FOOL'S EYE VIEW
Radical New Regime For Financial Advice

By James Carlisle
January 18, 2002

You may have noticed something in the news last Monday about the Financial Services Authority (FSA) and something called 'polarisation'. It sounds more like something out of Star Trek than a framework for delivering financial advice, yet it sums up the current situation pretty well: few people understand it. Monday saw the publication of two major pieces of research into the market for financial advice, plus the FSA's proposals for improving things. It's pure dynamite. Believe me, if you need some dinner party conversation over the weekend, read on!

What is polarisation?

The current system, known as polarisation, was born out of concerns that the big financial companies might be able to use their power to manipulate the market for financial advice. To deal with this, advisers had to be 'polarised' into one of two camps. Either they could be 'tied agents' and only recommend the products of one company or they could be 'independent financial advisers' (IFAs) and recommend products from anyone. Limits were also placed on investment by the big financial companies into IFA firms, so that they couldn't apply their influence through the back door.

Why isn't polarisation working?

The research published on Monday showed that the system isn't working. The first bit goes into how consumers perceive advisers and the advice that they give. The evidence suggests that they're mostly pretty confused by the status of advisers and how they get paid: apparently only the most financially sophisticated consumers understand that they pay for the commission that their adviser receives.

The second piece of research looks at whether financial advisers are influenced by the commission they get for selling particular products. Not surprisingly, human nature being what it is, the answer was yes. For 'with profits' bonds, there was found to be a bias between providers ('provider bias') that depended on commission levels, while there was found to be some 'product bias' against ISAs in favour of products paying higher levels of commission. On top of this, commission bias was only found to affect IFAs, rather than tied advisers, suggesting that consumers are not suffering adversely from going down the tied route.

What are the FSA's proposals?

Abolishing polarisation

The FSA's number one proposal to deal with these problems is simple, abolish polarisation. Bosh! On top of this, advisers will only be able to call themselves independent if they only get paid in fees (that don't depend on the products recommended), rather than commissions (that are dependent on the product).

This really is stunning news. People have been banging on for years about the problems of commission-based advisers calling themselves independent. None more so than us Fools, but I'm not sure many of us really expected much to be done about it.

Improving disclosure

The removal of the old system does, however, leave something of a hole. There are two main problems to overcome. First of all, the removal of polarisation and, incidentally, the restrictions on investment in IFA firms, means letting the big financial companies loose on the market again.

The way that the FSA plans to deal with this (potential) problem is to improve disclosure and the transparency of products. Most importantly, this involves 'unbundling' charges, whereby the costs of a product will have to be clearly identified, separately from the product itself. This should enable products to be compared easily and increase competition. In addition, the FSA suggests that salesmen should have to disclose whose products are on offer, who is responsible for their advice and conduct, who has financial interests in an advisory firm, what the complaint handling arrangements are and what qualifications the adviser has (some of these disclosure obligations already exist, but presumably they're to be tightened up) .

Providing advice to those on lower incomes

The second problem comes from the 'defined' fee that gets charged for independent advice. The awkward fact is that many people just don't like paying fees. Even though it generally ends up costing them a lot more, they'd apparently prefer the costs to be wrapped up inside their policy as commission - that way they don't have to think about it. So, the FSA is aiming to protect these people from themselves, but it may just end up with them not doing anything about their finances at all. It's worth remembering, though, that providing good quality financial advice to those on lower incomes is already a major problem under the current system. As the FSA says in its consultation document

'So-called Industrial Branch business which traditionally served low-income customers, albeit with mostly poor-value products, has virtually ceased. At the same time, IFAs are increasingly targeting more affluent people.'

The FSA makes several suggestions for addressing this problem. Essentially they respect that advisers need to be paid a fair fee for providing advice, so the emphasis is on reducing the costs to advisers of providing that advice. One possibility is a 'portable financial healthcheck' whereby basic questions are asked by a suitably qualified adviser and generic advice given, so that the recipient knows where spare cash should be targeted and can go off and compare different products with greater confidence. This could be backed up with improved consumer education. The FSA notes that the Internet (for example its own consumer website) could play a role in this, but it's unlikely to be enough on its own.

Another idea is to introduce a 'two-tier' system where there are cheaper, less well qualified advisers, that are able to advise on a limited range of lower-risk products. Further thought on this is required, which is why the FSA is consulting but, however it turns out, it's hard to see how it can be much worse than the mis-selling of overpriced pensions and endowments that we've seen under the current system.

How might this affect the market for financial advice?

Perhaps not surprisingly, IFAs don't seem too keen on the FSA's proposals. Well, that's a generalisation: I'm an ex-IFA myself (fee-based) and I think they're great. The likely effect seems to be to extend the role of product providers, and the old 'tied' agents, while exposing them to greater competition. At the same time, you'd expect an increase in demand for 'fee-based' IFAs. It does seem likely, though, that commission-based IFAs will get squeezed in the middle.

One way or another there will still be financial products that need to be distributed to the people, according to who needs them. So long as advisers are happy to provide good quality financial advice for a fair and open fee, they should have nothing to fear. In fact, the proposals provide an opportunity for the industry to tidy up its reputation: something that it desperately needs to do.