Compensation for personal financial advisors is a hot button topic. A 2015 report from the Obama-era White House put losses to American retirement savings as a result of conflicted advice—the fact that your financial advisor may be acting in his own best interest instead of yours—at approximately $8 billion.
Many countries have started regulating advisor fees in the hope of eliminating bad advice. The logic is appealing. If advisors deceive customers because of contingent fees, then reducing these fees should improve the quality of advice. In my study with co-author, Martin Szydlowski of the University of Minnesota, we show that this simple intuition can be misleading and fee restriction might not improve client welfare.
Understanding conflict of interest
Let’s say that you procure a real estate agent to help you buy a house.
Knowing your agent’s incentives, you might not automatically take everything your agent says as gospel. You will probably enter the relationship knowing you should discount some of what he says because he receives a commission from the sale. For example, if he tells you, “this house is easily worth $400,000” you might mentally subtract a certain amount from his estimate, knowing that the agent receives the commission only if the house is sold and thus he might have incentives to oversell it.
Similarly, in an advisor-client scenario, the advisor receives commissions and fund distribution fees throughout the duration of the relationship, as well as when he or she persuades the client to buy assets. The literature finds that such a conflict of interest results in lower investment returns and affects households’ financial wellbeing. However, it is often assumed that customers are naïve in the sense that they do not understand the incentives of the advisors.
Formalizing the advisor-client relationship
In order to better gauge client welfare in the face of conflicted advice, our study formalized the advisor-client relationship by focusing on the effect of different fee structures on clients’ welfare. Unlike in the literature, our model defined clients as rational in their investment decisions and selection of advisors and considered an environment where advisors competed for clients using information provision. We looked at what happened to the advisor-client relationship under different compensation structures of advisors.
Perhaps surprisingly, our study found regulating advisor fees does not improve client welfare.
When regulators lowered or restricted advisors’ fees, advisors either bumped up their fees or provided lower quality information to clients. We recover a powerful irrelevance result. As the fee structure of advisors changes, clients’ welfare always stays the same. Even moving to a fiduciary duty standard, where advisors are forced to tell the truth and only charge up-front fees, will not improve welfare, as advisors will simply respond by charging a higher fee.
So which kind of regulation is useful? We show that the clients’ welfare is determined by the relative scarcity of advisors with valuable expertise (supply of information) versus clients who are uninformed (demand of information). Financial literacy education, which aims at improving the skills of the least sophisticated clients, changes this ratio. We show that even taking a small set of uninformed clients and making them more informed causes a powerful ripple effect, which improves the welfare for all clients. When seeking to improve the market for advice, regulators should therefore prioritize education.
In summary, we are certainly not saying a conflict of interest is a positive—most individuals entering this relationship inherently understand that at the outset. But in contrast to the conventional wisdom, our study suggests that the real effect of restricted fee structures on client welfare is more complex, that important policy decisions should only be made with that full picture in mind, and that one should be careful in interpreting the empirical evidence.
Read the paper “The Market for Conflicted Advice,” forthcoming in Journal of Finance.
Briana Chang is an associate professor in the Department of Finance, Investment, and Banking at the Wisconsin School of Business.