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Fees or commission - which gives the best value?
31 January 2010
There has been some focus recently on paying fees for advice versus paying commission.
The debate has been sparked by Britain’s Financial Services Authority’s Retail Distribution Review in Britain, while the Irish Financial Regulator touched briefly on the subject in a report on the financial intermediary market in 2008.
The debate, as it has developed, conjures up an image of Irish consumers queuing up at brokerages to spend €250 an hour or more for financial advice. Brokers, on the other hand, are trying to insist that the advice is given without any obligation to pay.
Commission, in 80 per cent or more of cases, costs consumers less than fees, on the basis of standard industry mathematics.
Two questions arise:
* why would brokers exchange a fee income for their expertise for a lower - on average - commission income?
* are people so naive that brokers can pull the wool over their eyes with alarming propensity?
Less than 1 per cent - and significantly less in the life and pensions business - is actually transacted on a zero commission basis. The reality is that commission suits both the consumer and the broker.
Contrary to perception, most fee models that exist in the market are commission-integrated models, for the simple reason that commissions are simple and economic for most consumers. Fees, where they exist currently, are generally the preserve of the upper end of the consumer market or, in the corporate arena, where the size and nature of transactions make fees more economic for the client.
In the first instance, we should examine the role that independent brokers and financial advisers fulfil. It involves defining the financial goals that the client wants to achieve, outlining possibilities - some of which the potential client is unlikely to have been aware of - and obtaining consent to investigate their options.
This is a substantial element of the work for most advisers, yet it is difficult to envisage how most consumers would appreciate the real value of this service and agree a fee for work to be undertaken without the work first being done. It is akin to asking someone to pay a fee before entering a specialised shop without having an understanding of the products and how they may be of benefit.
Fee-charging tends to drive the less well-off consumer into the arms of the banks or other ‘tied’ agents, with an absence of choice and competition. Over the longer term, it can have serious implications for product pricing, product innovation and fund performance.
The Consumer Protection Code covers several ethical general policies, such as demanding that a firm‘‘ acts with due skill, care and diligence in the best interests of its customers’’ and ‘‘does not recklessly, negligently or deliberately mislead a customer as to the real or perceived advantages or disadvantages of any product or service’’. It also directs the disclosure of charges and commissions to consumers in a transparent way.
One point that has been missing from the debate so far is that you can become a victim of greed and unethical behaviour no matter how much you pay for advice or the method by which you pay for it.
Commission is not a gratuity paid to favoured financial advisers which, if removed, would lead to better value for consumers.
The rationale for the commission that insurers and lenders pay to brokers is that it represents the savings they make on the services supplied by the broker. In the absence of the broker, spend on marketing and advertising would increase, and they would have to put people and processes in place to advise and liaise with the customer.
It simply wouldn’t make sense for the broker to charge a fee to the consumer and direct that consumer to complete the business with the insurer or lender. This would lead to a double charge for the consumer as they would pay the adviser and then pay transaction charges to the provider.
Instead, most fee brokers wrap their charges in the commission structure, that is the bill is X less any commission received and X is often suspiciously close to the commission received leading to a charge if you do go ahead with the advice (commission) and charge if you don’t (a fee).
Given the overwhelming preference of Irish consumers for commission over fees and the fact that nearly all fee advisers will use a commission-integrated model, it is difficult to avoid the impression that the fee charge debate is more a channel for the self-promotion of a few brokers. There are also technical factors
driving the selection of commission (finance of adviser fee, convenience, tax relief on personal pensions and so on). These factors mean that, in the event of all other things being equal, consumers will rationally select commission over fees.
But what about commission bias you may well ask? This is where commission variation may lead to an incentive to recommend one product over another.
There are a number of responses to this. In stable markets, commission levels are usually bid to the same or similar levels, representing the marginal value of broker-led sales to the company and the savings they make over doing the business directly.
Secondly, consumers focus on overall value for money, not theoretical incentives; this is why fee-based business is predominantly done for very large investments and pensions where savings might be significant. For the average consumer, fees tend to be more expensive and consequently would remove or reduce access to independent advice. For such people, fees would also remove the option of not accepting a recommendation without payment.
The RDR in Britain has pointed the way to specified adviser charges, which is like a levelling of commissions; the broker will have a set fee which is equalised across all companies and, if the commission is lower with a particular company, it will be balanced by a top up consumer fee. This latter model is currently being studied for its implications for Ireland.
The evidence would suggest that, in the vast majority of cases, commissions will deliver better value to consumers compared to the typical adviser fees discussed by fee-based chargers. The consumer also has the right not to accept the advice and not be liable under a purely commission-based arrangement.
Fees do have advantages in the high premium and corporate advice segments of the market, but even here many arrangements are by way of variation of standard commission arrangements. Product provider bias is an issue in theory but not in practice, and the FSA review in Britain may point the way on dealing with this issue.
Diarmuid Kelly is chief executive of the Professional Insurance Brokers Association. Karl Deeter is operations manager of Irish Mortgage Brokers
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