The purpose of this series has been to question whether this duty works from a consumer viewpoint.  John Berry rounds out the discussion by asking (a) what are the benefits of the current “client interests first” interpretation? and (b) is this the duty we’d introduce if we were constructing a financial system from scratch?

As with the previous commentaries two different models for financial adviser businesses are covered.  The first is where advisers are tied and only sell in-house product (“restricted advice”). The second is where the adviser is free to select any product in the market (“independent advice”).

What are the benefits of the current system?

The current system regards “restricted advice” as putting “client interests first”.  Surprisingly none of the roughly 50 reader comments on parts one and two of this commentary set out a case for why this interpretation is appropriate.  Maybe the benefits are obvious and no one thought they need to be stated. 

Conversely, maybe it’s a touch awkward for the industry to publicly explain the current system’s rationale.  Or just may be no one is sure why we have the system we have.

Taking a pragmatic view, there are arguments in favour of “restricted advice” being treated the same as “independent advice”.  These benefits are:

• Accessibility of advice:  Firstly the current system may make financial advice more accessible and available for consumers.  If we had to call advisers from vertically integrated businesses “salespeople” then consumers may have less confidence in seeking their guidance and may instead opt for a “do it yourself” approach.  
  
  Asset class allocation help from a “restricted adviser” is better for consumers than not having any help. If we are going to accept this pragmatic reason for compromising on what advice means, let’s just be clear and explicit that we are compromising for the greater good of investors (i.e. trying to deliver the best “accessibility outcome” for the New Zealand investing public as a whole, not the best “investment outcome” for each individual investor). ¹
   
• The duty fits a range of business models:  Secondly the current system works because it fits the reality of nearly all financial adviser business models (both restricted and independent advice).  The current interpretation of “client interests first” provides a broad umbrella for the industry that everyone can shelter under.  Again, if we rely on this argument let’s be honest and explicit about it – the duty to customers suits business models of product providers. 
  
  But there is something deeply ironic about putting “business interests first” when designing a standard called “client interest first”. 

What if we had to build a financial system from scratch?

The best way to think about how “client interests first” should be applied in practice is to start with a clean sheet of paper.  Imagine we are designing a new country’s financial system from scratch.  Would we say:

“Ok advisers, you can divide into two groups.  “Group One” will sell only their own in-house product to investors.  You guys don’t have to think about any other product in the market, even if it’s a better product than yours.  Just fill your client’s boots with your own home grown product.  “Group Two”, you guys will be selecting from all products in the market.  Don’t build your own fund product, instead choose what you think is best for clients.  And we’re going to call everyone in Group One and everyone in Group Two “financial advisers” because you all do exactly the same thing.”

Would we really think that Group One and Group Two advisers provided an identical “client interests first” service to clients? Would we really set it up this way if we were designing NZ’s investment market from scratch? No, that would be bonkers. 

Under the current system consumers operate in a “caveat emptor” environment (“let the buyer beware”).  Whether they know it or now, a restricted adviser is effectively saying to clients “you have chosen my firm therefore you have already narrowed your product universe – you are on your own with that decision.”  If we were setting a financial system up from scratch I doubt we’d ever choose that.

Any other angles to consider?

In simple terms a vertically integrated financial business is likely to work as follows:

1. the fund management arm builds in-house fund product
2. on the private client side an investment committee chooses the building blocks (funds) for client portfolios.  This is likely to include or even be dominated by in-house product.  The funds selected are the firm’s Approved Product List.
3. the financial adviser implements the Approved Product List.  S/he puts their client’s interests first and provides “restricted advice”.

In this model, what is the duty that the investment committee owes?  Their role is absolutely critical to the investment process and the outcomes for clients, but do they owe any client duty?  The fund manager (step one) and the financial adviser (step three) owe an explicit duty to clients – so why not the Investment Committee (step two)?

One possibility worth exploring is requiring all vertically integrated financial adviser businesses to have an investment committee selecting building blocks for portfolios – and they must act in the best interests of clients when doing this.  They may select their own in-house product, if it can be objectively justified.  The adviser then provides “restricted advice” – putting the client’s interest first in selecting products from the investment committee’s Approved Product List.  That works.

Final thoughts

If we were creating NZ’s investment industry from scratch would we choose to treat “restricted advice” and “independent advice” as exactly the same thing and as equally beneficial for consumers?   If we say “no we wouldn’t set it up that way” then the system we have now is compromising consumer interests. Maybe we are compromising to improve accessibility of advice.  Or maybe the compromise is to suit adviser business models.  But if there is a compromise, lets acknowledge it.

Settling the right standard for financial advisers and adviser businesses is going to mean finding the right balance between client duty and business operations.  At the moment vertically integrated businesses have the best of both worlds: a “client interests first” duty that sounds impressive (but means nothing) and the ability to conduct business operations in a way that maximises profit from consumers.

We do not need to ban vertically integrated operations.   We should continue to allow providers freedom structuring their businesses so they can both build and distribute product.  However, this freedom must live within a meaningful duty to advance the interests of clients.  What this may mean is:

• For Fund Managers: a duty on the in-house fund managers to act in the best interests of unitholders (this is already a statutory duty under the FMCA)
• For the private client Investment Committee: a “best interests” duty to clients of the firm to thoroughly and objectively look beyond in-house fund product when setting the Approved Product List; and
• For Financial Advisers: if the Investment Committee has a “best interests” duty then a “clients’ interests first” duty now makes more sense for “restricted advice”

Let’s finish with a real life example of the “client interests first” duty in action. The 2014 business plan for a vertically integrated fund management business provides that “within a client best interests framework we are working” to “lift [our in-house funds] representation to 50%” of client assets under management (AUM). 

At that time its in-house funds were 32% of AUM.  Its funds were among the most expensive in the market, performed abysmally, lacked any transparency and had sub-standard governance.  It was never in the interests of clients that they were loaded with more of this in-house product.  The Code of Conduct allows this to happen – it shouldn’t.

John Berry, Director
Pathfinder Asset Management Limited

Disclosure of interest:  John is a founder of Pathfinder and invests in all Pathfinder’s funds. 

Footnotes:

¹  It would be a big positive to be able to argue that vertically integrated financial businesses make financial advice more accessible by lowering the cost of advice.  This should be possible because of the synergies of controlling each level of the process (i.e. from fund product manufacture to sales) and having margins at each level.  Unfortunately, there is only one case I am aware of where the business rebates their fund manager fee to clients who also pay advisory fees to their in-house AFAs.  The argument that vertically integrated businesses lower the overall cost of advice for consumers doesn’t seem to stack up.