The industry needs a more professional compensation model.
The latest round in the embedded compensation debate is over. Now, it’s time for regulators to push the investment industry toward a more professional compensation model. Traditional fund industry players can hardly be blamed for hanging on to existing industry fee structures. They have proven highly lucrative, and there’s no doubt that such a fundamental change will be disruptive. Yet, while the commercial justification for retaining the embedded compensation model may be evident, there is simply no basis for it.
Independent academic research has confirmed long-standing intuition that prevailing industry fee structures distort markets and harm investors’ returns. The existing model represents the single biggest obstacle to establishing the value of financial advice. As long as the industry continues to hide the costs of service and advice, it creates the mistaken impression among its clients that advice is free. Indeed, according to the Federation of Mutual Fund Dealers’ submission to the Canadian Securities Administrators, research conducted for the FMFD found that 70% of the investors surveyed believe that they don’t pay their advisor.
But claims that switching to an upfront compensation model will create a significant “advice gap” for lower-value clients are worrying. Among other issues, the contention that the industry won’t be able to service smaller clients under a direct pay arrangement implies that the industry does so now by using the fees charged to wealthier clients to subsidize services to less affluent customers. This peculiar form of stock market socialism is neither fair nor justified. And finally, worries regarding an advice gap underestimate the industry’s ability to adapt.
Despite the fact that the embedded compensation system undermines the value of advice and can harm investors, it’s not likely to change without regulatory action. While the industry as a whole should benefit in the long run from a move toward both a freer market for financial advice and greater professionalism, concerns about any short-term disruption will inevitably thwart voluntary action. Doing the right thing for investors is up to regulators and, ultimately, the industry.