Personal Finance Rule 6 – ‘Free Advice’ can be Expensive

Personal Finance can be a complicated topic. In this post, we see how professional, unbiased advice helps individuals get an optimized and comprehensive view of their personal finance. This is so even if the advice needs to be paid for. This article is a companion post to the India version of Harold Pollack’s Index Card – Pollack’s Index Card: All the financial advice that you ever need – India version

Advisor – Formal Definition

A lot of individuals seek advice on their issues and questions in personal finance. A professional dispensing such advice can be called an advisor.  SEBI defines the term this way in their Investor Glossary.  (In this post, we would use many definitions and explanations from SEBI; they are the most prominent authority regulating advisors in India.)

Adviser
A financial planner or financial intermediary who offers advice on personal financial matters. Advisers
may be paid an upfront or an ongoing commission for the investments that they recommend.

Finacial Advisor

Courtesy: Forbes

The definition makes it clear that an adviser may be paid commissions. SEBI also regulates a specific category of advisors who earn only from fees charged to the clients; they earn no commissions and/or incentives.

Most financial advice in India is given out by people who earn incentives, commissions, etc. from the investments that they recommend. Very little advice is given by people who charge a fee for their advice and earn nothing from the investments that they recommend. This article would argue that the former type of advice often provides sub-optimal results for the investor. This is not based on the competence of the advisor, but due to the conflict of interest faced by them.

Interestingly two spellings are used, often interchangeably: adviser and advisor.  A subtle difference is given by Wikipedia.

Both spellings, advisor and adviser, are accepted and denote someone who provides advice. According to one textbook, adviser and advisor are not interchangeable in the financial services industry, since the term adviser is generally used “when referring to legislative acts and their requirements and advisor when referring to a practitioner. Since [a financial advisor’s practice] is never described as an advisery practice, advisor is preferable when not referencing the law.”

SEBI also uses the word adviser in all their regulations.  In this post, we would use the word adviser when specifically referring to the regulation and use the term advisor when referring to the people providing advice.  The term financial planner is also used as a self-description by many advisors.

Fiduciary, ‘Fee-only’ Advisors

Fiduciary Advisor

Courtesy: Safe Harbor Wealth

A fiduciary is a person who holds a legal or ethical relationship of trust with another person. In personal finance, a fiduciary advisor is some one who places the interests of her client above her own interests.

In simpler terms, a client can believe that the advice provided by such an advisor is in the client’s best interests.  It is very, very important to know that very few financial advisors are required to act in this capacity. Most advisors choose to not act as fiduciaries.

Obviously  an advisor acting as a fiduciary would have to be compensated for their efforts and this has to come from their clients. The simpler term ‘fee-only’ is often used to denote such advisors.  A fee-only advisor takes a fee from the client and provides advice. Since they earn nothing else based on the advice provided, they can be trusted to put the interest of their client above their personal interest.

The rest of the article goes into a lot of detail – the type of advisors, their knowledge level, sources of conflict of interest, etc. If you already hold the view that a ‘fee-only’ advisor is the most suitable advisor for you, then you may not need to read any further. If you are a consumer of ‘free’ financial advice and believe that it is good for you, please spend a few more minutes and read the rest of this article.

Types of Financial Advisors

Globally (India included), advisors can be placed in many categories. The US body regulating advisors specifically mentions that the following professionals can refer to them as  advisors: brokers, investment advisers, accountants, lawyers, insurance agents and financial planners.  SEBI regulations indirectly give a list of professionals who could give qualified advice. From the regulations, we can list the following:

  1. Investment Adviser (IA) – These people can provide advice: “relating to investing in, purchasing, selling or
    otherwise dealing in securities or investment products, and advice on investment portfolio containing securities or investment products, whether written, oral or through any other means of communication for the benefit of the client and shall include financial planning”  These advisors are required to register themselves with SEBI and then can call themselves Registered Investment Adviser (RIA).  Many of these advisors use the term ‘fee-only planner’ to refer to themselves. We would cover this category in detail later. SEBI specifies that RIAs have to act as a fiduciary.
  2. Insurance Advisors/Agents – They provide advice related to insurance products and are registered with, and regulated by IRDA.  SEBI requires that these people get IA registration if they provide advice on other products.
  3. Pension/Retirement Advisors – They provide advice on National Pension Scheme (NPS) or other pension products regulated by Pension Fund Regulatory and Development Authority (PFRDA). SEBI requires that these people get IA registration if they provide advice on other products.
  4. Persons/entities providing ‘incidental advice’ – SEBI lists a variety of professions and entities that can provide advice that is incidental to their primary activity:
    1. Advocate, solicitor, or law firm; Chartered Accountants; Company Secretaries; Cost and Works Accountant; etc.  SEBI’s FAQ provides a good example that a CA preparing a tax return may advice her client on tax-saving mutual funds
    2. Mutual Fund Distributors, Stock-broker or sub-broker, Portfolio manager, Merchant Banker, etc.
  5. Employees/partners of firms that provide any of the above services. In particular, a company, partnership firm, etc. can be registered as an Investment Adviser. Their employees, partners, etc. need not get individual IA registrations; but they need to meet the qualification and certification requirements of an IA. For the other advisor categories, most reputable firms would require their employees providing advice to possess certifications in advice and planning.

We also hear another common term – Independent Financial Advisors (IFA).  This term has a regulatory meaning in the United Kingdrom.  In India, it is loosely used to denote advisors who are not employees/partners of any firm. Many of the self-described IFAs deal with mutual funds and can be considered as part of 4.2.

Knowledge and Expertise of Advisors

Knowlwdge

Sourced from the web

In India,  National Institute of Securities Markets (NISM), a public trust established by SEBI, conducts a variety of certification examinations. These examinations are always one of the main requirements for registering with SEBI for a variety of roles. Investment Advisers need to clear two examinations conducted by NISM: a) NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination and b) NISM-Series-X-B: Investment Adviser (Level 2) Certification Examination. Individuals can also use alternative certifications, including CFP. Certified Financial Planner (CFP) refers to a worldwide certification awarded by a private body. In India, Financial Planning Standards Board India is authorized to provide this certification. You may come across many advisors who have this certification.

These mandatory certifications, and the additional employer-required certifications, typically ensure that individual advisors (whether employees/partners/independent) have a reasonable amount of knowledge and competence in the relevant areas. Lack of sufficient knowledge is seldom the reason for poor advice. The biggest factor that makes ‘free advice’ poor is the conflict of interest.

Conflict of Interest for advisors

SEBI regulations make it clear that RIAs should not have conflicts of interest, or declare these conflicts clearly to their clients. There are no such requirements for other advisors, who taken together vastly outnumber the RIAs. First, we would look at the areas with fewer instances of conflicts of interest.

  1. Professionals providing incidental advice (see 4.1 above) may not have many conflicts of interest. They typically have qualifications that are hard to obtain, and have a motivation to maintain their standards of service.
  2. Retirement Advisors are fewer in number and this is relatively a new area in India. They are restricted to NPS and similar products (at least in theory).
  3. Portfolio managers, Merchant bankers. etc. work with fewer clients and often have a reputation to protect. They can be expected to disclose their interests to their clients and provide ‘above-the-board’ advice.

This strongly worded freefincal article talks about how conflict of interest can affect investors.  What is Conflict of Interest?

Advice from Insurance Agents

Insurance agents/brokers form the largest chunk of advisors in India. While the regulations require them to stick to insurance products alone, they often extend their ‘advice’ to other investment areas. Life Insurance industry in India has grown around investment-cum-insurance products. The industry practices actively promote these products.

Personal Finance Rule 6 - 'Free Advice' can be Expensive 1

Photo by rawpixel.com from Pexels

For instance, term life insurance is often the most suitable product for most individuals. However most insurance companies don’t count term policies towards the quota for agents.  An agent, like any salesman, is highly motivated to meet her quota. The industry practice means that agents are incentivized against selling term insurance policies since these sales would not count towards their quota target.

Agents earn commissions based on the premium amount collected, and the commissions are the highest for poor (for the individual) products like endowment policies. If you were to ask an insurance agent about the most suitable insurance policy for you:  a) The agent is incentivized and motivated to suggest an investment linked policy  and b) The agent has no obligations to put your interest above theirs. Investment linked policies like Endowment policies, Whole life policies, ULIPs, etc. can take up a large portion of your investment money and leave you unable to invest much into pure financial instruments.  Almost all these products provide poor returns compared to their pure play counterparts.   a) Endowment policies give worse return than the combination of PPF plus term insurance,  b) ULIPs give worse returns than the combination of  ELSS plus term insurance, and so on.

In summary, ‘free advice’ from insurance agents would force you into expensive products with poor returns.

Advice from Bank Personnel

Bank managers, ‘Relationship Managers, etc. are another large group of ‘advisors’. A lot of persons that you meet in a typical bank seek to guide you in your personal finance. Since they often have a good idea about your money situation, they can use the information to steer you towards specific products. In almost all these situations, they are seeking to maximize the gains of the bank, and are not looking out for your benefits.

bank advice

Courtesy: dilbert.com

You can read this conference paper from Monika Halan and Renuka Sane for a glimpse into the losses suffered by investors because of this ‘selling’.  Misled and mis-sold: Financial misbehaviour by retail banks? Public sector banks may be less harmful as they seem to steer people towards Fixed Deposits – while these give lower returns, they are well known, and the returns are steady. Most of the private sector banks pitch insurance products like ULIPs and pension plans. Shockingly, hardly any correct information was provided on insurance products when they were being sold to the customers. The overselling and mis-selling  of insurance can be fixed if the regulations are more strictly implemented. Compared to an individual agent, a bank has much more to lose – reputation, trust, insurance commissions, etc. Below are quotes from the research paper.

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In private sector banks with high sales incentives, the high commission product is recommended. In public sector banks, where there are deposit mobilisation targets, fixed deposits are recommended. Banks rarely make voluntary disclosures on product features. When specifically requested, information provided is inaccurate or incomplete. Our results demonstrate the challenges of mandating disclosures when buyers have little understanding of the relevance of product characteristics,and distributors are themselves ignorant or influenced by incentives.

The private sector prescribes the most expensive products,while the public sector prescribes the least effort default product. In either case, unbiased financial advice in the interest of the customer seems to be missing. This is reminiscent of the situation of health care in India – where the private sector makes more of an effort and prescribes more drugs (often to the detriment of the patient), while the public sector does less of both.

Regardless of the bank, or the product sold, bank managers rarely disclose complex product attributes such as costs and lock-in. When pressed for information on these features, managers provide information, but in a majority of the cases, the content of the disclosure is incorrect, or incomplete.

In summary, trusting your bank manager/contact is misplaced and most probably would leave you with an inferior product.

Advice from Mutual Fund Distributors

SEBI regulates that mutual fund distributors can offer only ‘incidental advice’. Investors believe (or are led to believe) that the distributors offer comprehensive advice. Many of the distributors mention advice as a specific value that they provide.  In a situation where the investors abide by the advice, the distributors has an upper hand in guiding where the investments happen. In the past, factors like entry load, opaque commissions, upfront commissions, etc  caused conflicts of interest to the distributors. They gain more if investors switched from fund to fund. These have been eliminated now and there are fewer areas of conflict of interest.  For focusing on the larger issue of costs, let us assume that there are no conflict of interest faced by a mutual fund distributor. Let us also ignore the fact that many distributors provide advice far beyond the spirit of ‘incremental advice’ that SEBI allows. FAQs on SEBI (Investment Advisers) Regulations, 2013  states this:

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What does ‘incidental activity’ mean with respect of distributor of mutual fund?
Mutual Fund Distributors registered with Association of Mutual Funds in India (AMFI) can only provide basic advice to its mutual funds clients incidental to its distribution activity. Incidental activities with respect to distribution of mutual funds means providing basic advice pertaining to investment in mutual fund schemes limited to such schemes / products being distributed by him to his clients/ investors or any other MF product.

Direct plans in mutual funds were introduced on Jan 1, 2013. More than six years have passed; but a majority of the retail holdings in mutual funds is still in regular plans.The investor pays a real cost for regular plans by way of higher expense ratios.  And this alone can make advice from distributors expensive. Mutual Fund Regular Plans – Pay more for ‘free’ advice This freefincal article analyzes the differences between actual returns of direct and regular plans. Returns & corpus lost to commissions in regular plan mutual funds

While a lot of the mutual fund investments are via regular plans, SEBI continues to focus on the ‘practices’ by distributors. We can reasonably expect more tightening of the space that the distributors enjoy now. If you are satisfied with the services that you receive from your distributor, it is good for you. But please do two things:  a) Look at the gross commission column in the periodic Consolidated Account Statements that you receive  b) Be prepared to face more changes in your operating model

In summary, returns lost due to commissions can make getting advice from distributors more expensive for you.

Advice from ‘fee-based’ planners

Before we talk about RIAs, there is one more category of advisors. They self-describe themselves as IFAs or Financial Planners. There are also RIAs who run a combination of advisory and ‘execution’ services.  In these business models. the investor pays a fee for a financial plan and related advice. The advisor ‘processes’ the investments too and earns a commission from them. This model works on the basis that the investors are not very aware of the various regulations and/or don’t see any issue in investing ‘through’ the financial planner.   Once commissions/incentives are involved, every conflict of interest in the previous sections applies to this model too.  One could argue that this model is worse for the investors than the ‘free advice’ model – at least you get the advice for free in the latter. As recently as Nov 2018, SEBI put out a list of do’s and dont’s for dealing with Investment Advisers

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1.Always deal with SEBI registered Investment Advisers.

2.Check for SEBI registration number. …

4.Pay only advisory fees to your Investment Adviser.   ….

11. Do not deal with unregistered entities.

12.Don’t fall for stock tips offered under the pretext of investment advice.

13.Do not give your money for investment to the Investment Adviser. …

The list gives out clear instructions. Unfortunately a lot of the investors do the complete opposite.

Fiduciary, ‘Fee-only’ Advisors – Revisited

We briefly looked at the Investment Adviser Regulations from SEBI.  The entire regulation can be found here. The language is reasonably simple. Chapter III of the regulations lists these general responsibilities of Investment Advisers.

(1) An investment adviser shall act in a fiduciary capacity towards its clients and shall disclose all conflicts of interests as and when they arise.
(2) An investment adviser shall not receive any consideration by way of remuneration or compensation or in any other form from any person other than the client being advised, in respect of the underlying products or securities for which advice is provided.

(3) An investment adviser shall maintain an arms-length relationship between its activities as an investment adviser and other activities.
(4) An investment adviser which is also engaged in activities other than investment advisory services shall ensure that its investment advisory services are clearly segregated from all its other activities, in the manner as prescribed hereunder.
(5) An investment adviser shall ensure that in case of any conflict of interest of the investment advisory activities with other activities, such conflict of interest shall be disclosed to the client.

no commissions

Courtesy: freefincal

Points 1 and 2 are crystal clear and require the RIA to act as a fiduciary.  An individual RIA can only follow a fee-only business model.

Many firms are Registered Investment Advisers (RIAs).  The regulations allow a company RIA to have other business activities, but they need to be separate. It can be argued that points 3, 4, and 5 give an amount of leeway to companies to bundle multiple activities. In fact this happens in reality. Many mutual fund portals list their RIA number as well as AMFI (distribution) Registration Number side by side.  A real-life statement from a specific firm is below. “XXX provides both advisory services and execution / distribution services however through distinct identifiable divisions. The Client is under no obligation to avail either or both advisory services and execution/distribution services from XXX.”  Theoretically, it is still possible to hold the RIA side of any business to the fiduciary standard and the fee-only model. Practices like this are used by some to argue that individual, stand-alone fee-only planners are more suitable.

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There are quite a few individual, fee-only financial planners in India. Their number is tiny compared to the other kinds of advisors. It is your choice to help this number grow. Mint newspaper runs a great series about once a month where they highlight a financial planner through their clients; you can find the articles here

I am convinced about paid advice, who do I contact?

If you have read this far, you are hopefully motivated to shun free, possibly-biased advice in favor of fee-only advice.  You can read these articles to get a start.

See Also

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