Striking the right balance

It is no wonder, therefore, that new regulation is taking shape that seeks to ensure that distributors act in the best interests of the end-customer and that questions continue to be raised about whether commissions paid by manufacturers or out of products create unacceptable conflicts of interest.

The regulatory approach differs from jurisdiction to jurisdiction, but is commonly some combination of higher qualification standards for advisers, a focus on monetary benefits but attention also to non-monetary benefits (including hospitality), and some form of ban, restriction and/or increased disclosure. A regulatory pick ’n mix.

The UK Retail Distribution Review (RDR) led the way and the regulatory debate is now circling the globe. There is, though, increasing awareness of an advice gap for those with only modest amounts to save, who cannot afford or who are deterred by the initial advice fee. While the FCA ponders how to respond, it will no doubt wish to reflect on what approaches are being adopted elsewhere.

Within Europe, MiFID II bans commissions paid to independent financial advisers and wealth managers (not currently covered by the UK rules). Any form of inducements paid to other parties must pass a “quality enhancement” test with regards to the service received by the client.

MiFID II’s impact could be profound in the longer term as it will increase transparency and could have a substantial impact on the distribution landscape and the cost structure of the industry. Initially, however, fragmentation of the Single Market is likely. Some member states will apply additional restrictions on inducements, there may be different national interpretations of the quality enhancement criteria, and there might even be slightly different interpretations of “retail client”.

Different distribution channels dominate across European markets, so the impact of MiFID II will be different in each.

There is likely to be low impact in an already fee-based environment. In bank-dominated distribution markets, banks may initially retreat from their tentative steps towards “open architecture”, unless and until the quality enhancement test bites. Distributors will focus on a smaller number of products and providers and thus avoid the ban.

In Australia, the debate has been conducted under the Future of Financial Advice (FoFA) banner and impacts all providers in the industry not just financial advisers. Legislation codifies a best interest duty on advisers and product manufacturers, and bans all conflicted remuneration. The ban is not limited to trailer fees paid directly to an adviser, although existing arrangements are grandfathered. The reform has required significant business model changes across all market participants. All advisers have to be registered, with details of their licence and competency recorded so that consumers can select and verify their details. And proposed legislation aims to raise the professional standards of advisers.

South Africa launched its own RDR in late 2014. The review foresees a “proactive and interventionist regulatory approach” by moving away from purely rules-based compliance. The new approach aims to change incentives, relationships and business models in the market. Ultimately, the 55 proposals in South Africa’s RDR seek to rekindle customers’ confidence in the retail financial services market. They are expected to roll out in stages from now to 2018.

Meanwhile, the US regulator – the SEC – has launched a multi-year examination initiative, focusing on registered investment advisers and broker-dealers and the services they offer to investors with retirement accounts. It is examining the reasonable basis for recommendations made to investors, conflicts of interest, supervision and compliance controls, and marketing and disclosure practices. The SEC continues to examine investment advisers and broker-dealers that offer retail investors a variety of fee arrangements, focusing on whether recommendations of account types are in the best interest of the retail investor at the inception of the arrangement and afterwards, including fees charged, services provided and disclosures made.

In April 2016, the Department of Labor published its fiduciary rule, which is considerably less onerous than the draft. It clarifies that advertising, research reports, commentary and other marketing materials do not amount to advice. Under the “negative consent” provision, clients will have 30 days to object, otherwise the fee arrangements – commission-based or otherwise – will remain intact. Similarly, investments made under prior recommendations could remain unchanged, provided the client is informed and does not request any adjustments. Also, the various client disclosure requirements are less than originally proposed and the requirement for advisers’ remuneration to be made public on company websites has been retracted. Nevertheless, the introduction of fiduciary responsibility is described as a game changer for the industry.

Elsewhere, the Brazilian regulator requires the distributor to inform its clients of its total remuneration and has prohibited the rebating of administration fees by funds in which funds of funds are invested. The Mexican regulator has targeted sales practices in an effort to standardise services to protect consumers. It is looking at the regulation of independent investment advisers, which must now be registered.

In Canada, the Mutual Fund Fee Report (also known as the Brondesbury Report) evaluates the extent to which fee-based, versus commission-based, compensation changes the nature of advice and impacts long-term investment outcomes. It concludes that while commission-based compensation is sufficiently problematic to justify the development of new compensation policies, there is insufficient evidence of better long-term outcomes under a fee-based model.

The report cautions that while fee-based compensation is likely a better alternative, it is not a behaviourally-neutral form of compensation. Other forms of inducements that influence advice, such as bonuses or the potential for promotion at the dealer firm, and affiliation between a fund manager and a dealer firm, would likely persist under a fee-based model. The report also finds that investor behavioural biases are an important factor in sub-optimal returns on investment and that these biases are unlikely to be overcome as a result of changing compensation schemes alone.

Right around the globe, commissions and other forms of remuneration are under the regulatory spotlight. For the UK in particular, the focus is now on the second phase: what are the impacts of rules imposed to date, have they achieved what was intended or had significant unintended outcomes, and how best can we address emerging issues? As the FCA formulates its response, it will wish to reflect on other approaches around the world and on the Canadian research.

There is no right answer. Regulation needs to strike a balance between requiring reasonable conduct by firms and an acceptance that consumers cannot be prevented entirely from making mistakes.

Julie Patterson is director, regulatory centre of excellence at KPMG