Fees and Bias in Financial Advice
Most of us rely on recommendations from brokers and other financial advisers when making important decisions about purchasing financial services such as mortgages, consumer credit, life insurance, and investment products. But, do we get impartial advice from these financial intermediaries? What are the consequences when financial brokers' impartiality is compromised? What role is there for regulation to improve matters?
To better understand such important questions, Marco Ottaviani (Bocconi University) and Roman Inderst (Goethe Universitaet Frankfurt and Imperial College London), in their recent paper How (Not) to Pay for Advice: A Framework for Consumer Financial Protection (Journal of Financial Economics, Volume 105, Issue 2, Agosto 2012, doi: 10.1016/j.jfineco.2012.01.006), study the determinants of the compensation structure for brokers advising customers on the suitability of financial products. The model explains why brokers often receive contingent commissions from product providers, even though such a compensation scheme might be at odds with unbiased advice.
In the absence of regulation, the market outcome depends on whether the customers are naïve or not. If customers wrongly believe that they receive unbiased advice, product providers charge high product prices and give high commissions to advisers so as to exploit customers. Instead, when customers understand advisers' conflict of interest, contingent commissions might induce the advisers to discover which specialized product fits best the specific needs of customers.
When customers are wary about the advisors' incentives and sufficiently flexible contracting is allowed, product providers are able to commit not to pay secret inducements to advisors that would bias advice, and this can be achieved when a low price is charged for the product. Then, advisers charge wary customers a high fixed fee, which, in turn, is transferred to product providers. Through such a mechanism advisers and product providers jointly maximize profit.
However, and more realistically, when customers are naïve and fail to take into consideration the potentially self-interested nature of advice, the fee structure is no longer efficient. Product providers exploit naïve customers by implementing a compensation scheme with a lower upfront charge for advice and a higher final price. In equilibrium, customers are subject to biased advice and higher product prices in the form of higher management fees on investment product.
The analysis provides a simple rationale for policy intervention, but also cautions about potential pitfalls. Given a mixed population of naïve and wary customers, mandating disclosure of commissions protects naïve customers and improves social welfare, provided that disclosure turns otherwise naïve customers into wary customers. However, prohibiting or capping commissions could have the unintended consequence of stifling the advisers' incentive to acquire information.