All the finger-pointing, blame-shifting and mea culpas obscures the underlying problem with what's gone wrong with so many of our financial institutions' failures in the stewardship of clients' hard-earned savings: applying the fundamental test of "client's best interests". And the way in which most of the reward and incentive structures have been set-up – from the top of the governance tree, the board, through to the client-facing financial advisers – has created a conflict of interest that can only compromise the "best interest" test.
We shouldn't be naive about how these financial institutions operate. Whether working in a private sector bank, or superannuation fund, or a financial adviser/manager of a profit-for-member superannuation fund, it is reasonable to expect the adviser will be suggesting products offered by that institution. It's hardly reasonable to expect an adviser from XYZ superannuation fund to suggest a member move their funds to another superannuation fund. Similarly, if a financial institution has investment products that are offered by that institution as well as other institutions, there will be a bias to promoting "home products". It's hard to get away from this reality. Unless financial institutions move away voluntarily or are otherwise precluded from providing these integrated offerings of advice; product and administration.
But as long as we have these integrated offerings by banks; superannuation funds and others, regardless of whether they are for-shareholder profit or for-members profit, the system must have an incentive structure that underpins the "best interest" test. This is missing in our current system. There are (or at least were) some financial advice institutions that base adviser incentives and rewards on client service – such as the delivery of high-quality and "appropriate" advice – not on the amount of business written or funds under advice.
The delivery of financial services that meet the "best interest" test requires a number of things. Firstly it requires recognition that the financial institution has a fiduciary obligation to the individual to whom it is providing financial services, whether advice or insurance, or funds management. There is an overwhelming asymmetry of knowledge favouring the financial institution (and hopefully the adviser, though this is sometimes doubtful) over most individuals. Financial literacy is notoriously poor among the population. Trustees of superannuation funds are aware of their fiduciary obligations (or should be). This obligation should be formally extended to all those who have the stewardship of people's financial affairs. And it must become a core part of the culture of these institutions. A corollary of this fiduciary obligation is that financial advice and related services must be transparent and clearly explained (not dozens of pages of fine-print product disclosure). This fiduciary relationship should create and sustain trust in the financial institution.
Further, individuals offering financial advice and managing the savings of individuals should be subject to professional standards with ongoing compliance monitoring. What this might look like in terms of training, accreditation, supervision and monitoring is something the professional associations and regulators are well-placed to develop and implement – and they must. Financial institutions must put in place a comprehensive, independent program of robust audit of advice provided to clients. This should be done in co-operation with and, perhaps, as an agent of the relevant regulators. This requires considerable investment in systems and technology as well as auditors. This is not cheap. But with hindsight, possibly much cheaper than the costs of remediation and penalties for failure to comply with the regulatory obligations.
A large part of the problem is the incentives that drive senior management; incentives that are put in place by boards. These are heavily weighted towards short-term financial outcomes: earnings growth being one of the major drivers for listed institutions. No matter how much focus there is on other metrics, the short-term financial performance, particularly for listed entities, is the major incentive and the major driver of behaviour. Boards are responsible for governance. They set and evaluate KPIs. It is up to boards to move away from an emphasis on the current KPIs that underpin the behaviours we are seeing. Boards need to focus on the longer-term sustainability of the business as well as driving behaviours that are aligned with the best interests of the client base. These go together; they are not inconsistent.
For a start, boards and senior management should focus on developing lead and lag metrics that measure how client outcomes align with the commitment to the client. They should have regard to the evidence from the independent risk-based audit of advice as to how and whether the fiduciary obligations are being met: the quality of advice and service. They should develop measures as to how well advice aligns with client's risk/reward-based expectations, and, indeed, whether these expectations are realistic and reasonable. And if the institutions can shift the focus of KPIs to appropriate fiduciary tests then perhaps regulators can step back and focus on training, standards and compliance.
There may be more radical solutions to the problems that are now receiving so much attention; such as the forced separation of the provision of advice from the provision of investment product. However, this may not be the most efficient solution. But a very different incentive regime with the right alignment of interests driven by the board plus a strong regulatory framework driven by ASIC and APRA is a good place to start.
By Thomas Parry
2 May 2018
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