Why changes in the finance industry are good news for DIY investors

Since MoneyWeek magazine launched just over ten years ago, one topic has got us more worked up than any other.

I’m not talking about the never-ending British obsession with house prices, nor the general financial illiteracy of our politicians.

I’m talking about commission payments for financial advice.

If you’re new to investing, you may not know what I’m talking about. So let me explain.

Once upon a time, there were two ways to pay for financial advice. Some independent financial advisers (IFAs) charged you upfront. They’d ask for a fee (either an hourly rate, or a percentage of your investment), and in return, they’d tell you where to put your money, and deal with all the admin involved.

But most IFAs were paid via commission. You’d come to them; they would ask you a load of questions about your attitude towards risk; and then they’d tell you where to put your money, and deal with the admin etc.  They didn’t ask you for money, and so it looked like you were getting advice for free.

Of course, those IFAs needed to earn a living too.  So how did they manage it?  Instead of being paid by you, the customer, the IFA would get paid by the company whose funds he recommended you invest in. In other words, he’d get paid a commission for selling certain financial products, such as funds.

Some funds paid more commission to IFAs than others; other categories of financial product – such as exchange-traded funds – paid none at all.

You can already see what the problem is here, can’t you?

If an IFA is offered a 1.5% commission on one product, and 0% on another, which one is he going to recommend? If you were an IFA thinking of your monthly bills that needed paying, which would you choose?

Regardless of your answer, you have to acknowledge that there’s a very clear potential conflict of interest there.

And just to be crystal clear, this commission payment would come out of the money that you had invested. So you were still paying for this financial advice, you just weren’t paying for it in an upfront, transparent manner.

A long overdue change

So one thing MoneyWeek has gone on about for years and years and years, is how potentially corrupting this system was. We even put together a list of ‘fee-only’ financial advisers to encourage those readers who wanted advice to pay for it, to avoid this potential commission bias.

The good news is, this is no longer necessary. Because from next year, the Financial Services Authority is banning commission. The changes are all part of something called the Retail Distribution Review (RDR).

Tedious acronyms are a speciality of the financial industry. It just seems to go with the territory. But ‘RDR’ is worth paying attention to.

In essence, the changes are simple: financial advisers won’t be allowed to take commission payments, so they’ll all have to charge upfront for advice. That’ll make it clear how much you are paying for advice, and what you’re getting for it.

Secondly, financial advisors will also have to be better qualified than they once were. That means that you should – hopefully – be able to expect a minimum standard of service and knowledge from your adviser.

You might think that this is how things should always have been. And you’d be right. But let’s just be grateful the change is happening now.

Why RDR is good news for DIY investors

You might also be thinking: why should I care about any of this? I’m taking charge of my own money.

However, RDR is good news for go-it-alone investors too. Why? Because now the whole fund management industry will be under pressure to cut its fees.

Under the old business model, most people in Britain bought funds through financial advisers. So if fund management groups wanted to attract more business, the most obvious thing to do was to pay higher commissions.

In effect, much of the financial advisory business was operating as a freelance sales force for the fund management companies. This is one reason why fees for fund management had remained so stubbornly high in Britain, despite apparently rampant competition in the market.

Now that is changing. Financial advisers will now be getting their money direct from their customers, rather than via the fund management groups. That makes it very clear where their interests lie: in keeping the customer happy.

It’s a lot easier to bill someone a few hundred pounds for your advice every quarter if you can point to their portfolio and demonstrate that you more than made that money back for them during the period.

Financial advisers aren’t daft. Like the rest of us, they know that you can’t predict the future. But you can keep your costs down. So if you’re hoping to make a decent return on your money over the long run, that’s where you should start.

So the smart advisers – the ones who will survive under the new regime – will be looking for all the same things that smart DIY investors will be looking for.

They’ll want to see low costs; they’ll favour cheap passive investments over expensive active ones; if they do take the risk of paying up for active management, they’ll want evidence that the manager is actually adding some value.

And if fund management companies want to stay in business, they’ll have to provide these things.

Three questions to ask before you buy any financial product

Don’t think this means you can let your guard down.

The financial industry is like any other business – it wants to sell you stuff; as much stuff as possible. You, on the other hand, just want to save and invest enough money to provide for a decent retirement, and to meet your other goals.

These two aims occasionally overlap – you’d think that the best way to retain a customer’s business would be to help them grow their money in a sustainable manner – but a lot of the time, they don’t.

(This is not always the financial industry’s fault – check out this story from US fund manager Jeremy Grantham to see how fickle investors often shoot themselves in the foot).

There’s no point in getting worked up about this. RDR will help a lot, but it will never be easy to make the incentives of the financial industry line up with the incentives of customers.

If you buy a TV and it stops working, you can take it back to the shop. If you buy a financial product, the trouble is that you usually won’t know if it’s ‘working’ or not until years down the line.

So always remember. Before you invest in anything, or buy any financial service, ask yourself:

• Does this product do what I want it to?

• Is it the cheapest way of getting what I want?

• If I am paying for something over and above the basic service, is it worth it?

These are the questions that good IFAs will be asking on the behalf of their customers. You should ask yourself the same ones.

• This article is taken from our beginners’ guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here

  • David Craig

    I expect funds and IFAs will find a way around the new RDR rules. For example, funds might pay advisers lump sums at the end of each year based on how much clients’ money IFAs put their way. As we have seen many times, nobody is as inventive as a financial institution when faced with new regulations

  • jimtaylor

    The RDR relates to new money invested after 01 January 2013 but, as I understand it, all the existing investments will be unaffected so the IFAs will still continue to receive commission year after year from the investments that were sold prior to RDR, even in the many cases when no advice was ever given.

  • wildbloodhawk

    Thank you for your article on RDR. As somebody who worked in the commission only financial services sector unlike my self I have seen some financial advisors”” /salesmen selling anything that gave the best commission and convincing clients to cancel insurance policies at a loss by convincing the client they would benefit with the new one. My conscience is clear and I guess the others never had a conscience. It made me sick how salesmen were brainwashed to sell the highest commission products. there were those who thought they were doing the right thing even though it tuned out to be the opposite

  • sysdevman

    How will this affect fund supermarkets and DIY ISA and SIPP accounts held with the likes of Fastrade and Hargreaves Lansdown etc?

  • Iago

    RDR is Music to my ears, but sadly at 66 I have already made a significant contribution to the wealth of the financial services industry, with little return to my pocket in recent years. In collusion with government the financial services industry has enjoyed the perfect business proposition: ‘I will take your money and invest it on your behalf. After extracting my not inconsiderable charges, I will give you what is left of the profit. If there is no profit, I will take my charges regardless’
    People capable of orchestrating the perfect ‘legitimate’ scam will find many ways to circumvent RDR!

  • Roger Bishop jones

    Another aspect of opacity which I would like to see MoneyWeek campaigning on is the currency exchange costs involved in investing in overseas markets.
    My broker not only hides these costs, but also contrives to frustrate avoidance by sometimes not selling a stirling denominated ETF but redirecting clients to the dollar denominated version.

    Also, for trading on US exchanges I ought to be able to use a dollar account so that selling one US stock and buying another involves no currency exchange, but I can’t find anyone who does that, and US brokers don’t see to take UK customers.

    Cheap commissions are pretty irrelevant if the cost of buying and selling a foreign stock involves a 3% currency exchange siphon.

    A recent moneyweek article highlighted the currency exchange issue and then went on to list the merits of brokers without revealing the currency exchange charges they made.