Bureaucrats get it right for once!

New regulations often do more harm than good, but the new rules governing financial advisers are very good news.

I’ve never been a fan of financial advisers. I think too many of them give poor advice and would be better described as salespeople rather than advisers. However, new rules are set to come into force in December 2012, and I think they will push advisers to provide a better service.

Free service

The marketing message for most financial advisers is that they normally offer a ‘free’ service. That sounds great, but there’s a problem. If an adviser is offering a free service, that means he’s probably making money from commission. And if he’s paid by commission, there’s always the temptation for him to recommend the product that pays the biggest kickback.

This is true of advisers who work for banks – who can only recommend products offered by their bank – as well as Independent Financial Advisers (IFAs) who can recommend any product on the market.

Commission

Let’s look at how commission works in a little more detail.

Say you’re lucky enough to have a £100,000 windfall, and you visit an IFA looking for advice on what to do with your money. The IFA gives you free advice and recommends you invest your money in ten different unit trusts.

An initial charge is deducted from your investments which would probably be around 3 or 4% for each fund. You’ll also pay an annual charge every year which might be 1.5%.

These charges would go to the fund management company which would then pay commission to the adviser. The adviser would expect to receive some of the initial charge as well as a chunk of the annual charge in future years. These continuing payments are known as ‘trail commission.’

Sometimes advisers receive all of their commission in one block at the beginning. In other words, the fund management company estimates how much trail commission would be earned and pays a sum to the adviser at the beginning to reflect that. The adviser then receives no further commission in future years. Paying all the commission at the beginning is known as ‘indemnity commission.’

Different fund management companies pay different levels of commission on different products. Hence the incentive for advisers to recommend the products that pay the highest commission. Some products, such as investment trusts and savings accounts, don’t offer any commission at all, so the adviser has no incentive to recommend these products.

Clearly this set-up makes no sense. In the example of the £100,000 windfall, the adviser gets the most money if he recommends the unit trusts that pay the highest commission. But it might be a mistake for you to put all your money into stock market-based investments. Perhaps some should go into a savings account or into gilts. It all depends on your circumstances.

Don’t get me wrong. I know that some advisers always give advice that is in the best interest of the client. But I’m not convinced that all advisers do that.

New rules

The FSA’s new rules – known as the RDR – will change things for IFAs.  For starters, ‘indemnity commission’ will be banned.

On top of that, IFAs will no longer have any incentive to recommend the products that pay the highest commission.

Some IFAs will switch to a purely fee-based service. In fact, some already have. This means you’ll pay an upfront fee to see an adviser and he’ll then decide if you need to buy any products or not. The adviser won’t receive any commission and it makes no difference whether the client buys any products.

However, commission won’t die completely. There’s a second possible charging structure where the adviser can still get a cut of your investment. In this structure, a fee is agreed in advance and is taken from any investment that you may make.

The adviser still has no incentive to recommend the products with the highest commission. That’s no longer an issue. The fee has been agreed in advance.

But, with this second charging structure, he needs to recommend that you buy some products. If he says, ‘everything’s fine, you don’t need to change a thing’, he won’t earn any cash. If no money is invested, there’s no money from which the adviser can deduct his fee

Personally, as a client, I’d always opt for the pure fee-based structure because I want to be sure that the adviser has no incentive to recommend any product that I don’t need.

Education

The other big change is that IFAs must be more highly qualified. Currently all advisers must pass a ‘level 3’ exam that is roughly equivalent to a GCSE. Under the new rules, all advisers must at least be at ‘level 4.’

At least one adviser thinks this is a good thing. Martin Bamford of Informed Choice says that advisers have had years to get to this level and that Level 4 is an improvement but still leaves a lot to be desired. He thinks that advisers should be aiming to reach Level 6 which is a degree level qualification.

I welcome the moves to improve advisers’ education, and I wouldn’t even consider taking advice from anyone who doesn’t have Level 4 at the very least.

Overall, I think the changes in the RDR are very positive. For once the regulators have got something right!

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