, in my view, describe what most service companies would regard as good customer service. 

  Unfortunately, much of the industry remains focused on short-term gain from shifting product. Indeed many firms are happy to see themselves described as “product providers”, terminology which in itself distances them from their customers, many of whom assume that they are being given advice which takes their personal circumstances into account and who see their relationship with their bank or life insurance company as one for the long term and not solely transaction-based. “


  I know many financial advisers who believe that a 105% allocation with a 5% bid offer spread means that the client pays nothing for a product and yet they are still able to receive a commission payment of 3%, 4% or more. In fact when I first started advising back in 1994 I was regularly told by Insurance Companies that I could receive up to 7% initial commission for selling a With Profits Bond which had 100% allocation.

  By contrast a fee is an agreed payment between the client and the adviser for the provision of advice rather than a payment from a product provider for selling a product.
  The second part of your question is also extremely interesting. You seem to be suggesting that an adviser can only justify their fee in terms of excess investment returns.
  I saw a client the other day and we recommended some Capital Acquisitions Tax planning which should save the estate in the region of €1,500,000.

  How should I charge? For the excess return from the investment advice or for the tax savings?

A really good financial planning adviser will add value all the way through the advisory process, optimising tax structures, asset allocation and minimising investment costs. Each of these steps adds value.

The “traditional” commission model simply pays the adviser for selling a product. 

So, looking at your example of €100,000 invested with an additional €10,000pa.

Let’s say I would typically charge €1000 upfront plus an annual fee of 1%pa of the value of the portfolio. 

Your benchmark is 70% Large Cap and 30% short-dated bonds – this is perfectly plausible and along the lines of a traditional institutional asset allocation. I would entirely agree with your assumption to use short-dated bonds however, I have written at length on askaboutmoney.com around the subject of tilting a portfolio away from large cap for higher expected returns.

Be that as it may, I have back-tested the benchmark using data covering the longest possible period I can which is in US$ from 1926 to the end of May 2009. If you really want I could run a € series but you would only get 10 years of data which is insufficient to draw any meaningful conclusions.
  So, to measure your benchmark, I have used the following data:
  S&P500 70%
  5 Year US Treasury Notes 30%
_Source: Standard & Poors data services/Ibbotson Associates_

The benchmark portfolio has the following characteristics over the period 1926 to 2009:
  Average annual return 5.40%pa 
  Average annual volatility 15.52%pa

  I have then compared the benchmark with a slightly more diversified portfolio:
  5 Year US Treasury Notes 30%
  Emerging Markets Value 10%
  Global Core Equity 30%
  Global Targeted Value 20%
  Gold 5%
  Global Real Estate Investment Trusts 5%

  The second portfolio has been adjusted for a 1% initial fee and 1%pa fee and is annually rebalanced. It has the following characteristics over the period 1994 to May 2009:
  Annual average return 7.18%pa
  Average annual volatility 10.17%

    The shorter time period is due to data constraints.

So, to put aside any charges of “data mining”* I have re-tested the benchmark over the same period (1994 to May 2009) with the following almost identical results:
  Average Annual return 5.4%pa
  Average annual volatility 15.39%pa 

  Conclusion
  Compared to the plain vanilla portfolio a more diversified portfolio would have averaged around 1.78%pa more for an investor after fees and would have had a lower volatility than the benchmark by around 5.22%.
  This is consistent with our studies (some of which are published on our website) which assess the extent of the possible outperformance against [broken link removed].

Note that this portfolio does not represent a specific recommendation and is intended simply to illustrate the potential for "excess returns" against the benchmark. For any individual investor the correct asset mix is a function of their personal requirements.

*"data mining" looking for pattens in a data series or selecting a particular time period which supports an argument.


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## PMU (1 Jul 2009)

Marc: Excellent post (as usual). I think you’ve shown that, at least for large-sum investors, fee-based financial advice would be worthwhile.  In effect, you have shown that an adviser could generate excess returns, and, I think it would be reasonable for an investor to pay for such advice.  (I’m sorry I haven’t more time to give a more detailed response.)


Marc said:


> Let’s say I would typically charge €1000 upfront plus an annual fee of 1%pa of the value of the portfolio.


   I’d say the €1,000 up front is typical and is really not significantly different from fees for other professonals.  

But the ongoing 1% of portfolio value really just leaves the risk all asymmetric. If the value of the portfolio falls the investor loses big-time but the adviser loses only a relatively small amount.   An on-going fee of a % of the  portfolio’s outperformance of the benchmark (with no fee for underperformance) would provide an incentive for the adviser to review and suggest improvements for portfolio progress annually, rather than just collect a rent from the investor.


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## Marc (2 Jul 2009)

PMU, 

Thank you for your reply.  You seem to be advocating a charging structure based on outperformance against a benchmark which would be similar to the performance fee applied by Hedge Funds. 

My view on this form of pricing is simple:

In 2004 hedge fund fees totalled $70 billion on assets estimated to be $1 trillion, which works out to an average fee of 7%. In that same year, Alpha magazine reported that the average take-home pay of the top 25 hedge fund managers was a whopping $251 million.

Therefore it is reasonable to conclude that under this pricing structure, it is the fund manager who actually benefits most whereas I am proposing a fee of 1%pa which declines for larger portfolios.

One of the biggest mistakes I think investors can make is in failing to understand where investment returns come from which I believe sets up a dynamic between a client and an adviser that often leads to failure. 

In effect, clients place responsibility for the investment returns on someone else (such as an adviser or fund manager) who in reality is not responsible for the returns. The market and the positions of risk an investor takes are responsible for the return. 

See an excellent video here which explains the difficulty in attempting to identify a winning fund manager

My approach is based on the premise that risk and return are related. The role of a financial planner is therefore to assess the risk capacity of an investor and to recommend the correct asset allocation mix of cash, property, bonds and equities. 

Advisers should not be paid for selling products, attempting to pick skilled managers or attempting to time the market. 

In my earlier post I covered the potential benefits from strategic asset allocation. 

The other side of the coin is ongoing asset management. In my view this relates to managing the costs of executing the asset allocation strategy and ongoing portfolio review. No value is added from "actively managing" a portfolio in the traditional sense. The more you trade, the higher your costs. 

Again the role of the financial planner is to review the portfolio but in a way that keeps down costs and taxes.

By using mostly institutional class index funds with low portfolio turnover, on average, our studies indicate that this adds a further 1.5%pa to a client’s portfolio compared to a typical managed fund. Portfolio turnover is discussed extensively here 

Since a fee-based adviser will earn no commissions or fees on the products, investments and recommendations that they make to their clients and receive no referral fees. I believe it is logical to charge a percentage fee based upon of assets under management

An annual fee can be considered a casualty insurance premium with the role of the adviser being to protect investors and their capital from themselves. As Benjamin Graham (1894-1976), the legendary American investor, Warren Buffet mentor, and co-author of the 1934 classic, Security Analysis, stated, *"The investor’s chief problem - and even his worst enemy - is likely to be himself." *According to behavioural finance author and professor, Mier Statman, "When the market drops, our instinctive fear to flight is so strong, *even the most rational investors find themselves caving in to their own demise." A good financial planner* takes the emotions out of the decision making process.

A US study by Dalbar inc in 2006 indicated that during the 20 years from 1986 to 2005, the average stock fund investor earned returns of only 3.9% per year, while the S&P 500 returned 11.93%.

The Dalbar studies seem to confirm that the behaviour of average fund investors is an obstacle to reaching the published performance of the financial markets in which they are invested. 

Many investment advisors charge an investment management fee based upon the amount of money managed on behalf of a client. The theory is that with such a remuneration package the advisor is paid more the larger the account therefore there is an incentive to make the account grow through good investment performance. 
In the USA the National Association of Personal Financial Advisors (NAPFA), the nation's premier group of fee-only planners, has a simple but effective definition of what it means to be fee-only: An advisor must be compensated _only_ by his or her client--not by third-party money such as commissions, kickbacks, and rebates. What this means is that fee-only planners can be NAPFA members while employing a variety of fee structures. Hourly fees, retainer fees, and asset-under-management (AUM) fees, for example, all qualify _as long as_ the client pays the fees.

This system has worked well for years, and it curbs many potential abuses. 

When using an AUM fee structure, I believe that there should be a separate amount charged for equities versus bonds. If not, there is a built-in conflict of interest. Most advisors charge a flat percent for both bonds and equities, which I feel doesn't make sense.

Finally, the annual fee should also reduce as the size of the portfolio increases.


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